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January 11, 2005

The Business Case for Buying Junior Mineral Exploration Companies
by Bill McWilliam

Part I of II

Abstract

A convergence of factors has created ideal conditions for buying shares of early-stage junior companies in the resource sector. These are companies with low market capitalizations, extreme-risk profiles but offer large-scale deposit discovery leverage. This combination provides significant capital gain opportunities for the speculator. What are these convergent factors? Who and where are these companies? What is the leverage? And, why you need to take the risk.

Commodity Demand

Worldwide demand for many commodities has grown explosively over the past 6 years, with high-levels of consumption forecast to continue for several years. This growing demand has absorbed excess supply, reduced inventories, and led to significantly higher commodity prices. Much of the increased demand originates in Asia, primarily China, where economic reforms and consequent growth have led to accelerated urbanization and massive infrastructure development, compared by some to that of the United States in the 1950s and Japan in the 1960s and early 1970s. Since the mid-1990s demand for cement, coal, crude oil, iron ore, and copper has exploded in China. Many believe high levels of demand will continue throughout this decade and perhaps much longer as the multiplier effect of this infrastructure development is difficult to predict.

Current commodity shortages are also occurring after a long period of low commodity prices, which discouraged capital and exploration spending in the mineral sector around the world. Consequently, in the past 10 years there have been few new large-scale mineral discoveries and fewer prospects ready for production. This looming supply shortage is well known to the major producing companies and they are scrambling to increase production and secure new resources.

The China Factor

There has been a lot written lately on the subject of China as an emerging world power. Comparisons are made to the major periods of industrialization experienced by the United States, Japan and, later, Korea. All of these countries have had long periods of sustained economic growth. The United States stands out as the world power that has achieved an astonishing growth record over a long period of time, especially for such a very large economy. Korea and Japan experienced more rapid growth rates for shorter periods of time in much smaller economies. Several segments of China's economy, however, have been growing at double digit rates for over 10 years and its trajectory of growth appears to be getting steeper. The momentum, sheer size and diversity of the country and its manufacturing base bode well for the long term sustainability of China's growth and its very large appetite for raw materials.

Urbanization

It has only been recently discussed in the public domain that China's urbanization is a mega-internal migration, which has been underway for the past 18 years. During this time, over 200 million people have moved from a rural to an urban setting, which has been accompanied by a significant increase in wealth. Rural wealth has also increased but the gap between rural and urban purchasing power continues to widen. This income gap reinforces the migration trend and the motivation to relocate to urban settings.

China's cities, of which there are over 600, play a very special role in the urban movement and the industrialization of the country. Cities compete with each other for projects and the financing to develop the projects. They compete for the labour required for the industrial projects and whole families relocate to participate in the getting-richer-faster process that is offered.

The urban migrations of the USA, Japan and Korea were measured in the millions and at times, 10s of millions of people. In China, it is measured in the 10s of millions and 100s of millions. In Japan and the USA, commodity demand peaked when 65% to 90% of the population lived in an urban environment. In China today, it is estimated that 38% of the population is urban. To achieve the 65% level in China, an additional 350 to 400 million people have to migrate, implying great pressure on the world's resources for the foreseeable future as the industrialization and related infrastructure has to increase by an order of magnitude to accommodate the forecast migration.

This urban migration is also the labour source for China's immense manufacturing capability and the engine of China's manufactured-goods exports. Due to the supply of relatively low-cost labour, China can import high-priced commodities and transform them into large volumes of lower priced, high-quality manufactured goods for world consumption. There is little doubt that this is a mega-migration in its early stages and its sheer size is unprecedented in human history. Given the additional power of the income effect on human nature, it is difficult to foresee what could interrupt this major trend.

Industry Consolidation

During the past 20 years the global mining industry experienced significant consolidation as many small or specialized mining companies were merged into larger entities. The rate of consolidation appears to be increasing.

One reason for this is simply the cost saving synergies that occur when similar companies merge. But there are other important reasons driving the consolidation such as the size that a new development project has to be for it to impact the balance sheet of the larger companies. In addition, giant mineral deposits are favoured because they produce metal for many decades, which means they are more likely to be exposed to the high-price points as well as the low-price points of the commodity cycles. This averages the cash flow and produces a better return over the life-of-the-mine. The problem is that giant deposits require large capital costs for development and associated costs and to finance them without incurring undue balance sheet leverage. This requires large companies with substantial equity and robust balance sheets. This is driving the creation of bigger and more diversified mining giants like Rio Tinto and BHP and more consolidation is coming.

The capital required for today's large mining projects is measured in the billions. The Spence project in Chile, which is going to produce 200,000 tonnes of copper per year, has an estimated capital cost of US$960 million. Barrick Gold, for example, has a new mine development budget for the next six years of US$2.2 billion for five projects. This will deliver annual production of over 2 million ounces of gold.

Most of the large integrated mining companies are increasing production of coal and iron ore. The defined resources of these commodities are very large and little new exploration is required and consequently this is not the arena for junior companies. World production of coal is over 4 billion tonnes and iron ore is about 1.2 billion tonnes. Crude oil is the largest commodity traded and is dominated by several mega companies. Daily production of 80 million barrels amounts to 4.7 billion tonnes worth US$1.3 trillion annually. Development of producing resources requires large amounts of capital and finding new large-scale deposits of crude oil, for example, require putting huge amounts of risk capital on the table. This development risk factor has driven the consolidation of the world's oil companies and it is now driving the consolidation of the mining companies.

One of the major effects of the consolidation in the mining companies was steadily decreasing expenditures on exploration as the combined companies spent less than the total exploration budget of the former companies. As budgets were slashed, many high-quality explorationists were available as consultants. More importantly, a lot of geological talent migrated to the junior sector and many companies attracted highly qualified management with deep geological experience and knowledge. This "geopeople effect" is an important factor in the success of junior companies and a fundamental reason you should be aware of geopeople and their activities. It is the talented exploration geopeople in partnership with resources to finance the ideas that creates enormous shareholder wealth.

World Commodities

As mentioned above, the world's primary resource commodities are crude oil, coal, cement, iron ore, copper, aluminum, gold, nickel, zinc and lead. Junior companies are generally focused on high-value commodities such as gold (US$13.3 million per tonne), silver (US$197,000 per tonne) and copper (US$3,100 per tonne) compared to coal (US$70 per tonne), iron ore (US$40 per tonne) and crude oil (US$275 per tonne).

Of the base metals, copper is the most important. World mine production capacity is currently about 15.8 million tonnes with a market value of US$47.5 billion and is an important market for junior companies.

(to be continued)

Bill McWilliam
SafeHaven.com

Bill has been involved in virtually all aspects of the investment business as a pension fund manager, broker, analyst and underwriter for the past 30 years. He has also founded, co-founded and financed successful start-ups in the technology and mineral exploration sectors.

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