The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
Editor's note: This is the third part of a series on making money in mining.
NEW YORK (
) - In
of this series, I outlined the seven stages of development which characterize the evolution of almost every mine, and then described the preliminary exploration which occurs with a mining project.
, I discussed the drilling-phase of development, and how to evaluate whether a property is being developed in an efficient (and potentially lucrative) manner or whether management has fallen into the "dilution trap."
We are now ready to move on to the third major phase of mine-development: calculating a resource estimate of the ore deposit which the miner has been drilling. While this may seem like a very straightforward stage in the evolution of a mine, there is certainly the potential for "surprises" here --- and also opportunities for the astute investor who takes the time to do his/her homework.
At some point during the extensive drilling necessary to identify a potential, commercial ore deposit, a mining company will decide to prepare a resource estimate of the mineralization in the ore being drilled. As I hinted at in my previous commentary, there are many factors which go into the decision of when is the appropriate time to engage in such an assessment.
Generally, a mining company will not engage in the time/effort/expense of commissioning such a study until it is reasonably sure it has uncovered a sufficient body of ore so that a completed resource estimate will show a deposit with sufficient profit-potential to justify (at least) an economic assessment.
It then hopes that the economic assessment will conclude that the body of ore is large enough, and the grades good enough so that it is commercially viable to construct and operate a mine.
Occasionally, however, a miner will engage in a preliminary resource estimate as merely a stepping stone in the drilling process. In other words, as I explained in Part II, when a miner is engaged in extensive drilling, this generally requires several infusions of cash to pay for this capital-intensive activity.
To avoid the "dilution trap" I warned about, it's important that a miner be able to do each new financing at a significantly higher share price, otherwise the equity financings used to raise this cash result in too much dilution -- and shareholders will be unlikely to reap much of a return by holding such companies over the longer term. Thus sometimes a miner will conclude that doing a small, preliminary resource estimate is the best way to raise more capital at an attractive price.
This is not a decision to be made lightly. Not only is there significant time and expense involved in calculating a resource estimate, but it requires a considerable amount of "in-fill drilling" to connect-the-dots with the previous drilling holes in order to provide enough data for the scientific calculations which go into such an estimate.
This in-fill drilling is not considered "newsworthy", since it is only adding to data which has previously been released. As a result, unlike exploratory drilling where a news release of the results can (and often does) cause a "pop" in the share price, in-fill drilling generates no news, and thus no additional appreciation in the share price.
Indeed, since most activity on a project will usually be put on hold (pending the results), the time spent in preparing these estimates tends to be one of those uncomfortable lulls in the evolution of a junior miner.
Often this period will mark some erosion in the share price, as short-term oriented investors and traders will pull out in impatience. However, for true long-term investors, the short wait required for this report to be assembled is justified by the concrete information yielded on the size of the mineral deposit.
Even with those junior miners who plan to take this resource estimate and then proceed directly to an "economic assessment" of the commercial viability of the project (as a whole), cost are not finished with their drilling.
As I first explained in Part II, expanding the perimeter of the "fence" on a particular ore deposit geometrically increases the expense involved in not only mapping out that fence with preliminary drilling, but also the additional costs involved with subsequent in-fill drilling. Thus, sometimes the size of a resource estimate is limited much more by capital restraints than the actual boundaries of mineralization.
This means that investors must remain cognizant as to whether the deposit remains "open" (i.e. unexplored) in one or more directions, so that they understand whether this resource estimate more-or-less represents the entire body of ore, or merely the first "chunk" which management has had the time/effort/money to define with their drilling and analysis.
If we have done our homework, then we should be aware of the context in which the resource estimate takes place. If we are unsure about certain details, or are a new investor with the company, then a quick phone call or e-mail to the investor relations department of that particular miner should alleviate any gaps in knowledge.
Even if we have stayed on top of the evolution of a particular project, this still leaves the potential for surprises when the resource estimate is announced. The precise geological nature of the ore-body could lead to some technical anomaly so that the results "surprise" observers -- even the miner's own geologists, in either direction. In addition, there is an important strategic decision involved with the calculation of any/every resource estimate: the "cut-off grade".
A body of ore is not a precisely delineated geological formation. In other words, you don't generally see a clear terminus of mineralization. Instead, grades tend to "fade" toward the edges of a deposit. Because the overall grade of every ore-body is unique, and because the rate at which the grades dissipate around the periphery also varies with each deposit, the choice of a cut-off grade can have an enormous impact on the bottom-line numbers from a resource estimate.
As a result, in the case of deposits where the fluctuations are especially large we will often see miners produce several sets of numbers - each corresponding with a different cut-off grade.
There are many reasons why investors need to thoroughly understand this concept. Typically, the fluctuations caused by using different cut-off grades are larger in lower-grade deposits. This increases the potential for "surprises" with such projects (for better or worse). It's also very important to understand that the cut-off grades chosen for these scientific estimates are typically quite conservative.
The minimum cut-off grade chosen is generally deemed to be commercially viable at current (or even lower) metals prices. Naturally, at the rate that gold and silver prices continue to rise, by the time a particular project goes from a resource estimate through to the complete construction of a mine, bullion prices could have easily doubled. In other words, many ore deposits continue to "grow larger" as the price of bullion rises, because the actual cut-off grade at which mining ore is no longer profitable continues to fall with time.
Thus, in the case of a resource estimate where we see a series of cut-off grades used (indicating a deposit where the grades diminish gradually), we can do some crude extrapolation on our own as to how many more tons of ore (and ounces of gold or silver) might eventually be added to the mine's reserves.
A note of caution: those readers who are in general agreement with the concept of "peak oil" will also understand that (rapidly) rising energy costs could cause the cut-off grade with some of these ore deposits to increase over time (despite rising bullion prices). In other words, with a low-grade or especially energy-intensive mining project, the amount of economically viable ore contained may decrease over time.
This is another reason why we must diversify within the sector. Every "basket" of miners should be well-represented with miners working on high-grade gold and/or silver deposits. There is certainly also a place in our portfolios for lower-grade/high tonnage projects. However we should avoid being over-weight with such companies in our portfolios, and we should be wary of investing in mining projects
upon moderately-priced energy (i.e. oil).
Understanding many of the parameters involved in resource estimates, we are now in a position to profit from that knowledge. As with most milestones in the development of a mining project, a resource estimate tends to be a "sell on news" event.
In other words, assuming that the results at least met the prior expectations of the market, this is an announcement which typically causes a "pop" in the share price -- and a selling opportunity for those who got in at a significantly lower price. However, there are exceptions to this general principle, and so we must evaluate a number of variables here.
If the miner is well-capitalized (and has plenty of "zones" still to explore), then not only will the miner often be able to carry-on with drilling around the calculation of the resource estimate, but if the miner is obtaining good results then it can often build upon the momentum generated by the resource estimate -- and the share price can continue to power higher.
Conversely, the parameters are much different with a miner with a much lower level of cash-on-hand. Such companies will need to do another financing shortly after the resource estimate is completed. Indeed, the sole purpose of the resource estimate may be to raise the share price to a higher level so that a financing can be completed on more advantageous terms.
This is why we must always remain cognizant of how well these companies are capitalized at any particular time if we are contemplating trading into/out of them. Obviously those investors with more of a "buy and hold" strategy aren't required to engage in the same level of "maintenance" with their portfolios, as they are implicitly accepting that they will ride out the up's and down's which are a natural part of the evolution of these companies.
The last scenario to discuss is where a resource estimate is deemed a "disappointment" by the market. Here, whether we are an existing shareholder or a potential buyer, it's important for us to not allow ourselves to be influenced by market sentiment, but rather (attempt to) objectively evaluate the data ourselves.
If the share price has actually fallen on the news (perhaps compounded by weak, overall "sentiment" at that time), investors must ask themselves whether this company looks like an attractive investment at the new price. This is especially difficult for existing investors, as there is always the tendency to "fall in love" with one's holdings.
As with most investing, those investors who are best able to put aside their own emotions and engage in objective analysis of their holdings will achieve the best results over time. Veteran analysts often suggest that the average investor is too willing to sell their "winners" and keep their "losers," so keep that advice in mind any time you are evaluating an under-performing holding in your portfolio.
With a little luck, and a lot of skill on the part of management, by the time a resource estimate is completed, most investors will now have enough data to see whether this particular project (and mining company) has the necessary metal(s) to potentially justify the construction of a mine.
However, this is often merely the first of a series of possible hurdles which a mining company must meet (and overcome) if it wants to turn an ore deposit into a profitable mine.
In the next part of this series I will get to the next stage of development in the evolution of a mine - the economic assessment - and also discuss several other potential "issues" which could stand in the way of the development of any particular project.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.