The Mining Investor's Handbook – Part 11 – Exploration Companies

This article looks at the high risk, high reward nature of mineral exploration companies and what you can do to increase your (slim) chance of picking a winner.

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The mere mention of mining exploration invokes images of rags to riches companies like Fortescue Metals Group Limited (ASX: FMG), Sandfire Resources NL (ASX: SFR) and Sirius Resources N.L. (ASX: SIR).

After three years exploring throughout Western Australia (WA) for mineral deposits, Sirius Resources was almost out of cash and drilling what they thought would be the company's final exploration hole. As luck would have it, they finally struck gold, or nickel in this case – the Nova nickel deposit is expected to be one of the lowest cost nickel mines in the world! Sirius shares surged more than 5,000% in the following months and the $10 million penny exploration stock skyrocketed to a market capitalisation exceeding $1 billion.

However, for every success story there are dozens of failures and most exploration companies will never find what they are looking for. Exploration companies are typically financed entirely by shareholders and once their cash runs out they will have to rattle the tin for additional funds (a tough sell if you haven't found anything) or close up shop.

Exploration companies

Because of the hit or miss nature of the industry, exploration companies typically find themselves in one of the following situations:

1. The company depletes its cash before a significant mineral deposit is discovered.

The odds are that most exploration companies will fall into this category. The main issue is that the large, easy to find mineral deposits close to the earth's surface have already been discovered. Future discoveries will require advanced reconnaissance work, deeper drilling, and more cash.

The graph below shows that although exploration expenditure increased during the mining boom from 2004 onwards the number of significant discoveries remained flat or decreased during this time.

Exploration discoveries 1975 - 2012
Source: Where are Australia's mines of tomorrow? (CET & UWA)

 

Exploration companies are struggling to raise cash to survive in the current resources downturn. Exploration activity is decreasing rapidly and it is likely that many companies will delist from the ASX in the coming years. Therefore, it seems likely that the number of discoveries will continue to drop even lower.

2. Discovery of a mineral deposit worthy of further investigation but the company is unable to develop it further 

Sometimes an exploration company will encounter a mineral system that is uneconomical to develop in its own right or the company can't afford to progress the exploration program. The company will usually have a few options: sell the exploration tenement to a production company that has existing operations nearby or to another interested party; form a joint venture with another company that can fund the additional exploration or development; or give up on the program.

Pioneer Resources Ltd (ASX: PIO) sold its Mt Jewell gold exploration project to Kalnorth Gold Mines Ltd (ASX: KGM) in 2012 for $8 million which allowed it to continue exploration and focus on its other high priority targets. $8 million may not sound like much when compared to typical corporate Australia, but it can keep an exploration company alive for another few years.

3. Discovery of a significant mineral deposit

This is the least likely outcome but is what all investors hope for: the rare discovery that is valuable enough to attract investment to develop a new mine and transform the company from an explorer into a producer.

Notable recent discoveries include Sirius Resources' Nova-Bollinger nickel deposit (2012), Sandfire Resources' DeGrussa copper mine (2009) and the Tropicana gold mine (2005), a joint venture between Independence Group NL (ASX: IGO) and AngloGold Ashanti Limited (ASX: AGG).

Discovering these deposits can often attract the interest of larger mining companies, as was the case when Independence Group recently launched a $1.8 billion takeover offer for Sirius Resources. The discovery drill hole for the Nova deposit is shown below.

Nova_discovery_drillhole
The Nova deposit discovery drillhole. Photo credit: Sirius Resources

 

What can investors do to increase their chances of success?

Investing in the exploration industry is a high-risk gamble but there are a few things you can do to increase your odds for hitting that 1 in 1000 shot.

Experience is important: ensure you thoroughly research the company and the main geologists. What is their background? Do they have experience in the target minerals and have they made any discoveries before? For example, the founding Sirius geology team consisting of CEO Mark Bennett and Mark Creasy have substantial experience and have both discovered significant mineral deposits earlier in their careers.

The location of the exploration tenements is also a critical factor and the further they are away from existing infrastructure, the larger the discovery required for it to be economical to develop a new mine. If the company is exploring a new area outside of the existing, well-known mineral provinces then the probability of a discovery will be significantly less.

After the Tropicana, DeGrussa, and Nova deposits were found in relatively unexplored areas of WA there was a rush by other exploration companies to claim the surrounding tenement acreage in the hope of finding similar deposits. Investing in a select number of these companies could be a good strategy to increase the chances of exploration success. For example, Legend Mining Limited (ASX: LEG), Windward Resouces Ltd (ASX: WIN) and Segue Resources Ltd. (ASX: SEG) are currently exploring around the Nova deposit in the Fraser Range, WA.

Motley Fool contributor Mitch Sonogan has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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