How smaller miners graple with the commodities cycle
Peter Koven, Financial Post Published: Monday, August 25, 2008
Michael Judson did everything right. And like many other mining entrepreneurs, he is now fighting to stay in business.
Four years ago, Mr. Judson, 46, was among the first people to realize that metal prices were getting ready to break out of their decades-long funk. He looked around for opportunities and found a zinc mine in New Brunswick that was shuttered years before.
He started a company called Blue Note Mining Inc. and bought the project, completing financing in 2006 just after the price of zinc really started to take off. And unlike so many other juniors, he actually delivered on his plan by getting the mine back into production and generating real cash flow.
His reward for that hard work: a 5¢ stock price and a message to shareholders that market conditions need to improve for Blue Note to remain viable.
Blue Note has been hit by many of the crises facing the mining industry, including falling commodity prices (particularly for zinc), high operating costs and a collapse in investor confidence that makes it incredibly hard to raise money.
Mr. Judson, a "glass-half-full kind of guy," says he is learning to be more flexible and find new efficiencies on an hourly basis to get through the tough times. But he knows many of his competitors won't.
"Blue Note went into this with a reasonably strong balance sheet and an operating mine, and we're still suffering," he says. "But some of the other guys out there didn't enter this environment with a balance sheet of any size or health. Many of them won't make it, just because the stresses are too great."
On the surface, this seems strange. Commodity prices are still high by any historical standards, demand is strong and producing companies are generating plenty of cash. These are supposed to be good times.
The equity markets are telling a different story. Mining share prices are getting savaged by investors, and are badly under-performing the commodities themselves.
The awful credit markets, soaring exploration and production costs, rising political risks and signs of an economic slowdown are all big factors. The result is that investors have lost all appetite for risk.
The good times of the past few years have ground to a halt for many small companies, and the question is how long it will take before they return -- and how many companies will die off meanwhile.
While shares of all the major producers have fallen sharply since mid-June, they continue to generate plenty of cash at these prices (BHP Billiton PLC, for example, just reported an annual profit of US$15.4-billion). These companies can wait patiently for investors to return to them.
The junior miners have no such option. They began to get nervous when the credit crunch hit last August, and many moved on to full-blown crisis mode in the past few months as their share prices plummeted and they ran short of cash, with little chance of raising more on the horizon.
"I've been around long enough to see several cycles and this is a really nasty one, no doubt about it," says Canaccord Adams analyst Wendell Zerb, who chronicles the carnage in the Junior Mining Weekly report. "We've been in this period since May where we're waiting for a catalyst to turn it around. It just hasn't come."
One disturbing trend he points to is volume on the TSX Venture Exchange, which is a good indicator of interest in the junior resource sector. Trading volumes fell 19% in July year-over-year, and 43% month-over-month as liquidity dried up. That is even more troubling than the fact that the index is off more than 40% from its high last year.
Even resource investing guru Eric Sprott admits he did not think it would get this bad. Mr. Sprott correctly predicted the subprime crisis and collapse of the U. S. credit bubble, but his bet that junior gold and energy stocks could dodge the resulting turmoil was way off. He didn't expect the financing to dry up so much for those companies, and he didn't expect the capital costs on mining projects to rise to such obscene levels.
"I've seen a lot of companies where management is ponying up their own money because they can't raise any on the public markets. The equity markets will have to turn around for these guys to [survive]. Because there's no such thing as debt financing for smaller companies anymore," he says.
About the only thing experts agree on now is that this crisis will subside as commodity prices improve and the panic that has gripped the markets dissipates a bit. But for that to happen, some kind of catalyst will have to take hold and change investor sentiment.
One possibility is consolidation, as the valuations of many junior companies are incredibly cheap now. That gives cash-rich majors like Barrick Gold Corp. and Teck Cominco Ltd. a once-in-a-cycle opportunity to pick up quality assets at bargain-basement prices.
That dealmaking got underway with the proposed takeovers of junior gold companies Aurelian Resources Inc. and Gold Eagle Mines Ltd., but neither managed to light a fire under the market.
Another possibility is that the valuations are so cheap that investors just won't be able to resist them and will start to flock back.
"I think we've got to be pretty close to the bottom here," says Mark O'Dea, chief executive of Fronteer Development Group Inc. "A lot of companies out there are trading at or near cash value, and investors are looking for the deep value stories to load back into when the sector turns."
Fronteer continues to put out strong drilling results from its gold projects in Nevada that get ignored by the market. On the other hand, the company still hasn't recovered from the pounding it took last April when its uranium subsidiary in Labrador got hit by a three-year ban on mining from the local Inuit.
The fact that the moratorium does not affect the company's development timeline means nothing -- investors have no patience for political risk these days and Fronteer was punished as a result. "Investors are much more reactive to negative news than positive news right now," Mr. O'Dea says.
That said, there is plenty of positive news the market will come around to as the panic selling subsides, experts say.
The most important one is that the fundamentals for this commodity cycle still look solid to most observers. While the health of the United States economy is an open question, China's gross domestic product grew at a 10.4% clip in the first half of the year, and India is not far behind. That means the demand story that has propped up commodities for most of this decade hasn't changed. With that story entrenched, sentiment could change fast once investors start focusing on the good news.
Experts also point out that a lot of the bad news isn't so bad if you have a long-term view.
For example, the plunging prices of zinc and nickel (both off more than 60% from their record highs) have a lot of companies panicking. Zinc is suffering because rising supply has more than caught up to demand, and nickel is still hurting from last year's price leap, which eroded demand for stainless steel.
Low prices, along with soaring costs, have created such a crisis that some mines have actually started to close (and just last Thursday, Hud-Bay Minerals Inc. announced the closure of its Balmat zinc mine). Much of the exploration spending has dried up as well.
This is not what a hot commodity market is supposed to look like. But for long-term bulls like Mr. Sprott, this slowdown can only lead to supply shortages and higher prices in the future.
"It's not an overnight process. But if you take the price low enough, and risk high enough, things just don't move forward. The market is too short-term to look that far out," he says.
That is little consolation for Blue Note, the small zinc miner that had the right idea but happens to be producing the wrong commodity at the wrong time.
But Mr. Judson is an optimist, and his thinking is that zinc prices can only increase in the fall when the holidays end and the liquidity on the markets picks up. Meanwhile, he is ramping up production himself and is not about to let a little market turbulence get in the way of his long-term goal.
"You get a spike or two with the price and all of a sudden you can see sentiment change quite significantly," he says. "And if we continue to see strong growth numbers out of China and India, I think that will in turn help with metal prices and investor sentiment."
News 
Market Data 
Discover 
