An adapt-or-die moment for junior miners

By Mining Markets staff / May 21, 2013 / / Article Link

Newsletter writer and mining analyst John Kaiser sounds a little dejected as he describes the utterly bleak state of the mining industry today.

"The phones are completely dead, nobody cares," says the editor of Kaiser Research Online. "Companies can't raise money, it's like a complete dying sector."

Kaiser made a now-famous prediction last year that around 500 juniors were bound for "extinction" because of an inability to raise capital, low share prices and negative sentiment on commodities.

As of mid-May, that number has grown: Of the roughly 1,800 publicly listed TSX and TSXV companies involved in mining or exploration and listed in the KRO database, 694 had less than $200,000 in working capital - basically the amount needed annually to maintain a listing.

Kaiser adds that about 70% of all the companies in the KRO database are trading at below 20 .

"It's starting to feel like 1999, and we still had several more years to go after that," Kaiser says of the last prolonged downturn in the industry. "That's when the dot-com stuff was taking off and I remember subscribers mocking me for still talking about resource stocks, they were history - technology was the place to be."

Whether the current difficult conditions last as long as that is impossible to predict. But both producers, which have been hit with massive cost inflation, and juniors, which have been dealing with a capital-anemic environment for the past two years, are in for more pain. In the next phase, we can expect uneconomic mines that were built in the previous rush to meet escalating Chinese demand to be shut down, close to zero exploration (by both juniors and majors), mass de-listings, and a fair amount of consolidation. (See related article: Juniors should consider M&A as a defence mechanism in tough market.)

So who will end up surviving the current market, when even the world's biggest gold miner, Barrick Gold (ABX-T, ABX-N), finds itself trading at a 20-year low under $20 - depths it didn't even reach during the financial crisis?

Even during this slow, grinding period, for companies with good management and projects that can demonstrate a path to production and relatively low capex, there are ways forward, says Peter Gray, managing director of the minerals capital and advisory practice at U.S. investment bank Headwaters MB.

Gray says few companies are making use of the alternative sources of capital that are available to them.

"Far too many of them are focused just on survival, and their plan for survival is to preserve cash," Gray says. "The reality is there's a lot of capital there - there's pools of capital that will invest in the mining space for quality assets."

Blindsided juniors aren't necessarily ready to deal, but because traditional bank debt and equity sources have dried up, they will have to seek out new partners. Those partners, which have a long-term view on commodities and are stepping in to take advantage of low valuations in the sector, could include sovereign wealth funds (such as China Investment Corp.), and private equity in the form of resource funds (Resource Capital Fund, for example), family office money (Electrum Group) or commodity traders (like Trafigura's Galena fund).

"There's a lot of different pools of capital that haven't traditionally been major players in the resources space that are starting now to show a real interest," Gray says. "It's a function of supply dynamics, supply economics, it's a function of market valuations and recognizing the long-term economic return on an investment in metals."

Because these are newer sources of capital, however, there's a "relationship gap" between them and juniors, Gray says. Headwaters' mining division, which was started up last year, specializes in playing matchmaker between the smaller companies in the mining sector and this capital and is currently working on several alternative financings, including: a couple of listed companies that are doing deals with Chinese sovereign wealth funds, and a deal involving bridge financing provided by family office money.

The new funders all have different investment philosophies and time horizons, but they do have two things in common: they're looking for quality and they're looking for production.

"None of these groups want to be speculators," Gray says. "They're not looking at discoveries, they're looking at development and production."

Grassroots exploration

While it's true that so far these groups have been attracted to companies with feasibility-level projects or projects with measured and indicated resources - Resource Capital Fund has invested in Noront Resources (NOT-V), while the Electrum Group has invested heavily in NovaGold Resources (NG-T, NG-X), Gabriel Resources (GBU-T) and Sunward Resources (SWD-T), for example - there is some indication of interest in earlier-stage exploration as well.

New York-based fund manager The Lind Partners recently completed a long-term financing agreement with junior Olivut Resources (OLV-V). The three-year deal, which will provide a maximum of $18 million over three years, will see Lind invest $200,000 every month in Olivut shares, after an initial investment of $500,000 ($200,000 in common shares and a $300,000 callable convertible debenture).

The deal is all the more notable because Olivut is a diamond exploration company - probably the hardest hit category of junior since 2008. Olivut owns the early-stage HOAM diamond project in the Northwest Territories and has an option to earn 50% of the Itapoty diamond project in Paraguay.

"They invest with a long-term view," Olivut president and CEO Leni Keough says of Lind, which has done similar deals with Australian juniors. "They're seeing well beyond what's happening in the next month or two or three - they really want to help build a company."

The agreement means a steady, assured stream of money coming into Olivut, without the junior having to pay new legal and other types of fees each time. The pricing of each tranche also varies, based on the volume-weighted average price of the previous 20 trading days. The deal contains ways to limit dilution, including an option to use a floor price protection of 40 on the financing price, and provides flexibility to do smaller or larger (up to $500,000) financings, depending on market conditions, or to raise additional money from other sources.

Keough notes that maintaining a viable company "takes more than just flow-through dollars," which may be easier to raise, but can't be spent on things like general and administrative expenses or exploration outside of Canada.

Although Lind has used this investment structure to fund more than 35 juniors in other markets, it is entirely new to Canada. Keough says it took a year and half to get it approved by the maze of regulators involved, from the TSXV to the provincial commissions to the Canadian Securities Administration. But now that the structure has been worked out and approved, Keough hopes other juniors will be able to complete similar financings.

While Olivut no longer has to worry about "extinction," it is one of few exploration-stage companies that have succeeded in finding any type of significant financing.

"Early stage exploration, at the moment it's almost impossible to raise money - it's friends and family," says Gray, who adds the money isn't going to come back quickly for discovery-stage projects.

"That capital is beg, borrow and steal. It's going to be a significant challenge for the next three to five years to find that capital."

Kaiser notes that the lack of money going into exploration actually makes it much easier to narrow down the investing options for any speculators still left in the game.

"I half-jokingly say my criteria for stocks to look at and buy right now are ones that actually have a drill program going, because those that do are only going to be drilling because they've got a geologically well-developed target where, if it delivers, it's going be big," Kaiser says.

"Pretend companies" that drill holes they know to be useless just to keep investor attention, will be absent.

"Now that investors couldn't care less, there's no way they're going to spend their lifestyle money on a useless drill program," he says. "So useless drill programs are not going to happen - they're all going to be high-stakes, high-reward programs that get done."

He points to junior Colorado Resources (CXO-V) as one such play that has recently delivered with its North ROK project in northwestern B.C.

When will things improve?

In the long-term, money will have to come back to grassroots exploration because of continued demand from emerging countries coupled with increasingly lower grades being mined at higher costs.

But first, Gray says there will have to be a period of consolidation and closures of uneconomic mines.

"There will be a period here where marginal production becomes challenged and non-economic. Once that production is removed from the supply side, prices will recover and then substantially increase, but that's not a short-term effect, I expect that will be 2014, 2015 before you see a material improvement in prices."

Kaiser points out that with April's drop in the gold price, this is already happening with costs at a lot of operations higher than current metals prices. McEwen Mining (MUX-T, MUX-N), for example reported all-in sustaining cash costs of US$1,500 at its El Gallo mine in Mexico, which began commercial production earlier this year, and US$1,480 at its San Jose mine in Argentina, Kaiser said.

"That was with Q1 gold and silver prices, so guess what Q2 is going to look like," he says.

The next year or two won't be pretty, but Gray insists it's up to companies to figure out a survival strategy.

"There are companies that are going to find they can finance their projects, but what they have to give up in the process is going to be too bitter a pill to swallow," he says, referring to companies with $1-billion projects and market caps of less than $200 million. "What I'm circling back to is companies do have some control over their destinies today, but they have to be proactive in that process, otherwise they're going to be left with no choices."