It was the best of times – for bottom fishing and acquiring distressed mineral assets.
It was the worst of times –to finance exploration as distinct from rediscovering what was already found.
It was the age of wisdom – the sudden realisation that grade is king scale alone can never make a project work.
It was the age of foolishness – transfigured into a global financial crisis with jargon designed to confuse and obfuscate.
It was the epoch of belief – that the physical world is important and just not the cloudy vision of myopic markets
It was the epoch of incredulity – that we would continue to find new quality mines without looking for them.
It was the season of Light – the Internet and its possibilities access to knowledge
It was the season of Darkness –the Internet and its manipulation by the evil.
It was the spring of Hope – that we would take risks again and not be afraid of failure.
It was the winter of Despair to see good money squandered by inept management on marginal projects.
We had everything before us but we felt we had nothing before us and that the fortunate could sit petrified on their cash savings and somehow that it would hatch and not lose value without some risk and speculation. The Majors stopped exploring and even Juniors with the most promising of early-stage projects struggled to refinance. Somehow we thought it had all come to an end. It was inertia, not of course because we believed that there was enough new ore deposits in the pipeline to meet the future needs of unborn souls but simply because we had become afraid to explore and fail.
An Arbitrage tale of two North Cordilleran Volcanogenic Massive Sulfide Deposits?
Canadian Zinc Corporation (CZN) is listed in Toronto and is developing its flagship Prairie Creek project in the Northwest Territories of Canada. At writing CZN has a market capitalisation of C$53,330,000. Is that good value?
Prairie Creek Property is a Volcanogenic Massive Sulphide (VMS) deposit and hosts measured and indicated resources of 5.43 million tonnes grading 10.8% zinc, 10.2% lead, 160 g/t silver and 0.31% copper, which includes a reserve of 5.22 million tonnes averaging 9.4% zinc, 9.5% lead, 151 g/t silver (no copper in the reserve statement). There is also an inferred resource of 6.24 million tonnes grading 14.5% zinc, 11.5% lead, 229 g/t silver and 0.57% copper and additional exploration potential. It is difficult to grasp the potential value of four different metal grades when they are put in front of you so we it is custom for digestion to reduce these polymetallic grades at the resource stage and for project comparisons to either an equivalent zinc or equivalent copper grade based on gross metal value – as distinct from recovered metal and net smelter return.
CZN has just announced the start‐up of its underground program at Prairie Creek following a tender process through which Procon Mining and Tunneling Ltd has been awarded the contract to carry out mine rehabilitation, exploration, mine development and initial production at the Prairie Creek Mine. The grade is very good at around 19% Zn equivalent (eqv) but the location of the project in the far north of Canada which was always going to drive up the pre-mine capital cost estimated at back in 2012 at $160 million for a project with noall-weather access road to the site, limited to an ice-road for part of the year and with no access in summer, no grid power except what can be generated from oil-fueled generators.
Another Canadian-listed company called Foran Mining with a market capitalisation of CDN$20,000,000 is advancing its flagship McIlvenna Bay deposit in the Flin Flon Greenstone Belt of east-central Saskatchewan. McIlvenna Bay is a large zinc-copper-gold-silver Volcanogenic Massive Sulphide (“VMS”) deposit and Foran claims it is one of the largest undeveloped VMS deposits in Canada with an indicated resource of 13.9 million tonnes averaging 1.3% copper, 2.67% zinc, 0.5g/t gold and 17g/t silver devoid of lead or about 13% Zn eqv. There is an also an almost equal inferred resource of 11.31 million tonnes averaging 1.3% copper, 3% zinc and 0.4g/t gold and 17g/t silver. Foran announced in September that it had commenced a Preliminary Economic Assessment of the project so it is a long way behind CZN at Prairie Creek with a lower grade but with a bigger deposit and certainly not nearly as remote. The question for me is does Foran with a market capitalisation just above a third of the market capitalisation of Canadian Zinc present a valuation opportunity? Is the discount just for project maturity and lower grade?
A feasibility study is a potent valuation milestone as it reduces project risk and makes valuation easier and more transparent. In June 2012 CZN announced highlights of a Preliminary Feasibility Study:
A pre-tax Net Present Value (“NPV”), using an 8 per cent discount comes out at about $253M, based on metal price forecasts of $1.20/lb for both zinc and lead and $28.00/oz silver, for the first two years of mine production during 2014/15, then reducing to long-term prices of $1.00/lb zinc, $1.00/lb lead and $26.00/oz silver in 2016 and thereafter seems reasonable and maybe a bit conservative at least for zinc and lead based on latest street lack of consensus.
The Project generates average annual earnings before interest taxes depreciation and amortization (“EBITDA”) of $66M per year and $686M over the life of the Project with a projected life of mine of 11 years. This is based exclusively on a defined mineral reserve of 5.2 million tonnes, grading 9.4% zinc and 9.5% lead, with 151 g/t silver. We are advised to note that the 2012 PFS does not take into consideration the Inferred Resources of 6.2 million tonnes of 14.5% zinc, 11.5% lead and 229 g/t silver and if upgraded to measured or indicated could add to mine life.
This new mine does not come cheap at $201 million including working capital and contingencies. But what is the level of return expected by a shareholder in CZN? Is a discount rate of eight per cent a bit miserly in a world competing for returns? A shareholder could expect a capital gain crystallised by the sale of the project to a strategic or a dividend over time or some combination. We can calculate the expected rate of return using a Canadian ten year bond at 2.5 per cent, average long term annual returns for small to medium size enterprises of 8.2 per cent and a beta of 1.26 per cent for the metal and mines sector lead us to an expected return of for a shareholder of at least 10 per cent as more appropriate. A discount rate of 12 per cent drops the NPV from $250 million to roughly $175 million by my calculations. Given that the pre feasibility study was completed two years ago a more appropriate rate for an unfunded project several years from full production might have been more like 15 per cent discount rate which would drop the NPV to $131 million – but let us not become like Attila the Hun.
How can the prise loose the value created by these mathematical contrivances if they are in fact real? Canadian Zinc not only has to plough cash flows back into discovery and exploitation of new mineralisation but it has exploration chicks in Newfoundland with fully extended gaping beaks. This ploughing back of cash-flows into R&D is the typical industry model for junior and mid-tier resource companies although I did work for a Junior once which was an exemplary exception to this norm. So I would say that dividends from Prairie Creek are possible but probably unlikely and this will further weaken the investment proposition. There is of course the possibility of a future opportunistic exit and sale to a strategic investor. We could look at Nyrstar as a superlative example of what is possible for shareholders in the prey but maybe not in the predator.
A $300 million dollar deal!
In the first three months of 2011 Nyrstar completed the acquisition of the Campo Morado mine in Mexico from Farallon Resources for US$300 million (CDN$395 million ) – the exchange rate at the time. Campo Morado was an old mining camp exploiting a rich VMS deposit but it had run out of ore until the transformative discovery of the G-9 deposit nearby. In June 2005 Farallon discovered very significant grades of zinc in what was to flesh eventually out to become the G-9 deposit. A new mine was constructed at a cost of US$150 million with first commercial production in 2009. In 2010 Farallon’s G-9 deposit produced approximately 42,000 tonnes of zinc, 4,000 tonnes of copper, 1.8 million ounces of silver and 19,000 of gold generating operating earnings of $33.7 million but just US$7 million in cash flow.
Prior to production the G-9 deposit contained a measured and indicated resource of three million tonnes averaging 3.2g/t gold, 210 g/t silver, 1.2% copper, 9.4% zinc and 1.4% lead at a zinc cut-off of 3% . Project upside was apparent from an inferred resource of almost another million tonnes at similar but lower grades. The Southwest Zone and another four deposits in the camp were much lower in grade containing an aggregate of 13 million tonnes measured and indicated with half the zinc grade, a bit over one third of the copper grade, two thirds of the gold and silver and similar lead compared to G-9. Most interestingly there was only enough ore for two years and eight months at a planned production rate of 2,000 tonnes of ore per day based on proven and probable reserves of 1,369,000 tonnes averaging 3g/t gold, 222 g/t silver, 1.4 % copper, 1.6% lead and 10.8% zinc.
Nyrstar must have been convinced that the remaining resources at G-9 had “legs” and would convert to reserves using the usual rule-of-thumb and simply that there would be lots more ore to be found. In 2013, the Campo Morado operation produced 25,000 tonnes of zinc, 4,900 tonnes of copper in concentrate, 1.156 million ounces of silver and 11,700 ounces of gold which as far as zinc goes was down substantially on Farallon’s 2010 production. Interestingly since the third quarter of 2013 the exploration and resource-build focus has moved away from G-9 to El Largo and Naranjo southwest zones. Under CIM definition standards there are also no Reserves established now at Campo Morado and the remaining global resource in measured and indicated resource for the camp sits at 17 million tonnes averaging only 3.9% zinc. 1.5g/t gold, 0.7% copper, 0.9% lead, 113g/t silver. When Nyrstar bought Farallon for $300 million in 2011 the consideration included $150 million in Capex expenditure to build the new mine and took into account some $20m in the treasury so the resources and exploration upside represented the balance of $130 million price. On the basis of where Campo Morado is now it looks to me that the Farallon shareholders got a great deal. What we can compare with Prairie Creek and McIlvenna Bay is the pre-mine reserve-resource. There are a lot of metal grades to grasp and absorb for the various deposits above. If we were to use Foran’s price criteria to simplify the numbers then the McIlvenna Bay resource has a zinc equivalent grade of just over 13% and Prairie Creek 19% compared to G-9 before mining which was 31! The zinc equivalent grade at campo Morado has now fallen off a cliff. Based on grade alone it is easy to see why Nyrstar coveted G-9 but based on Nyrstar’s change of focus at Campo Morado they may have been over optimistic that the tonnage of this deposit would build enough to justify the acquisition cost.
Going back now to Prairie Creek and considering the projected average EBITA of $66 million over the life of mine we might assume that the market would value the company at say our times 2019 profit. This might be a tad generous for a Company which at the time was still a few years from production and an assumption of 100% debt funding for only an 11 year life of mine. The implied equity value would be around $64 million and an implied investment return for today’s buyer looking to sell within five years would be only 4%/y.
The investor has to hope that once again there will be aggressive Majors out there willing to pay handsomely for exploration potential as zinc prices rise in the short-term and that Foran’s capital cost for McIlvenna Bay will come in substantially lower than Prairie Creek to compensate for lower grade. Valuing these VMS deposits at and indeed all metallic deposits different stages of maturity from development to old age is a complicated process indeed. There is plenty of room for differences of opinion and methodology and most of all value arbitrage.
Red Dog and Volcanogenic Massive Sulfide deposits
Teck’s Red Dog Mine in Alaska accounts for some 10 percent of the world’s annual zinc mine-production and long may it last, probably until 2031. The polymetallic deposits at Red Dog form a cluster of volcanogenic massive sulphides (VMS). Volcanogenic massive sulphide deposits are probably the best understood of all ore-forming systems and deposit types. This is partly because we believe that we can observe contemporary analogues being formed as black-smoker systems on the sea floor. It is pretty hard to observe an orogenic (mesothermal) gold system forming at a depth of seven kilometres in the earth’s crust. VMS deposits tend to form by episodic debouching and accumulation of mineral rich fluids at or near the sea floor and linked genetically to nearby volcanism. Such mineralisation is close in time and space to volcanic activity and therefore metals concentrate in clusters of deposits confined to a particular layer or strata of rock which is commonly volcanic in origin but in some places sedimentary. Red Dog as it turns out is one of those deposits that are hosted in sedimentary rocks. These polymetallic deposits of precious and base metals vary widely in the relative and total abundance of metals. Many are small or not economic or both and some are big and the good ones are economically very important sources of copper, zinc with payable amounts lead, gold and silver. The metal value per tonne of ore can be relatively high compared to other mineral deposits so they are attractive exploration targets. Another advantage is that cash-flow is not dependent on one metal but rests on several and might compensate for mine production being out of synchronisation with the price cycle of any particular metal. VMS deposits are hard to explore as the target is usually sharp and relatively small and not diffuse and big like a porphyry. Also structure can be complicated. You have to recover metal out of the rock to get paid so it is important to realise that in some cases complex metallurgy can be lead to challenging mineral processing and can be associated with undesirable metals such as mercury. Gold can be difficult to recover from these polymetallic ores so be careful not to get carried away with the headline resource gold grades.
You can spend a career studying these deposits and key districts such as the Iberian Pyrite Belt, the Pontides (extending from the Balkans across Turkey), Skellefte (Sweden), Mt Read (Tasmania) and Bathurst in Canada and the Northern and Southern Cordillera running link a severely scoliotic spine down the western side of the Americas. Some particularly passionate aficionados have divided this deposit class into broad types such as Mafic or Cyprus type, Bimodal Mafic or Abitibi-Urals type, Mafic Siliclastic or Besshi type, Bimodal Felsic or Kuroko-Baimak type, Bimodal siliclastic or Iberian-Bathurst type. There is a whole world out there to discover. A real case of the expert knowing more and more about less and less.