The odds of finding an economically prospective ore deposit are similarly mind-boggling. And the political forces set on taxing and bootstrapping the mining business today makes those odds even longer.

A prospector might stumble upon a showing of gold in a sample he took downstream from an outcrop up the hill yonder. But statistically speaking, the odds that it will become a mine are one out of 1,000. That is, for every 1,000 mineral targets, only one will become a bona-fide mine. That does not mean you can’t make money in exploration stocks. Like the eggs of the adult pacific salmon, a good lot of them still make it into the ocean.

Unfortunately, most of them end up drowning.

And I don’t mean the fish.

Even when someone finds a worthy deposit, there are still obstacles to actually mining it — environmental, infrastructure, political, construction and/or financial.

Still, the surest proof of the economics of any deposit is actually producing stuff. Until that moment, everything that we know about a deposit is academic.

For the junior that makes it to this moment, however, it is like the salmon that grew to adulthood and made it upstream. It has survived many life cycle risks.

 In the market, once a company reaches this stage, investors pile into the stock and often send it higher in a big way. The market will pay more for earnings as their prospect nears rather than for deposits in the ground. This process is often called a “re-rating.” That is, the market re-rates the asset in light of its changing risk-reward profile as it evolves through a life cycle. The life cycle often goes like this: From an inspiration to a venture to a discovery, development and finally production. At each stage of its evolution, as in any business, the company’s audience expands. It makes the radar of more fund managers that have minimum criteria. Many investors are willing to pay more for a proven asset.

Ready to Spawn

One such alevin that appears to have made it upstream is European Minerals (TSX: EPM), a Canadian-listed mining junior who owns the Varvarinskoye gold-copper skarn deposit in Kazakhstan.

The company has spent nearly $200 million since 2004 building the mining infrastructure. Now it is nearly complete.

European Minerals expects the mine’s first gold pour in December. It expects to reach full capacity by the middle of next year.

The president of Kazakhstan visited the site in September and gave it the royal A-OK. The company’s shares are in the midst of a re-rating that is not likely to end until its first full year of production. Of course, there are still risks, as the company could run into production difficulties at the starting gate. But, the company has stockpiled more than one million tons of ore already — a three-month cushion.

Background on This “Red” Gold

A Soviet geologist originally discovered the deposit in the late 1930s. This was when Kazakhstan was still part of the USSR. During the 1980s, the Soviet geological survey rifled some 800 drill holes into it.

After Kazakhstan won its independence in 1991, the country moved toward market reforms. In the mid-1990s, a group of former brokers and financiers from London formed a company called “Kazminco” to acquire the deposit in stages (Kazminco became European Minerals in 2001).

Led by Bert Kennedy, an economic geologist familiar with mining in the Far East and specializing in bringing ore bodies to production, Kazminco drilled another 200 holes for a feasibility study that had outlined a resource of over three million ounces gold and 400 million pounds copper in 1998.

The mine had obstacles: Relatively low grades (1 gpt Au and 0.25% Cu) and high strip ratios. And with gold and copper prices at record lows, the project was uneconomic. The mineral value of one ton of Varvarinskoye ore declined to less than $10. The company expected it to cost about $9 to process.

But management didn’t give up. It toiled with different methods and technologies. By 2003, when the outlook for commodity prices perked up, efforts paid off. Changes to the mine plan and pit design combined with the discovery of additional gold and higher commodity prices to breathe new life into the project. Funding cheapened too. The economics of the prospect suddenly looked a lot better.

Ripe for Double

Today, it costs a little more to process one ton of Varvarinskoye ore ($12-13), but the mineral value of that ton is now expected to fetch somewhere between $20 and $30. And the company locked that in.

As part of its development financing, the company sold forward 443,000 ounces of gold, or half of its 120,000 ounces in annual production of gold (LOM) over the next eight years. One downside to hedging is that it erodes some of the advantage the company could otherwise enjoy from rising gold prices.

On the other hand, combined with the stockpiling of ore it adds to a strong base of value below $1 per share for this stock, should gold prices fall. Operating this mine will cost the company $50-60 million annually. The hedge book effectively covers half of that for eight years. 

I am no fan of hedging, but due to the re-rating potential of this stock, there is still plenty of upside.

At current gold and copper prices, the operation could produce U.S. $80-100 million in annual net cash flows during its first three years (starting mid-2008, when the company expects the plant to be at full design capacity — 4.2 Mtpa). Production rates decline subsequently but the mine is expected to last 17 years.

Those cash flows translate into 28-35 cents per share (or 18-23 cents fully diluted s/o). The stock currently trades at less than five times those numbers.

Yet the market is paying 10-20 times cashflows for established gold “producers” today — the high end of the range is usually reserved for companies that the market thinks has additional growth potential.

Ignoring growth and extrapolating prices and production costs over the life of the operation returns a discounted net asset value of somewhere between Can. $1.60 and Can. $1.90 per share based on the currently issued share capital (284 million) and a 10% discount rate (which is relatively conservative).

But producers’ shares tend to trade at a premium to discounted long-term cashflows, as markets tend to focus on near-term cashflows. Moreover, the potential for additional growth exists, even if furtive.

All this makes investing in European Minerals a timely way to benefit from higher gold prices.

Sincerely,
Ed Bugos
November 29, 2007

Junior Mining Companies was originally featured in the Penny Sleuth.