News & Thoughts

Mining The Upside

Mar 12, 2019

Everywhere we look at the moment we see the market values of exploration and development companies of all shapes and sizes that don’t reflect even a sliver of the cash their assets might create if the world just stayed the same. Why is it so?

I am sure in many cases it’s got to do with the nuances of geology and metallurgy that are well beyond my understanding.

For some, it’s geography and the wonderful sense of humour someone had putting many of the best orebodies in places people describe as god-forsaken.

But mostly it seems to me that the industry needs to address the fact that the vast majority of people who buy shares in businesses, and businesses of all shapes and sizes, simply do not see most mining companies or prospective miners as “businesses”, or their executives as businessmen.

When investing in other areas of enterprise, these investors consider that they are buying a share in an enterprise that seeks to make profits and with that they are acquiring the right to a share of future cashflows of that business. That they don’t buy shares in the vast majority of mining companies is down to the fact that a great number of high-profile mining company executives don’t believe they are running businesses whose mission is to make money. Or if they do, they are incapable of enunciating that in a language that most rational investors understand.

A few years ago at Diggers and Dealers in Western Australia I saw a young CEO, not lacking in confidence, present to the audience the idea that his company was in the business of making money for shareholders. Yes, they were a mining company, but he boldly declared they were in the business of making money first and foremost. Gold mining was just their chosen method.

He wasn’t the first CEO I have seen make that claim, but he went further than most.

He even put on his slide the logos of industrial companies and a bank (from memory) and declared he wanted people who invested in those companies to see his company as a viable investment alternative. Those non-mining businesses were the peers against which he wanted to be measured.

The older heads in the audience were clearly amused. You could see that they thought the young whippersnapper was setting himself up for a fall. “He’ll learn” or, “he’ll get his arse handed to him”, were the kinds of comments muttered.

Didn’t this young mining engineer know what “everyone” else in the industry knew?

People run mining companies to produce tonnes of something and other people buy shares in mining companies to get exposure to the “soon to be rising” prices of those things they mine. It’s all about The Upside – rising commodity prices!

It doesn’t matter how many shares you issue or how much you borrow (dividends are for wimps), but whatever you do, don’t give up The Upside.

Note most of the discourse involving even today’s industry leaders. It’s all about who can run mines better, not about creating a vehicle that can match the investment returns of the best outside their field.

Everyone in the industry ‘knows’ The Upside is coming, they just don’t know when.

In the meantime, they drill and/or dig and deliver, and travel the world going to conferences, talking to other people who drill, dig and deliver and investors whose only mandate seems to be to buy mining shares exposed to The Upside.

While together at these conferences they get worked up about all the people who don’t appreciate how important mining is. But they totally confuse the disdain for the way they run their businesses with the business they are in.

The investing population can like what mining does for society and our living standards but choose to not always be invested in mining or be highly selective. I for one admire enormously the geological intuition, the engineering skills and the metallurgical genius I regularly observe, but I do not need to invest in mining businesses that are not run by businessmen in a businesslike way.

What’s more, if professional investors and increasingly the public through ETFs, just want to make money on The Upside they can buy commodities directly. A basket of commodities can’t go to zero, something even once-great mining companies have a habit of doing.

The fascination with The Upside is so great in some quarters that in January a North American mining company announced that it had raised money by way of a gold prepay agreement with an upside twist. Gold prepays or gold loans (indeed, metal denominated loans more broadly) are in and of themselves a very sensible and naturally hedged form of finance.

We recommend them to our clients as a sensible risk-balanced form of debt.

However, in this case the company was seemingly worried that investors might be angry that they had given up The Upside by selling future production today. Their compromise was to include gold options in the structure that got back The Upside between US$1,300/oz and $1,500/oz in 2022, the year in which they would deliver gold against the prepay.

Looking at the price of the options in the structure, it’s safe to assume the company probably increased the debt raised under the arrangement by about $14 million in order to include those options in the deal.

That increased number was not outlined in the announcement, but on the terms of the deal announced and options prices at the time it’s going to be close to that cost.

What is certain is that the very best return the company could get out of the options purchased and sold is $30 million. A best possible net surplus of $16 million and only if the gold price is consistently above $1,500/oz in 2022.

If the best thing a leading gold mining company can find to do with $14 million of borrowed funds is to bet double or nothing on the gold price, then it’s no wonder cynics abound and rational investors stay away from the sector more broadly.

What’s more, deals like this, that are more akin to speculation than risk management, muddy the water for those companies that do use hedging and derivatives to legitimately reduce their business risks.

Run a good business of any kind and rational investors will find you. Worry about what you can control, obsess on the execution of your plan, respect the things you can’t control but can destroy you (aka The Downside) and The Upside will more often than not look after itself.

Perhaps then it’s not surprising to look at the share price trajectories of these two different companies over the past five years.

The business that mines to make money has seen a nearly eightfold increase in its share price and has even outperformed the banks and industrial companies it dared to see as peers.

The share price of the gold miner that feels the need to buy back The Upside is essentially unchanged, right in line with the vast majority of its peers!


*Sean Russo is managing director of Noah’s Rule, a specialist debt and risk advisor