Making the grade: how to spot mining winners

But delve a little deeper, and you'll find that most mining companies stumble at the very first hurdle. In fact, less than 1 per cent of all exploration projects end up becoming a mine. That's because finding an economic mineral deposit - that is, one that could realistically make money at a range of commodity prices - is exceptionally difficult and time-consuming.

Be under no illusions, most junior exploration companies will ultimately fail and will eventually go bust. Not only does it take an average of around 10 years to turn a new exploration prospect into a mine - although it sometimes can take significantly less - it also requires a lot of money and a lot of guesswork along the way.

To help put the difficulties in perspective, let's briefly look at the general exploration process itself. While there are a vast number of supplementary exploration techniques, the only real way to determine if a project hosts metals in economic concentrations underground is to use a diamond drill - colloquially known as a 'truth machine' - to drill several two-inch wide holes in the ground up to several hundred metres deep. Thin slices of rock are then brought up and small representative samples are tested for metal content. The ensuing value is then extrapolated to include the 10, 25 or 50 metres nearby for which there is no data until the next two-inch drill hole. Companies then pay independent firms to estimate how much metal is in the ground and create a mine plan in order to get it out. All this happens over years, amid often volatile commodity prices and local governments. What could possibly go wrong along the way?

As you can imagine, there is a plethora of factors that can make even the most promising deposit virtually unminable. Investors need to determine if a project has any of these as quickly as possible, and get out. Conversely, they can also use them to help determine the few projects out there that have none of them - and therefore find the ones most likely to succeed. These factors are what geologist Brent Cook calls the potential "fatal flaws" of early-stage exploration projects. He is the author of mining newsletter Exploration Insights and, with decades of field experience in over 60 countries, we reference his work for some of the more technical and geological aspects of this article.

The good news is that it's precisely because the exploration process is so challenging that good-quality deposits are in such rare supply - and thereby in high demand - and why finding and proving up an economic deposit is the key focus of so much of the mining sector. Junior mining companies need to find one in order to build their first mine and create cash flow, while major and mid-tier miners similarly need to discover or acquire them so as to grow or replace current production.

If they do it successfully, companies and their shareholders stand to be rewarded handsomely for their effort, patience and risk tolerance - occasionally securing 10-fold gains or more.

Below, we lay out a 10-point checklist that investors can use to evaluate junior mining plays. You don't have to be a geologist to use this, either - you just have to be willing to put in a bit of extra research and ask the right questions.

JUNIOR MINING CHECKLIST

1) The big picture

First, try to get a general sense of the project area's geology, including what minerals the region is most prospective for and what type of deposit the company believes it has. Understanding the basic geological context can be helpful in interpreting drill results and advances in exploration.

For example, is the company looking for a high-grade epithermal gold deposit in an area of active volcanism, where gold grades can often be high - meaning less ore is required - but also highly variable? Or is it exploring a low-grade copper porphyry system, where it needs to prove up a huge resource in order to make up for the low grades and justify the large capital expenditure required to build a big enough mine? Getting a rough idea of the basics will help with everything else. This information can easily be found on decent companies’ websites and in technical reports compiled by independent consultants, depending on the level of exploration already conducted on the property.

2) Grades

Finding a huge, high-grade deposit may be every mining company's dream, but in reality positive drill results often come in many shapes and sizes. It can be frustratingly difficult for investors to determine which grades - by this we mean the amount of metal contained in ore – are good and which are so-so. Bad grades, on the other hand, are often easier to determine: they tend to involve very low metal content over very small intervals.

It would be nice if we could say one gram of gold per tonne of rock is bad, 10 grams of gold per tonne is good. But as we see in the following example made by Mr Cook in one of his newsletters, it’s all about the cost of getting the mineral out of the ground – and high grades can sometimes be misleading:

This is because the ore from Fresnillo's near-surface Herradura deposit is very homogenous, easy to access and cheap to process. Great Basin Gold's Hollister deposit, on the other hand, is located much deeper underground, requiring expensive underground mining machines. The gold there is also hosted in thin veins averaging about 0.7 metre thick that are surrounded by waste rock, so the company has to very selectively drill, blast and dig the good material out, all adding to costs.

In the end, the key is to figure out what grades are good for different types of mining operations. One way to check is to ask management for geologically similar deposits and cross-reference the grades of comparable projects that have become successful mines. You can also search online for mines producing the same metal(s) in the same country, but remember, many other factors – for example, proximity to infrastructure – can come into play.

3) Size

Behind grade, size is the second most important factor in determining a deposit’s economic viability. Because the costs of building a mine are so immense - usually in the tens or hundreds of millions of pounds, but often in the billions - a deposit needs to reach a certain size before a long-term construction decision can be made.

There is no standard size used by the industry, as each company uses a different set of financial criteria to judge the merits of their projects and each deposit itself is unique. But, broadly speaking, the higher the grade, the less big the deposit has to be. The right deposit size also depends on whether the junior company plans on bringing it to production itself, or hopes to sell it on to a major. A 1m-2m ounce gold deposit might be large enough for a junior company to develop on its own, but the magic number for major gold mining acquisitions these days is 5m ounces of gold or more.

Care should also be taken here to distinguish between different resource estimate classifications. Proven and probable reserves are worth much more to mining companies than the equivalent or greater amount of inferred resources (the lowest classification which requires much less confidence to estimate).

4) The right kind of rocks?

Digging a bunch of rocks out of the ground is one thing, but extracting metal from those rocks can be an entirely more difficult and expensive procedure. This is because the valuable minerals hosted within ore are sometimes intricately joined to the rock that is waste, making them difficult to separate. Other times, they can be separated by merely smashing up the rock or sprinkling it with chemicals. In other words, all rocks are not created equal.

Metallurgy - the science that deals with extracting metals from ore - is one of the most important but least focused-on variables in junior mining plays. And it needs to be looked at as early as possible in the course of exploration. Poor metallurgy, or poor recovery of metals from host rocks, is often a killer for even the most promising of projects. Take the Bakrychik gold deposit, for example, one of several high-grade projects owned by Canada's Ivanhoe Mines, described below by Mr Cook.

So what gives?

The primary issue comes down to the properties of the host rock and how the gold is tied up in the mineral crystal lattice. The ore at Bakrychik is encapsulated within the matrix of the sulphide minerals (arsenopyrite and pyrite). The sulphide minerals are hosted in a nasty black shale, containing 4 per cent carbon. Both the gold encapsulation and the carbon make recovery of the gold extremely difficult (double-refractory).

The recovery gold process at Bakrychik requires the building of a complex flotation plant and roaster [capable of heating the ore to 700°C]. These are significant up-front capital cost items. Additionally, roasting the ore is a very energy-intensive process: hence, costly. Every step in the procedure necessitates additional equipment, labour and materials, thus increasing the cost to produce an ounce of gold. In summary, our apparently high-grade deposit becomes marginally economic once we add in all the costs and effort it takes to actually recover the gold.

In summary, there are two main factors concerning metallurgy that investors need to figure out. First, what are the potential recovery rates from the ore? And second, but more importantly, is it going to cost a lot, or relatively little, for the company to get them out? As Mr Cook counsels: "Solid, legitimate companies begin preliminary metallurgical work as soon as they have a feel for what the ore types and distribution within a deposit may be. Speculators had better come to grips with metallurgy as well, or face the wrong side of the value curve."

5) Waste versus ore

Dilution. Strip ratio. Grade distribution. Orebody continuity. These are all subtle factors that affect how much waste rock a company has to deal with (costing the company money) versus how much ore it can mine (making the company money). In some cases, just one of these factors can make a deposit uneconomic to mine (imagine a low-grade, large-tonnage deposit unfortunately located underneath a small mountain - the high strip ratio required in moving all that earth to get to the orebody would likely render the deposit unminable as an open pit).

These variables can be difficult for average investors to quantify so questioning management or your brokerage firm’s mining analyst about them can help you get a more complete picture of the deposit.

Another thing to watch out for here is 'grade smearing', whereby companies will report misleadingly positive drill results in press releases. They do this by spreading the value of a small but very high-grade section of mineralisation over a much wider interval that includes waste rock to create the illusion of longer intervals of good-quality ore. Here, investors should take a close look at the assay results in the press release, in order to check for outlier grades contained in small sections of a drill hole. If the press release doesn't include them, it's not necessarily a bad sign - the distribution of metal could be fairly homogeneous - but it could spell trouble.

6) Location, location, location

What we really mean here is: does a project have access to infrastructure? Take Alternative Investment Market-traded Afferro Mining, for example. It has discovered a nice, big iron ore project named Nkout in Cameroon, but the project is stranded more than 200 miles from a deep-water port on West Africa's coast. A preliminary economic study pegged the net present value of the project at $4.6bn (£2.9bn), and yet the market capitalisation of Afferro today is a mere £56m - even less than the company's current cash holdings plus expected payments. Why? Because the whole project depends on a railway and port being built to ship all that heavy iron ore to China for processing. That means getting other companies to pay for infrastructure, which causes delays and entails a considerable amount of negotiation. Building these can be done, but often it costs billions of dollars, which junior mining companies simply do not have and usually cannot raise.

Other questions around location also arise for junior miners. Is there access to reliable electricity, or will the company have to put in expensive diesel generators, increasing both capital and operating costs? Are there good-quality haul roads to bring in equipment? Is the deposit located near the top of an inaccessible mountain, or in harsh Arctic tundra? Is there access to water and a sizeable local workforce? All these factors affect the market value of the deposit and the company. With commodity prices near historical highs, many infrastructure problems can be overcome with the corresponding improved economics - but not all, especially with costs spiralling ever upward. Much of the information investors need to get a good idea of infrastructure challenges should be relatively easy to find out and is often detailed in technical reports and decent companies' websites - although if you're really keen, you could always try to find satellite pictures of the project area on Google Earth.

7) Political risk and permitting

The inherent long-term nature of mining, and the fact that from the moment a mine is built it cannot be moved, means a construction decision is made with security of investment top of mind. However, with fewer and fewer high-quality discoveries being made in more traditional mining regions, exploration is being pushed farther into riskier regions than ever before despite long histories of instability. This means assets located in safer jurisdictions, such as North America, Chile or Australia, for example, demand a premium in the market as the majority of major miners avoid purchasing deposits in countries popularly deemed too risky to operate in. Understanding and minimising political risk is key to a solid investment strategy - most fund managers we talk to avoid buying shares in companies that operate in jurisdictions with really high risk, although junior miners are inherently risky anyway and we tend to judge each company on a case-by-case basis.

An equally large risk for new mining ventures these days is posed by the extensive regulatory framework in traditional mining regions. The process is not only time-consuming - taking years, not months - but can be very costly, often including 3,000-plus-page environmental studies and requiring dozens of separate permits. Investors need to take this into account when looking at companies' time horizons for development.

8) Stakeholders

In these pluralist times, nearly everyone - no matter the distance from the affected area - is considered a stakeholder in projects and has to have a say in their development. This is all well and good, but investors need to be careful of projects in developing countries as popular opinion can quickly and violently overcome engineering advancements and careful planning, shutting down operations very quickly, especially if there are concerns about water contamination. Western countries are not excluded from this: aboriginal groups, agricultural groups or environmental NGOs can tie up projects in the courts, blockade access routes or lobby governments.

9) Management track record

Ideally, you should look for management teams and directors who have plenty of experience in the region and specific metal where a junior company is exploring. And preferably, ones that have already successfully built and operated a mine, and thus know what it takes to build another. The chief executive doesn't have to be a mining engineer - some of the most successful promoters aren't - but he or she will hopefully have been involved in the sale of an important asset or company to a major. Either that, or worked for a major miner in a key role.

10) Financial matters

Diluting shareholders is almost inevitable for junior mining companies. But some tend to haemorrhage shares more than issue them selectively and have little regard for smaller investors. As the time horizons involved in developing a project are so long, investors need to be wary of micro-cap explorers that could have trouble raising further capital or do so at very depressed share prices. A tight float can mean less liquidity, but fewer shares need to be issued to help pay for necessary exploration.

If management has a large shareholding in the company, so much the better. But make sure to find out how much they paid for their shares and if they've sold any in the past year. Field visits, drilling costs, resource estimates and feasibility studies all suck up valuable capital quickly. We like to see companies with enough money to carry out their stated exploration programme and then some, or be able to go at least a year without raising more capital.

Finally, is the commodity the company is exploring for currently in demand? Does the commodity have strong fundamentals in place for continued upside? Likewise, are shares of the exploration company considered cheap? Determining the value of a deposit is no easy feat, with months of work and millions of dollars spent on feasibility studies trying to answer exactly that question. But, as we have discussed, it all comes down to the potential profitability of the deposit and how much it will cost to get the metal out of the ground. If you can get a good understanding of that equation, then you've figured out how to profit from junior mining shares.

THREE THAT MAKE THE GRADE

Aureus Mining (AUE)

Run by experienced mine finder David Reading - who took European Goldfields from a market capitalisation of £50m to over £1bn - Aureus's New Liberty gold project in Liberia ticks almost all the right boxes. It boasts a relatively small, but sizeable, high-grade gold resource totalling 2.6m ounces across all resource categories. A recently released feasibility study demonstrated pleasing economics at $1,400 an ounce gold and the project is fully permitted. The high strip ratio leaves something to be desired, but the higher than average grades and near-surface nature of the deposit mean cash costs can be kept low. With expected production of around 100,000 ounces of gold a year and, importantly, low initial capital costs, New Liberty is a great example of what should soon be a profitable, new, mid-sized gold mine. All that's needed now is the last half of mine financing from the banks. Last IC view: Buy, 50.5p, 2 November 2012.

Aureus Mining - Key Criteria

Condor Gold (CNR)

Nicaragua-focused Condor Gold took the Alternative Investment Market by storm this summer with a near 150 per cent share price rise from July to September. Drilling on its 100 per cent-owned La India gold project returned some remarkable high-grade gold intersections, including 12.2 metres averaging 35 grams gold per tonne starting from a down-hole depth of 173 metres. Indeed, the drilling helped propel total resources at the project to 2.37m ounces averaging a stellar 4.6 grams gold, with about 1m ounces located in an potential open pit and 1.4m ounces better exploited via underground mining. Condor began another 7,000-metre drill program in November using three rigs, looking to prove up ounces inbetween and along strike of existing open-pit zones. A preliminary economic assessment for the project is also currently under way. Last IC view: None.

Condor Gold - Key Criteria

Belo Sun Mining

Highly recommended by Brent Cook, Belo Sun Mining (ticker: BSX on the Toronto Stock Exchange) controls the huge and growing Volte Grande gold deposit in Brazil. Belo is currently completing an updated resource estimate for the project, expected later this month, as well as a pre-feasibility study due in the first quarter of 2013. Mr Cook describes the company as a "prime takeover target and worthy of accumulation ahead of the new resource estimate", and we agree. That's because the estimate will include 263 new holes and should bump up the total gold resources at Volta Grande above the 6m ounce mark. The deposit boasts above-average gold grades of around 1.7 grams gold per tonne and the mineralisation shows good internal continuity. Moreover, it is amenable to low-cost, bulk open-pit mining. Volte Grande is quickly shaping up to be the real deal. Last IC view: None.

Belo Sun Mining - Key Criteria