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Fatal Flaws and Opportunities in Gold Investing: Brent Cook
Source: Brian Sylvester of The Gold Report (3/28/12)
Brent Cook, editor of Exploration Insights, describes the past 15 years of change in gold, copper and iron. In this exclusive interview with The Gold Report, he shares what he sees as the fatal flaws and opportunities in this complex industry, details the most important factors he looks for before investing, and names companies he believes have the right stuff.
Brent Cook: During 1997–2002, we were probably in the most unloved sector in the whole investment world. Gold had collapsed to less than $250/ounce (oz), copper was under $0.85/pound (lb) and anything that didn't have a dot-com to its name didn't get much respect. The idea of blowing up rocks to make metal out of them was an archaic concept clung to by the remnants of the industrial revolution; it was a brave new world. By contrast, today gold is over $1,600/oz, copper is $3.80/lb and iron ore has gone from $12/ton (t), to $140/t; we're in the 10th year of a commodities boom. Back then, it was very difficult for mining companies to raise money.
Working with Rick, I was fortunate. He'd put together two funds of about $14 million (M), so we had some money. We were pretty much alone in the sector, hence we were able to put some money into really good projects and people. So in retrospect, that was one of the best times of all to be investing, but at the time, it felt horrible in that we'd invest in these companies that we thought were a good value and see the share price continue to fall for a year or so. We were able to buy a company like Virginia Gold Mines Inc. [now Virginia Mines Inc. (VGQ:TSX)] for nearly cash in the bank yet watch it fall to a 20% discount to that cash, and this was a company run by one of the top guys in the industry, Andre Gaumond. Today, however, you have a lot of money chasing everything in this sector, and it's subsequently tougher to get real bargains on projects or people. It's important to recognize that because this is such a risky investment sector that to make money at it consistently, you need to buy companies when they are cheap based on legitimate valuation metrics.
TGR: Is it more difficult for a retail investor to make money today in small-cap mining equities or was it more difficult then?
BC: Both time frames have their challenges. It's always been about finding quality, high-margin mining projects at any stage and buying those at less than what they're worth. A high-margin deposit is one whose cost of production is in the bottom third of the total production costs curve for that metal. Say the average cash cost to produce one ounce of gold is $700—ideally you want to own properties that can produce substantially below that cost.
There have been periods in this sector where all the turkeys flew and everybody made money, but we're back to a period where it's going to be tougher for retail investors to make money if they're not very selective and knowledgeable about what they're buying. The big difference between the late 1990s to early 2000s and now is there's so much more information immediately available to anyone interested, therefore, investors have to research and understand the details of a mineral project before they buy. They need to know why they're buying it, what they expect, what it could be worth and what the fatal flaws might be. This level of due diligence is critical because we know that most mineral projects are eventually going to fail. That's a fact of nature and the Earth's evolution. So, in a way, it's a bit tougher now, because you need to be so much more educated on what it is you're actually buying. Following the stuff that comes in the mailbox doesn't work anymore.
TGR: What are the most typical fatal, or tragic, flaws that are going to lower a share price?
BC: More often than not, it's the realization that after the first few good drill holes into a project you start putting it together and the geology or the continuity doesn't hang together. Bear in mind that it costs money to mine waste and a mine is a terrible thing to waste.
Another typical flaw is metallurgy or metal recovery. You want to find out as much as you can about the metallurgy as soon as you can because that factors heavily into what your production costs are going to be. For instance, is the ore oxidize, sulfide, carbonaceous, refractory etc.? If you're dealing with Carlin-style sulfide gold mineralization, you immediately know that somehow the sulfide has to be broken down to allow recovery of the gold. That's going to take a roaster or an autoclave of some sort, which is extremely expensive to build and consumes considerable energy. If the project is in the Yukon, an investor has to think about the cost of building an autoclave or roaster. That means the grade has to be quite high to cover the capital expenditures (capex) and power costs. However, in Nevada there is excess capacity for refractory ores, you don't have to factor in the cost of an autoclave.
TGR: You were recently at the annual Prospectors & Developers Association of Canada mining conference in Toronto. More than 600 companies had booths at that event. What are some trends you noticed?
BC: Companies are starting to recognize that it's not so much about size as quality of mineral deposits. Grade, or more succinctly margin, is getting more and more important. There are a lot of very large, low-grade deposits out there, and the majors aren't buying these. That's a real issue and you have to question why. If the majors don't buy them, these junior companies with these large, low-grade, low-margin deposits are then doomed to build. I think it's going to be tough to raise the money, or at least the debt portion, to do that. So I think one trend is toward smaller, higher grade, higher margin deposits.
There are still people out there trying to raise money on new deals, new projects as they move from one busted company to the next one. Unfortunately, for companies with average properties, the music has stopped and they are facing terrible share dilution to fund the exploration on their average projects. As I said earlier, average ain't going to cut it this year.
There is also a severe shortage of technically qualified people—resource estimators, mining engineers, geologists—to do the work. Company presidents and VPs of exploration are in strong demand. Because there is more work than qualified people, I'm seeing a lot of sloppy preliminary economic analysis (PEAs) and resource reports. That's a serious and financially dangerous trend. You can no longer blindly rely on a company's scoping study or its PEA. You need to look at the details. I could tell you some pretty scary stories in this regard.
TGR: What are some of the sloppy things that you're noticing?
BC: In resource estimates, there is a tendency toward plugging it all into a computer and generating a model without going through the time and detail it takes to fit the model to the geology and structural controls. So grade is being put out into an area of the deposit where there isn't actually that grade. If these mines eventually go into production or they get down to the very detailed work, these resource estimates are going to be cut back significantly because the model is not honoring the geology or the geostatistics. That's a serious issue I'm seeing. To quote a friend of mine who does resource estimates, these are "faith-based estimates."
TGR: Do you think that sort of shoddy work is responsible for some of these one-mine or two-mine operations not performing as well as expected?
BC: Definitely, although we have to bear in mind that they are called estimates for a reason. It's rare these days that a company goes into production and its production costs are what they were supposed to be according to their PEA and the literature they used to raise money. Nevsun Resources Ltd. (NSU:TSX; NSU:NYSE.A) at its Bisha mine in Eritrea had to cut its gold reserves by about one-third because of a mistake in the resource estimate that related to how poor core recovery was handled in the estimate. Remember, in a resource estimate we are extrapolating a small amount of data, basically a 3-inch tube of core, across hundreds of feet of complex rock and assuming that we can know the grade of that rock. There’s bound to be some uncertainty.
TGR: While you were in Toronto, you made an appearance on BNN where you discussed the lack of big discoveries over the last 17 years. One chart that you used showed that in 1992, the mining industry discovered roughly 100 million ounces (Moz) gold in both copper-gold and primary gold deposits but by 2009 that amount had dropped to about 23 Moz in both types of deposits despite the fact that the industry was spending almost $5 billion (B) annually on exploration. Tell us about that.
BC: That data was put out by Barrick Gold Corp. (ABX:TSX; ABX:NYSE), so it's pretty good data that pertains to economic deposits. It shows that over time we are discovering fewer large deposits. Basically, we are mining about 83 Moz gold annually yet only finding in the order of 20–30 Moz a year. So there's a serious gap between production and discovery that we're not filling.
It's getting harder and harder to find quality deposits—and we're talking economic deposits here, not resources that will never make it. Explorationists have pretty well explored most of the Earth's surface and then some. Therefore, it's also getting more expensive because we're going into blind areas and drilling deeper into more complex geologic settings. That is why it's getting tougher to find these big deposits. Then add to the increased geological difficulty the fact that social, political and environmental realities are pushing way out the time to permit and build a mine and it becomes pretty easy to understand the decreased discovery rate. I don't see that changing.
The net result of this discovery gap is that when a company, let's hope it's a junior company, finds a legitimate, high-margin economic deposit, it is going to be worth a lot more money than you would normally expect. The dearth of new discoveries means that those of us who invested early in a company that proves up an economic deposit stand to make some serious change. So now I'm focusing, as best I can, on high-margin deposits, or at least mineral systems that show the potential to produce those deposits and mostly avoiding geologic setting that don't offer that shot at a home run.
TGR: Another reason for the lack of discoveries is the high cost of mining, which has gone up dramatically over the last four or five years, given fuel costs and labor costs.
BC: Yes. In 2004, the capex to build Cerro Casale was $1.4B. In 2011, it's $6B. That's a huge increase in capital costs that throws a lot of uncertainty onto any big capex project a company is considering. That's happening across the board. Your average cash cost to produce one ounce of gold 10 years ago was on the order of $340/oz. Today, cash costs alone are closer to $740/oz and your all-in costs, according to a Randgold Resources Ltd. presentation (GOLD:NASDAQ), are closer to $1,200/oz. Cash costs are just what it costs to produce at the mine. They don't include exploration, depreciation, amortization, royalties, G&A etc.; so it's gotten a lot more expensive to produce all metals.
TGR: How would you respond to someone who says it's easier said than done to find early-stage companies with drill results that hint at the potential for high-margin, multimillion-ounce deposits that majors want to buy?
BC: I agree 100%. It is hard to find projects in an early stage that offer the potential of coming up with a major deposit that shows the profit margins and the size that a major company needs to buy. That's just a function of geology. As the Earth evolves it changes and those changes are recorded as anomalies in the earth's surface. A volcano forms, erupts a few times, cools down and is covered by the next volcano, over and over again. This process is responsible for millions of geochemical and geophysical anomalies that provide the stories the Vancouver resource market is founded upon. However, very few of these anomalies combine the right geological, geochemical and hydrological characteristics to produce a concentration of metal that has the tons, grade and metallurgy located near surface in a favorable jurisdiction to form an economic deposit.
TGR: If there aren't enough early-stage, potentially high-margin deposits, won't companies take the large, low-grade deposits just because that's what's available, and they'd bank on rising metal prices to make those deposits worthwhile?
BC: That's a valid point and investment strategy. It's a different investment thesis than I go with, but certainly there are a lot of these large, low-grade deposits that are marginally economic at $1,500/oz gold. If your gold price assumption is $3,000/oz, then these are the things to buy. In my personal portfolio, I don't need 100 companies—I need 10 that have something that I think is of a high enough margin to be economic today.
Lydian International Ltd. (LYD:TSX) is a company that I've owned since I first visited the property. At that time, it was $0.76/share. It's now about $2.45/share. Lydian owns a nice, simple, high-margin deposit in Armenia. Once the world starts to recognize that Armenia is a good place to do business, then this gets bought by a midtier company. It has about 3 Moz. I reckon its cash costs are about $500/oz. The capex isn't too bad. So that's a deposit that I see out there that offers the margin that a company needs to make money on, and it's selling at a discount today.
Atna Resources Ltd. (ATN:TSX) looks like an interesting company, as well. Its Pinson mine is a good grade deposit, and it should be able to produce at a decent price. So you have a decent, high-margin deposit there. Its capital costs are virtually nil because the infrastructure is there and there are a number of options to ship the ore to, so its capex is minor.
Altius Minerals Corporation (ALS:TSX.V) is a great prospect-generating company that's been incredibly successful. It owns about 32% of Alderon Iron Ore Corp. (ADV:TSX; AXX:NYSE.A; ALDFF:OTCQX); at a cost basis of about $2M, it's now worth about $100M. Alderon owns an iron deposit in Newfoundland that is a good high-margin deposit. Again, the infrastructure costs are low because it is right in an iron-mining district. I think Alderon has a deposit that somebody else will either buy one day or work out a favorable offtake agreement. So you can buy Altius at a slight discount to its cash, royalties and equity holdings and get a management team that has grown a $20M micro-cap company to about $340M with virtually no share dilution. You're paying nothing for the upside in Altius, which sort of reminds me of the good old days in the late '90s.
One way to better your odds at finding a true deposit is to invest in the prospect-generator companies. These are tiny exploration companies that recognize the long odds at success and structure their business models accordingly. They're very good at generating ideas for mineral deposits, but at the point it's time to start spending big dollars on drilling, they bring in somebody else to spend the money. So your financial risk is cut down quite a bit, and the high-risk, high-dollar part of it is covered by somebody else. These companies go on and generate new ideas and new targets and bring in new partners, thereby providing shareholders with many more shots at a discovery for your buck. One of the companies doing that quite well now is called Riverside Resources Inc. (RRI:TSX).
TGR: It has an agreement with Chile's Antofagasta Plc (ANTO:LSE) in British Columbia and one with a steelmaker, Cliffs Natural Resources Inc. (CLF:NYSE) in Mexico.
BC: Exactly. And it has other projects being worked by smaller partners. It has on the order of $10M in the bank plus about $2–3M in equities. Again, $12M has been spent on its properties this year, and its market cap is on the order of $30M.
TGR: In those companies, you need above-average management teams because you have to foster all these different relationships and manage all these different relationships.
BC: Exactly. Eurasian Minerals Inc. (EMX:TSX.V) is another company that has done an exceptional job with that. It has on the order of $35M in the bank. It just bought a royalty that's going to bring it $7M/year, and it has projects in Turkey, Scandinavia, western U.S., Haiti and Australia that are being worked by major companies, including Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE), Newmont Mining Corp. (NEM:NYSE) and Centamin Plc (CEE:TSX; CEY:LSE)—companies that are looking for major deposits.
TGR: Having a paying royalty often is key, too. When you were on BNN, you talked about Virginia Mines Inc.; its royalty on the Eleanore mine is being developed by Goldcorp Inc. (G:TSX; GG:NYSE). Does Riverside have a royalty that could start paying in the near future?
BC: Riverside does have a callback to a royalty on its projects but, at present, none of them is producing any money. The company does, however, make money in many of the deals it structures by way of shares and management contracts. This income covers a fair portion of its general and administrative expenses. So it makes money back on these deals by working the project. Really smart.
TGR: What about Gold Standard Ventures Corp. (GV:TSX.V; GDVXF:OTCQX)?
BC: We're going back to high-margin deposits, or at least high-margin potential. Gold Standard's property is on the Carlin Trend and is a major, very large, Carlin-style gold system. The key to making a big deposit is having a big system—a simple concept that is all too often ignored. Gold Standard's most recent drill hole intercepted potentially economic mineralization over 43 meters. If it's successful, this is a deposit that is big enough and high margin enough to attract the attention of Newmont Mining or Barrick or anyone, for that matter.
This is the important part about why I bought Gold Standard. It's not because of the next few drill holes. It's because we recognize we're into a system that's large enough to produce a mineral deposit, and we know now that this geologic system can produce the grades we need to see. So, it's still going to be a hit-and-miss exercise until the geologists can do the science well enough to find the exact core of the deposit, if it's there. The next results might be fantastic; they might be just encouraging. But we know we're into a big system. You stick with big systems.
TGR: Do you have any parting thoughts for us, in terms of what retail investors should be on the lookout for throughout the rest of this year?
BC: It's going to be, in general, a tough market to make money in if you're just throwing darts. You really have to have a handle on what a company's looking for in terms of deposit type and what that deposit is worth in terms of a net present value on the deposit, if it is successful. Too many companies are out there exploring projects that even if they're successful, the real values aren't worth the risk it took looking for it. So stick with intelligent management looking for high-margin or large deposits. The junior mining and exploration business is such a technical and complex science and industry populated by paid touts, scam artists and people of dubious character, that it is well worth the effort to get good, honest advice. And be very selective in what you buy.
TGR: That sounds like great advice. Thank you.
Read Rick Rule's strategy for taking advantage of volatile precious metals markets here.
Brent Cook brings more than 30 years of experience to his role as a geologist, consultant and investment adviser. His knowledge spans all areas of the mining business, from the conceptual stage through detailed technical and financial modeling related to mine development and production. Cook's weekly Exploration Insights newsletter focuses on early discovery, high-reward opportunities, primarily among junior mining and exploration companies.
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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Lydian International Ltd., Alderon Iron Ore Corp., Riverside Resources Inc., Goldcorp Inc., Gold Standard Ventures Corp. Streetwise Reports does not accept stock in exchange for services.
3) Brent Cook: I personally and/or my family own shares of the following companies mentioned in this interview: Lydian International Ltd., Riverside Resources Inc., Virginia Mines Inc., Gold Standard Venture Corp., Atna Resources Ltd., Eurasian Minerals Inc., Altius Minerals Corp. Alderon Iron Ore Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.