Survival Guide for the Mother of All Commodity Bear Markets from Veteran Bottomfisher
Commodities / Resources Investing May 06, 2015 - 10:13 AM GMTBy: Metals_Report
When North Americans wake up to the dangers of relying on China and Russia for essential metals like zinc, rare earths, antimony, niobium and scandium, the juniors now suffering with anemic stock prices could turn into cash producing machines worth writing home to mom about. In this frank assessment of everything from gold and diamonds to potash and zinc, Kaiser Research Online author John Kaiser names for The Mining Report readers the companies that could be swept up in a rush to security of supply.
The Mining Report: John, what are the global issues you are watching that could have an impact on commodities, particularly gold?
John Kaiser: There is a risk that the economic growth slowdown already underway can deteriorate further, precipitating major general market declines and causing demand for raw materials to flag. This would worsen the current situation where the supply response from the bull period of the past decade is already, in most cases, exceeding demand and, therefore, resulting in a further glut to depress prices and hurt companies involved in both development and mining of raw materials. At the same time, the subdued global growth outlook is creating domestic stresses that in turn are translating into geopolitical conflicts, which have me thinking about security of supply risks should globalized trade come unglued.
TMR: What effect does political instability in Russia and the Middle East have on gold prices today? History would suggest that uncertainty would drive prices up but that doesn't seem to be the case right now.
JK: A major market correction and evidence that the world is sliding back into recession would be negative and push gold down toward that $1,000/ounce ($1,000/oz) level. Many projects are not viable even at the current $1,200/oz level. This would certainly harm the valuations for producers and the near producers.
On the other hand, even if we avoid a global economic downturn, we are still vulnerable to geopolitical disruptions such as Russia's gradual annexation of Ukraine and its increasingly precarious relationships with Europe spinning out of control and creating some serious supply issues in the gas, oil and nickel sectors. In the Middle East we are witnessing a regional power struggle between the Sunni and Shiite branches of Islam with America's ally, the Saudi monarchy, as potential roadkill. If Obama is unable to bring Iran out of its pariah status and establish a balance of power between Sunni and Shiite, we could see major oil supply disruption.
Meanwhile, China continues to assert its dominance in its neighborhood, as seen by the creation of man-made islands within the Spratly Island chain in the prospective oil rich South China Sea. This expansion of China's footprint is largely at the expense of American influence in that part of the world. That could be geopolitically destabilizing if the U.S. attempts to push back.
TMR: But wouldn't that hurt the dollar and, therefore, be good for gold?
JK: China pushing against the U.S. would have the perverse effect of boosting the dollar higher because the U.S. is still the biggest economy and the military superpower controls the world's shipping lanes. It can function as an island unto itself, especially if it forges a closer relationship with South America. In fact, its attempts to end the cold war with Cuba are part of this initiative. I would say that cases of this sort of instability would cause the dollar to rise and gold to go up. The main hope for a gold uptrend that is beneficial to gold developers and producers because it is not just a reflection of a declining U.S. dollar or global inflation is geopolitical uncertainty. Bad news for gold would be a scenario where the world peacefully sags into a depression.
TMR: You have talked about gold as a store of energy. What does that mean?
JK: I point that out in reference to people who call gold money. Money is an information system, which keeps track of credits and debits. It allows an economy to go beyond the barter system by enabling the exchange of goods and services extended through space and time. Gold has in the past served as a guarantor of the integrity of money, but that is not the same as money, which is an information system whose underlying cost should be as low as possible. Gold requires a fair amount of energy and time to bring it out of the ground into concentrated form. In that sense, gold is a form of stored energy that cannot be unleashed to produce work in any other form. If you wanted more gold aboveground to back the expansion of economic turnover, you would have to invest energy.
Unfortunately, the energy required to bring incremental gold out of the ground is rising as we deplete the low-hanging fruit at the surface of the earth. That, by the way, is a key problem with the gold sector in general. We are now producing 89 million ounces (89 Moz) annually, the highest ever in history, and the price to bring this gold out of the ground is also at an all-time high. Gold makes sense as an asset class because it is a reservoir of expended energy, and the ability to "make" more gold today requires a higher input of energy per unit gold than ever before. The existence and size of an abstract information system such as money should not be linked to the cost of energy.
TMR: How are companies pulling gold out of the ground creating value when the input costs keep going up, but prices aren't rising?
JK: In a lot of cases, companies are simply shutting operations. Where they can, they are rationalizing the costs. Low oil prices are helping some companies, particularly those in remote locations dependent on diesel, provided they did not hedge the future cost of fuel. They may benefit down the road if they are hedging their future consumption at the current levels, for it's unlikely that oil prices will stay at low levels for long.
Some miners are grade flexing. They mine higher grades when the price is low and lower grades when the price goes up. Companies have to be careful not to damage the mineability of the lower-grade portions being saved for later. Some are running the risk of destroying the longevity of the resource, and therefore the future of the company.
TMR: What's an example of a company that is mining gold successfully right now?
JK: Probably the most successful company at the moment is Goldcorp Inc. (G:TSX; GG:NYSE). It has done a good job of acquiring deposits and putting them successfully into production.
Others like Agnico Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) have also done a good job in this regard.
Then there are companies like Barrick Gold Corp. (ABX:TSX; ABX:NYSE), which has done well with its Nevada assets but not so well elsewhere in the world.
TMR: What are juniors with advanced projects that are not viable at $1,200/oz gold doing to stay relevant?
JK: Midas Gold Corp. (MAX:TSX) is an example of a company that has spent over $100 million ($100M) delivering a prefeasibility study, which had to be modified from the preliminary economic assessment (PEA) assumptions to accommodate a lower base case price for gold. The company is optimizing the pit, improving the metallurgy and scaling down the size of the operation to get away from the very high capital expenditure (capex) that made sense when gold was on its way to $2,000/oz but not at $1,200/oz.
TMR: I understand a company just sold 8M shares of Midas. What was behind that?
JK: That was Vista Gold Corp. (VGZ:NYSE.MKT; VGZ:TSX). The company today trades around $0.37/share. It was $14 in 2005. It raised about $25M at the $3/share level in 2012 and spends about $3–4M per year on overhead. The Midas shares that it held were acquired by spinning out the Stibnite project into the public company that became Midas Gold.
Vista sold 15M shares last year to raise money to keep its operations afloat, and it sold another 8M shares this year at an even lower price to raise money to keep its overhead funded. It has another 7M shares to go in six months, which the market will likely also have to eat because Vista's own projects really are in the same boat as all the other junior companies with advanced projects that do not work very well at the current gold price.
TMR: You mentioned that the Stibnite project just had a prefeasibility study released that wasn't embraced by the market. What is it going to take for the market to see that the adjustments the company has made could make the project viable?
JK: This is the mother of all bear markets for the resource sector and the investor community has turned blind to upside potential. One of the problems with the Midas prefeasibility study was that a good part of the resource had to be excluded due to a lack of sufficient drill holes in some areas. That cut the cash flow potential of the Stibnite project, which hurt the net present value projected by the study. However, additional infill drilling will likely bring the missing ounces back into the production model. The market was unhappy that the project appeared to shrink rather than stay the same, but I think this is a temporary result of the feasibility demonstration cycle.
The second thing that the market doesn't like is the location of the project in Idaho, a state that is seen as being very difficult to permit. I think this attitude is misguided. The Stibnite project is a reclamation project funded by a gold mine. This is an environmental disaster area created during World War II when the area was mined for antimony and tungsten, and then the same antiquated mining practices were used in the 1950s into the early 1960s for gold. Putting this mine into production using modern methods would restore fish migratory channels to a big area that is blocked by the leftovers from the old mining operations.
The other thing that people do not understand is that the antimony byproduct supply could become of critical importance to the U.S. because 78% of all antimony comes from China, a country adopting a new environmental policy of cleaning up its very polluting operations. It is reasonable to expect the supply of antimony from China will decline as it shuts down polluting mines. If we encounter geopolitical conflict where material is not flowing out of China for strategic reasons, then the U.S., which still needs a fair chunk of antimony for industrial manufacturing purposes, will find good reason to see the Stibnite mine go into production and provide a domestic supply of antimony.
TMR: Is security of supply becoming a more important story particularly for materials like antimony, tungsten and scandium?
JK: Yes, for multiple reasons. I think the assumption that globalized trade is going to be with us forever is flawed. We are already seeing extensive use of trade sanctions instead of physical warfare. The side effect of using sanctions is that it fragments the global supply chain. I also see a retrenchment of parts of the world into their own trading arenas. One example is the Asian Infrastructure Investment Bank, a development bank that China is inventing as an alternative to the World Development Bank and the International Monetary Fund, that every country except the U.S. and Japan have decided to join. Its goal is to develop infrastructure in Southeast Asia where China expects to be the dominant player.
Another reason unrelated to geopolitical conflict is government environmental policy. There are no Chinese leaders declaring, "I am not a scientist" when asked about the cause of climate change. They understand that without changes China will move from being the second biggest source of the problem to the biggest source. They are also getting tired of their self-appointed role as the world's toilet for industrial emissions. An environmental awakening similar to what swept the United States during the 1960s is underway.
The result could be a shrinking supply of critical metals as Chinese mines are forced to shut down or increase their cost of production by following environmental rules. The resulting supply gap will push up metal prices that will not be greeted by new Chinese supply. Projects elsewhere in the world that are sitting idle because their operations must meet environmental standards will end up in the money and receive a development green light.
Yet another reason to think about security of supply is the innovation surge accompanying the rush to deal with environmental policy goals. China's crackdown on pollution is disruptive of metal supply, but its adoption of climate change-related greenhouse gas reduction goals is a demand driver as new energy-related technologies get developed. The innovation frontiers are alternative energy and energy efficiency. Personally I much prefer to see metal prices rising because of environmental policies rather than geopolitical conflict.
TMR: Let's talk about some of those supply and demand equations for the individual materials. Start with tungsten and what companies could meet that demand.
JK: Tungsten is an important metal. It is used as a hardening agent largely in the tool industry and has seen considerable demand growth during the shale drilling boom. But demand tends to follow the global economic trend, so it is suffering a bit from the worldwide slowdown. It is, however, also a war metal used in weapons and as a hardening agent for armor. If we do end up in a period of conflict that encourages an arms buildup, we could see demand for tungsten go up dramatically.
The company that I follow closely in this space is Northcliff Resources Ltd. (NCF:TSX), which advanced the Sisson project in New Brunswick to the stage where it is pursuing a permit to go into production. This is a low-grade tungsten-molybdenum deposit, which would represent close to 8% of current global production. At the current tungsten price, the Sisson project is not viable, but a geopolitical disruption could completely change the equation.
TMR: When we talked in October, you were waiting for an environmental report. Did that work out as you'd hoped?
JK: There are many stages in the environmental process. I don't expect to see final approvals until the end of this year, maybe early next year. Northcliff is treading water while it endures the tungsten price slump. There is no reason to rush the permitting process. It has a 15% shareholder in Todd Corporation Ltd., which is eager to own the whole company. The risk is that unless there is a breakout in tungsten prices before the company runs out of money, it could be absorbed by the Australian conglomerate to secure long-term supply of tungsten for its tool businesses.
There is another concept that people don't think very much about. That is the idea of natural depletion. In the zinc market, major Western mines are shutting down because they have run out of ore and there is not much in the pipeline to replace this lost production. But no one has really cared because China has increased zinc production 3,000% from 160,000 tonnes in 1980 to 5 million tonnes in 2014. Its global share has expanded from 3% to 38%. China's mines tend to be small scale, poorly operated, aging and polluted. And it is getting more expensive to access Chinese antimony, tungsten and zinc deposits as high-grade near-surface zones get mined out.
Nobody except perhaps the Chinese know what the Chinese zinc cost curve looks like. Production was unchanged in 2014. I suspect that we will see a decline in output and an increase in the price of zinc. I think we will see the same happen with other metals such as antimony, tungsten and graphite in which China dominates. If China has the geological capacity to switch from "small and messy" mines to "big and clean" mines, it will take quite a few years to happen.
Although gold does not fit into a security of supply framework because all 5.4 billion aboveground ounces are scattered all over the planet and theoretically for sale immediately, the Chinese depletion and environmental policy themes also apply to gold mining. China has grown from 225,000 oz production in 1980 to 14 million ounces in 2014, representing 16% of global supply. Yet nobody has heard of a world-class Chinese gold mine. Goldbugs may finally get some price upside as government regulations put China's small scale gold mining entrepreneurs out of business.
I'm of the view that this is an ideal year to look at advanced projects. The stock price downtrend since 2011 has bottomed. If they have sufficient money to carry on for another year, this is a time to buy these stocks, tuck them away with a one-year or longer time horizon in mind, and monitor global affairs for developments that may disrupt the supply or boost the demand for the metals these companies hope to produce in the future.
TMR: What about the supply and demand story for scandium?
JK: Scandium is an unusual metal in that demand is restricted by available supply, which is only 10–15 tons per year of scandium oxide from a variety of byproduct sources, such as in situ uranium leaching, titanium dioxide waste stripping and byproduct from the Bayan Obo rare earth mine. None of these sources is scalable in a serious way, and all of them tend to have fairly high costs, even for the recovery circuit needed to strip the scandium out as a byproduct.
So it's a pitifully small market worth about $20–50 million annually depending on price, which can range from $2,000 to $7,000 per kilogram ($2,000–7,000/kg). But scandium is to aluminum what niobium is to steel. It makes aluminum stronger, more weldable, corrosion resistant with a higher melting temperature and doesn't affect the conductivity. These factors enable scandium-aluminum products to save energy, which plays right into the greenhouse gas emission reduction movement, as well as universal cost consciousness. So scandium is a potential important player if it can become available on a scalable basis.
In the last seven years, deposits have been recognized in Australia's New South Wales that have grades three to six times higher than what was mined in the Zhovti Vody deposit in Ukraine by the Soviets during the Cold War. The aircraft industry alone would harvest a 15% weight savings for its aircraft by replacing all its aluminum parts with aluminum-scandium. The automotive industry has potential to adopt aluminum scandium alloy in parts of cars where strength might be needed or where the melting point is an issue, such as in brake rotors that are still made of cast iron and weigh double the aluminum equivalent. The rail industry could also benefit from using stronger aluminum scandium alloy to pull less of the train's own weight and more cargo weight and save fuel.
Scandium is a story that is going to explode with demand going up to 1,000 tons per year in about 10 years from next to nothing simply because juniors have discovered deposits that no one thought could exist at this grade. These companies are investing the time and effort to sort out the metallurgy and going through the feasibility demonstration stages. We will probably see the first small-scale mine in production in 2017. When the industry sees that scandium oxide can be produced at $2,000/kg or less, from a deposit where production can be scaled up to whatever level demand requires, then end users will start to commercialize all these applications that are sitting on their drawing boards.
TMR: What juniors are having the most success moving scandium projects forward?
JK: The two most important ones are Scandium International Mining Corp. (SCY:TSX), which owns the Nyngan deposit in New South Wales, and Clean TeQ Holdings Ltd. (CLQ:ASX), which is acquiring the Syerston deposit from Ivanhoe Mines Ltd. (IVN:TSX). The Syerston deposit is bigger than the Nyngan deposit and has a slightly higher grade. That project was originally a nickel-cobalt project, but Robert Friedland, a substantial stakeholder with a keen understanding of China's self-imposed environmental mandate, recognized the value of scandium enrichment at the periphery of the subeconomic nickel-cobalt deposit. Ivanhoe is selling Syerston to CleanTeQ because CleanTeQ's management has experience with flowsheet processes related to scandium recovery. Incidentally, China has become the world's biggest aluminum producer with 47% of 2014 global supply.
Scandium International is more advanced. It has been working on the scandium potential of Nyngan since 2010. It published a PEA in October 2014 for a 36 ton per annum operation with a capital cost of $78M. That's about four times what is currently supplied to the market. The company hopes to have the feasibility study done and the mining permit in hand by Q1/16. Then it has to raise the capex. I think it will be able to do it because the proposed mine is in essence a pilot plant study designed to be profitable if the company can attract buyers for its output at the $2,000/kg base case price of the PEA.
If the mine is operational in 2017 and demonstrates that it can deliver the scandium at a profitable price, the aircraft industry and the automotive industry will get serious with long-term planning for deployment of aluminum-scandium alloy components. For these two companies, scandium is a potentially extraordinary growth story where you go from a market that's almost nothing to a market that could end up being worth $2 billion ($2B) annually.
That is, of course, what has happened to niobium, which was in a similar situation as scandium until the Araxá deposit was discovered in Brazil and developed during the 1960s. That has grown to a $2.5B market today. It makes steel stronger and raises the melting temperature for use in all sorts of applications. Niobium is what you might call an energy efficiency driver for the steel industry because niobium-strengthened steel gets the job done with less weight.
TMR: What are the juniors in the niobium market that you're watching?
JK: There are only three major niobium mines. The first is Araxá, which is owned by a private Brazilian company that sold 30% to a consortia, one Chinese and one non-Chinese from Asia, for nearly $4B in 2011. It produces about 80% of global supply.
There is another project owned by Anglo American Plc (AAUK:NASDAQ) in Brazil that produces 10% of global supply.
Then there's the Niobec mine in Canada, which IAMGOLD Corp. (IMG:TSX; IAG:NYSE) recently sold for $500M to Aaron Regent's Magris Resources Inc.
These are the three that are in operation. The up-and-comer is NioCorp Developments Ltd. (NB:TSX), which owns the Elk Creek deposit in Nebraska. This was a deposit found and explored by Molycorp Inc. (MCP:NYSE) many decades ago. NioCorp just published a PEA, which has a rather high, $900M, capex for an underground mine. It hopes to be able to join the other three producers in supplying the world with affordable niobium by recovering a scandium byproduct credit because this deposit has a 70–80 parts per million (70–80 ppm) scandium component and would be a great domestic source of scandium in the U.S. For comparison sake, the grade of the Ukrainian Zhovti Vody mine that made the Soviet fighter jets possible was about 100 ppm, while the deposits of Scandium International and Clean TeQ have grades of 300–600 ppm. Unfortunately, Niocorp's current PEA flowsheet has only a 14% scandium recovery. Boosting the scandium recovery is an important way Niocorp could improve the economics of the PEA.
TMR: The market did not react well at all to that PEA. Then NioCorp had a press conference to update and clarify it. Did that make a difference?
JK: No. The after-tax net present value is too low relative to capex, and the internal rate of return for this sort of complex project should be over 20%. Plus, investors were disappointed that management had not caught an error that slightly lowered the economic figures before publishing. That served the company a credibility setback.
TMR: Are scandium and niobium similar to the rare earth elements (REEs) where the value is less in the mining than in processing and supply chain management?
JK: It is largely a processing problem that only grade can overcome, and it is the high grade of the Australian deposits that is the game changer for primary scandium supply that can respond to demand growth. Scandium tends to be very low grade. It is quite abundant in the crust, but it does not concentrate like chromium, so you get very low grades, and you have to crack the host rock to liberate scandium mixed with a lot of other elements. And each flowsheet has to be a custom design because the composition of the other elements can have negative effects in the chemical reaction, impacting the required amount of acid and heat, the two primary input costs.
For example, niobium is generally present as the mineral pyrochlore to whose cracking the flowsheet will be dedicated. But 30–40% of a deposit's niobium grade reports to other minerals that are not cracked and disappear into the tailings pile. In that sense scandium and niobium are similar to rare earth mines. What is different is that rare earths because of their similarity drop out of solution as a mixed oxide concentrate that has to go through a second expensive separation stage to yield individual rare earth oxides that are marketable.
TMR: Has the need for REEs been sufficiently recognized for its security of supply role in non-Chinese mining companies?
JK: We have tentative supply coming out of Molycorp's Mountain Pass operation. However, with the current prices for REEs, most projects are not viable. The bubble three years ago had the negative effect of spurring demand destruction as end users looked at ways of doing without REEs as critical inputs. China's ability to expand production, in particular in the heavy rare earth element (HREE) department, will be constrained by the environmental crackdown because ion adsorption clay mining operations are among the most polluting mines in the world. The deposits are also very inefficiently mined, which is of concern to China because the country could face depletion of these surface deposits within about 10 years.
That's why I'm watching two junior companies—Namibia Rare Earths Inc. (NRE:TSX; NMREF:OTCQX) and Tasman Metals Ltd. (TSM:TSX.V; TAS:NYSE.MKT; TASXF:OTCPK; T61:FSE)—both of which have HREE-enriched deposits in stable countries. Tasman has published a prefeasibility study (PFS), and Namibia has published a PEA on the Lofdal Area 4 deposit. It is a smaller-scale mining plant, and it produces 95% HREEs. Tasman's Norra Kärr project in Sweden is a larger-scale mine with about 50% HREEs. Both economic studies utilized price assumptions nearly double the current spot basket price and are in a bit of a holding pattern. They are continuing to do what is necessary. Tasman has already done detailed flowsheet work and is focused on permitting. Namibia Rare Earths needs to conduct PFS quality flowsheet work for which it would like to attract a partner that also has access to a heavy rare earths separation facility, for which the only non-Chinese candidate is the Solvay SA (SOLB:NYSE; SOLB:BRU) Rhodia facility in France.
I like Namibia Rare Earths because it has sufficient money in the treasury to maintain the project. It does not have sufficient money to bring it to feasibility or develop it, but a partner looking for supply security could make it possible for Namibia to explore the Lofdal carbonatite complex further. It has potential for other minerals such as niobium, and could host additional HREE-enriched zones. That project could emerge as a long-term supply of HREEs.
Tasman has started to assemble other critical metal deposits, such as chromium deposits in Finland and former tungsten operations in Norway and Sweden. Although the heavy rare earth output from Norra Kärr will be large enough to support its own separation facility, Tasman will need to bring on board a partner with the skills needed to build and operate such a facility. One of Tasman's advantages is that its deposit has a low thorium grade; until the world starts building thorium-fueled nuclear reactors, getting rid of this radioactive byproduct is an issue for non-Chinese rare earth mines.
TMR: You mentioned the natural depletion cycle of some minerals. What are the commodities and companies that could benefit from a natural depletion cycle?
JK: The companies with advanced zinc deposits are the ones that I think should be accumulated at this point. Zinc still hasn't had that price breakout above $1.20/pound ($1.20/lb) needed to get the market truly excited, but the investment community has been watching zinc very closely. A supply deficit is supposed to be just around the corner, though that has been a prediction for years. However, the zinc mountain in the LME warehouse has declined by a third since peaking in 2013, and after a pause late last year, has started to drop again. If China does not mobilize additional supply as everybody cynically expects will happen, or perhaps even starts to decrease its supply, the warehouse stocks could drop sharply and then we get that price breakout through $1.20/lb.
A price breakout not caused by supply disruptions viewed as temporary would be the green light where suddenly capital swarms into projects such as InZinc Mining Ltd.'s (IZN:TSX.V) West Desert project in Utah, for which the company has already published a PEA whose numbers were good at the base case price of $1/lb zinc, and which soar at $1.20/lb and above. InZinc needs $3M to properly delineate the deposit's limits and then probably a $15M program to complete a prefeasibility study as a prelude to going into production as an underground zinc mine with copper, gold, silver and indium byproduct credits.
Indium, by the way, is another one of these materials that is not even mined as a product. It is mainly recovered as a byproduct from zinc concentrates by smelters that do not pay the producer for it. But indium demand is also a critical metal used in a lot of new technologies. If a deposit like InZinc's were taken over by a company with a smelter, it would be able to capture that indium credit as well.
TMR: Is that the ultimate exit plan for InZinc, to be bought out?
JK: For most mines, especially in the polymetallic base metal arena, the goal is to bring a project to the point of prefeasibility, perhaps even push it to feasibility with a permit in hand, but then be acquired by a bigger company with the internal capital and skill to put the project into production.
TMR: Do you think InZinc will be able to raise enough money to get to that point?
JK: The PEA projected an after-tax net present value of US $258M using an 8% discount rate with an internal rate of return of 23% at $1/lb zinc. These are good numbers with capex at US$247M that improve substantially at $1.20/lb or higher. Zinc, however, has been in the sink forever. Until the market sees that price breakout, it's going to be reluctant to finance any advanced work for a zinc project. So InZinc is sitting there, treading water at $0.10 to $0.12/share, owns 100% of the project and does not have any exploration permitting issues because it is all privately owned land. It is located in Utah, which has a mine friendly permitting regime. When zinc breaks out, the stock will move up sharply and the capital will arrive. Right now, it is still tough for the company to raise any equity for serious feasibility demonstration work.
TMR: Is the world also facing a potash shortage?
JK: Potash does not so much have a depletion problem as a supply disruption problem. A good chunk of the world's supply comes from Belarus and its neighbor Russia. If this shoving match between Russia and Europe over Ukraine spins out of control, we could end up seeing supply disruption for potash pushing prices higher. The potash supply is controlled by a half-dozen or so major companies with Canada's Potash Corp. (POT:TSX; POT:NYSE) as the giant producer. The capacity to expand supply exists, but it will take time to mobilize. For example, BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) owns the Jansen Lake deposit in Saskatchewan whose development it is ready to fast-track once potash prices turn up again.
But the company that intrigues me the most is Verde Potash (NPK:TSX), which has a different type of potash deposit in Brazil. Most potash is mined from evaporite beds deep underground. They run 20–30% K2O. In Brazil, Verde Potash controls billions of tons of this silicate form of potash, which runs only about 8–12% K2O. Because it's a silicate, the potash is not very accessible. Verde Potash has developed a process to create two types of product. One is ThermoPotash, which blends heat-treated potassium silicate to create a nonsalt-based form of fertilizer intended for organic crops and ones like tobacco and grapes, which cannot tolerate potassium chloride (KCl) in the soil. Coffee, another important Brazilian crop currently fertilized with KCl, has shown taste improvement when fertilized with ThermoPotash, which also allows it to qualify as organic.
Verde Potash published a prefeasibility study estimating a $100M capex to produce ThermoPotash for this niche market in Brazil. It could also produce conventional KCl, but this product requires a potash price higher than $300/ton. The company's attempt to deliver a bankable feasibility study in 2013 failed because the pilot plant study for the process was not large enough to secure a performance guarantee for the size of equipment needed to make the process economic. The effort to convert the company's silicate potash resource into potassium chloride has been shelved because the cost of the required pilot plant study is $30–40M. However, if Verde builds a ThermoPotash plant, it could shut it down for several months and run the KCl process through this plant to demonstrate that it works at scale.
Verde Potash would be vital for Brazil because it is one of the great agricultural regions of the world, with the greatest agricultural output expansion potential, but much of its soil needs a lot of fertilizer. The country currently imports 90% of its potash. If we have supply disruptions elsewhere in the world, Brazil is the country that will suffer the most from soaring potash prices for whose mitigation it will be at the mercy of new supply mobilization from countries such as Canada.
TMR: Give us a story that brings the conflict and depletion cycle together and could get investors excited again. What's something that you would want to write home to mother about?
JK: Diamonds are a luxury good, which means that if all the gem diamonds for some mysterious reason flash evaporated, it would leave a lot of unhappy people behind, but the world would carry on as though nothing happened. Its demand is driven by fashion, and thus driven by a growing economy, especially where the growth is in the form of an expanding middle class, such as is the case in China and no longer in the United States. If we assume emerging markets will remain the main component of global economic growth, demand for natural gem diamonds will expand. That's a problem because although 5 trillion carats have been mined since the South African diamond fields were discovered, diamonds tend to just disappear.
Unlike gold, where the 5.4 billion ounces that have been mined in the last 10,000 years are all sitting there in vaults or hanging from people's necks ready to be melted down and resold when the price is right, diamonds seem to disappear into nooks and crannies from which they never emerge to flood the market. Although the stones are valuable, they do not get recycled. That's an issue for the jewelry industry because there have been no giant new discoveries made in the last 15 years, and the big mines like Jwaneng and Orapa in Botswana and others in Russia will be depleting in the next 20 years.
Unless diamonds fade as a coveted luxury good, a supply-demand imbalance will emerge that drives prices higher at a greater rate than inflation. This is important because if a junior owns a diamond deposit whose development costs have been established, the profitability of the mine will increase over time because the revenue side of the equation increases at a greater rate than the inflation-based increase of the operating costs. This is not done with a gold project because the main reason to expect a higher gold price is inflation. Adjusting revenues and operating costs by the same inflation rate is frowned upon because it mathematically boosts the present value of the cash flow. And there is no empirical basis to project a higher real price for gold. Diamond projects have been out of favor while gold was in an uptrend, but now that gold has stabilized at $1,200/oz in a low inflation environment, diamond projects are set to sparkle again.
Probably the best story out there right now is Peregrine Diamonds Ltd. (PGD:TSX), which has raised $28M since last October to collect a major bulk sample that will form the basis of a PEA in Q1/16. It has high-grade pipes on the Chidliak project with a high average carat value already established for the CH-6 kimberlite. If the bulk sample confirms preliminary grade, carat value and tonnage estimates, CH6 will be the equivalent of an open-pittable 4 Moz gold deposit with a grade just under 0.5 oz of gold at the current gold price.
The market has been so negative about anything resource sector-related that the Friedland brothers personally put up two-thirds of the $26M raised through a rights offering and attached warrant offering in the last six months. This stock has gone from a low of $0.14 to $0.34, with 300M shares out. It still has a valuation of only about $100M for a 100%-owned project that has potential to be worth 5 to 10 times that if the bulk sample confirms what we can already see from earlier results.
TMR: When might we see those bulk sample results?
JK: The bulk sample extraction will be done by the middle of May, and shipped from Iqaluit in July when the ocean is ice-free. We should start seeing grade results in Q4/15 with valuations in hand by the end of 2015 and new resource estimates and a PEA sometime in Q1/16. The bonus potential is that as Peregrine collects the largest ever bulk sample from Chidliak, we may start seeing those very big "specials" diamonds whose stone value can reach the hundreds of thousands of dollars. Although the Ekati and Diavik diamond mines in Canada produce high value diamonds, they have disappointed in the delivery of gem quality specials. The market is not assigning any premium to Peregrine for the potential of "specials," but if we do see these stones show up in the bulk sample, it should deliver an upside surprise for Peregrine shareholders.
TMR: What makes you think the specials are there?
JK: You do not know until you see them. That's the beauty of it. We could see a doubling or tripling of the stock from current levels by getting confirmation of what we've already seen from a surface bulk sample and what we see in the grade, but if we get the specials, that would be a bonus. Plus, the company is only testing three pipes out of 71 kimberlites that have been found on the property. If we get evidence that large gem-quality stones are present, then these other bodies that have lower-grade implications become potentially interesting.
TMR: What is the one thing investors should be doing to shift to a security of supply-focused portfolio?
JK: They should forget about expecting the sort of instant gratification that big exploration discoveries or dramatic gold price moves generate for shareholders of resource juniors. Not enough drilling is being done on high-risk, high-reward targets to give us the Voisey's Bay type of surprise that ignites a market frenzy. There also is nothing on the horizon to justify a sharply higher gold price except geopolitical developments that belong in the category of things we would wish had not happened.
Resource sector investors need to adopt a longer time horizon and choose resource juniors where the stock price would respond to identifiable future developments whose emergence can be monitored by reading the international news and becoming a globally plugged in citizen. It is wonderful if people do this for its own sake, but it is better when they can convert their understanding of global affairs into implications for a portfolio of resource juniors with security of supply-linked projects. You can see the benefit to your pocket if something goes wrong in Russia or if China undergoes an environmental awakening. That will make investing fun again.
TMR: Thanks, John, for your time.
John Kaiser, a mining analyst with 25-plus years of experience, produces Kaiser Research Online. After graduating from the University of British Columbia in 1982, he joined Continental Carlisle Douglas as a research assistant. Six years later, he moved to Pacific International Securities as research director, and also became a registered investment adviser. He moved to the U.S. with his family in 1994.
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1) JT Long conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an employee. She owns, or her family owns, shares of the following companies mentioned in this interview: None.
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