Central Asia Metals: A real lesson in diversification

That’s the (contested) argument, at least. Mind you, it isn’t just finance academics who like diversification. Within the natural resources sector, a well-established school of thought states that more (mines, oil wells etc) is indeed more.

From geology to politics, unions to prices and the odd operational calamity, reality can render even the most careful resource project assumptions obsolete. If a lot can go wrong, then it is logical for extractors to hedge, via new commodities, jurisdictions, or processes. What’s more, unlike a retail brand or software patent, all resource projects are finite. As the value of a mining asset is depreciated as it is steadily depleted, the urgency to find the next new thing grows.

Still, in the game of geology, individual assets make or break fortunes. And sometimes, the stars align into a combination of stable, long-life, and abundant output that is wildly cheap to produce. The Ghawar oil and gas field, still the world’s largest single source of primary energy 73 years after entering production, is one example. Without it, you don’t have a modern Saudi Arabia, let alone a £1.6tn Saudi Aramco (SA:2222). For iron ore colossus Rio Tinto (RIO), it is the red earth of the Pilbara.

A lesser known example is the series of waste dumps that sit next to the old Kounrad copper mine in Kazakhstan. These mounds, which accumulated during the open pit mine’s operating life between 1936 and 2005, are about 0.1 per cent grade copper. That’s less than a fifth of today’s already very diluted grades, and at a level that would be uneconomic were it still stuck in rock. On the surface (and given there’s nothing to dig, “on the surface” describes things well) it doesn’t sound too impressive.

Fortunately, this waste ore can be recovered via a process known as solvent extraction–electrowinning and turned into copper cathode at an on-site plant. Without the requirement for blasting, drilling or heavy lifting, the magic of chemistry turns a pile of pre-mined unwanted rubble into a mountain of cash. In the first half of 2023, when copper’s spot price averaged $3.93 (£3.08) per pound, the Kounrad recovery plant was able to produce copper at a cash cost of 67¢. That’s a gross margin of 83 per cent.

The genius behind this venture is the Aim-listed Central Asia Metals (CAML). Having acquired a majority stake in the dumps in 2007, it raised $60mn in September 2010 and defied the doubters by building the recovery plant, under budget and without a hitch. Since entering production in late 2012, it has expanded capacity, seen near-faultless consistency, and proved wildly profitable – throwing off cash which, without the need for big capital spending, has largely been directed to shareholders by way of dividends.

In the years immediately after construction, it wasn’t all gravy. For one, copper prices were on the floor. And despite CAML’s own corporate stability, the governance records of two larger London-listed Kazakh-based miners, Kaz Minerals and ENRC, jangled some investor nerves.

Still, returns were very good. From first production to August 2017, the shares posted a total return of 272 per cent, or an average annual rate of 32 per cent. This, it bears repeating, was amid a near-continual slump in the copper price, and all while the FTSE 350 mining sector was almost entirely underwater.

And yet the question of CAML’s diversification lay unanswered. An updated resource estimate suggested production at Kounrad could stretch until 2034. But in mining, a good thing rarely lasts forever, while another big question – surrounding Russia’s ambitions vis à vis Kazakhstan – was impossible to define. Some believed invasion was a matter of when, not if.

Aware of those physical and hypothetical cliff-edges, CAML began to look for its next asset. In 2016, then-chief executive Nick Clarke told the Investors’ Chronicle that investors, not wanting to see Kounrad’s unique profitability diluted, exhorted management to “not feel pressured” in their hunt. Behind the scenes, however, some shareholders were increasingly concerned at the concentration risk. Executives agreed, concluding that while the odds of finding an asset as profitable as Kounrad was near impossible, without a plan for expansion the equity could become a zero-sum game. While it rained cash on the steppe, the group scoured the world for its second chapter, and looked at more than 100 opportunities.

The diversification solution arrived in late 2017 with the group’s purchase of the Sasa zinc-lead project in North Macedonia. In a flash, the deal extended CAML’s shelf-life, geographic footprint, and into base metals about which the group was bullish. But there were trade-offs. Group-level operating costs would rise, obviously, but so would the cost of servicing and paying off $187mn in new and assumed debt.

Those borrowings are now cleared, and Sasa has generated more than $320mn of Ebitda under CAML’s ownership. But measured in shareholder returns, diversification is yet to show its worth. Total returns have been a near wash, while shareholders who subscribed to the £2.30-a-share equity portion of the Sasa financing are looking at a capital loss of 28 per cent.

Factors beyond management control have played an outsized role in that disappointment. While the price of copper price has climbed since 2017, lead and zinc prices have fallen. Higher interest rates have both increased the discount rate used to value Sasa, thereby magnifying depreciation charges, and pushed investors away from risky mining assets and into safer high yields. That depressed sentiment is reflected in a forward price to earnings of multiple of seven, compared to 10 on the eve of the Sasa deal.

Apply a similar discount rate to Kounrad’s future cash flows – reasonable, given the abatement of geopolitical uncertainties in Kazakhstan since 2022 – and you get a net present value that isn’t far short of CAML’s market capitalisation of £300mn. Ergo, the market sees almost no value in Sasa.

Faced with evidence of the asset’s net return to date (see Table one), one can understand the pessimism. So far, diversification has meant dilution to group-wide margins and returns. Given Kounrad’s world-leading cost profile, the 2017 claim that Sasa would leave the group better positioned to weather the commodity cycle was also always a stretch. As can be seen from segmental profits since the deal (Table two), Kounrad’s dependability – with an assist from better copper prices – would almost certainly have led to a much stronger return for shareholders. Heck, net income of £250mn would have been enough to fund a double-digit dividend yield and build a war-chest of a balance sheet.

Of course, such woulda-shoulda-coulda – though easily dwelt on – are of limited use. The counterfactual scenario of “running your winner” (and a winner Kounrad remains) would have meant greater perceived risk. All power to Markowitz, then.

Fast forward to 2024, and CAML’s current growth-oriented exploration efforts are focused on Kazakhstan. Even if risk perceptions have softened, this arguably dents the case against geographic concentration. Then again, businesses can only look forward, weigh the balance of probabilities, and act. Management insists that given their time again, they would still buy Sasa.

So what’s the parable? On balance, there might not be one. Though if you’re ever lucky enough to own the investment equivalent of a golden egg-laying goose, steel yourself for some hard decisions ahead. Odds are, it won’t feel much like a free lunch.