| Not a pretty picture...
Bracing for the extinction of 500 juniors or an entire institution?
Publisher: Kaiser Research Online
Sun Dec 2, 2012
Author: Copyright 2012 John A Kaiser
During my travels the past couple months I have been repeatedly surprised by declarations from others that about 500 Canadian listed resource juniors will disappear within the next year unless there is a remarkable turnaround for the resource sector in 2013. These numbers have their origin in my May 23, 2012 Kaiser Blog post Staving off Mass Extinction with the Big Anomaly which provided the grim statistics on which this now widely circulated warning is based. Since then the situation has worsened, as is evident in the figures as of November 30, 2012 which active KRO members can see updated on a regular basis in KRO Key Charts.
 Kaiser Research Online tracks all companies listed on the TSX and TSXV who appear to be involved with resource sector exploration, development or mining, as well as a handful of former resource juniors which have shifted their focus to energy or other arenas. We do not track the capital pools until they have made a qualifying transaction involving the resource sector, but we do track resource juniors that have abandoned their projects, reorganized, and are shells looking for a new focus. Currently we have 1,803 companies that are trading. The Working Capital Distribution chart above shows the percentage trading in each of the 12 price categories, the median working capital for each price range, and the average working capital. It also shows separately compiled figures whose particulars KRO members can peruse using our KRO Search Engine or by clicking the links in the table below.
The latest batch of figures do not yet include the September 30 quarterlies whose filing deadline was November 29 and which KRO will have updated by the end of December. Given that there are more than 900 companies for whom the latest balance sheet is dated June 30, I can guarantee you that the numbers will be worse, especially in light of the weak financing conditions in 2012. As of November 30, 2012 TSXV listings have raised only $3.6 billion through private placements in 2012, the lowest since 2004 when $3.7 billion was raised. November 2012 was particularly dismal in that only $179 million was raised, the lowest since May 2009. While normally 75% of the funding is for resource sector listings, during 2012 a higher proportion went to energy and other sector listings. Should we enter a dry period such as prevailed from 1998-2002, the TSXV as a junior resource sector financing institution will undergo terminal collapse.
 In that event much of the blame for handing the future of high risk high reward resource exploration and development to the Australian Stock Exchange can be laid at the feet of the TMX Group which in pursuit of short-sighted greed and possibly bankster inspired stupidity has strangled the resource sector as a risk capital allocation arena where investors speculate on fundamental outcomes rather than manufactured volatility. The decision to allow short-selling on a down-tick and the hookup of algorithmic trading systems to the electronic order book in a regulatory environment where juniors are severely handicapped in helping investors visualize the value of potential outcomes as a project travels from grassroots concept to a production decision, has created a one-sided playing field where trading predators systematically harvest capital in-flows from investors placing bets on fundamental outcomes.
Thanks to high speed connections that feed market depth data to powerful computers on a real time basis a new reality has been created whereby the TSX/TSXV market for resource listings can be likened to a vast information web on which lurk spiders monitoring for the slightest quiver that signals anomalous inflow of capital not emanating from fellow spiders. Like spiders sensing an ensnarled fly these traders race toward that stock's electronic order book and start feeding sell orders to match the incoming buy orders, displacing long shareholders by inserting their orders ahead of manually placed orders, or at the same price in the multitude of order execution platforms whose existence is touted as some sort of ode to competition and liquidity but which in reality fragments the market, violates the first come first serve principle that retail investors assume, and creates a two-tiered transparency where the professionals see the order book consolidated while the rest see only the TSX/TSXV order book unless they pay extra. The "spiders" see it all, and they intercept incoming real money orders by selling paper they intend to borrow, paper they never need to borrow, because before the day is over, after they have sucked up all the new capital possibly generated by a positive research report, a newsletter tout, a favorable mention by a video or audio media talking head or web article, or even by a direct pitch made by management to a fund manager or investor group, they lean on the bid side of the order book pounding out stock on a down-tick, triggering instant buyer's regret among the new shareholders placing bets on fundamental outcomes, and unleashing capitulation among the existing longs, who add their real sell orders into the downtrend, enabling the spiders to close out their short positions before the market close and eliminating the need to deliver on their intent to borrow the stock.
To what extent this happens today is hard to tell, because fundamentals oriented investors have withdrawn from the market, with the result that liquidity has dissipated, and the spiders find themselves cannibalizing each other, a practice that lacks sustainability because there is not a potential open-ended inflow of spiders with trading capital. Even if this equivalent of a vampire squid sucking the life blood out of the junior resource sector is muted today, the TMX Group has created the physical and regulatory infrastructure to facilitate this sort of activity on a massive scale should there ever again be a reason for fundamentals oriented risk capital to flood into the junior resource sector.
The tragedy is that during the past decade the Canadian junior resource sector matured, moving beyond the drill target generation and testing stages of the exploration and development cycle that characterized the eighties and nineties. The technical infrastructure to take a project from grassroots concept to a production decision is now available to the juniors, thanks to a strategic decision by producers to restrict their exploration to brownfields sites, namely next door to existing mines, and relying on takeover bids to bring mine development candidates into the fold. While the last decade proved very lucrative for geologists and mining engineers who migrated to the juniors where high salaries and stock options vastly exceeded the pitiful income they received while toiling as salaried company men for the majors, they tend to be over 60 years old, and not so keen to spend the next five years toiling in a bear market where extinction rather than a return to the glory days may be the outcome. Because the TMX Group has erected infrastructure that will snuff out the junior resource sector if and when it attempts a revival, we may see a situation where the Canadian resource sector not only sees the administrative institutions that support the junior sector vanish, but it may also witness the early retirement of the technical infrastructure. The latter is a problem because during the eighties and nineties when the environmental movement forced the mining industry to mend its ways, not a lot of young people felt compelled to study geology and mine engineering, and so there is a significant experience demographic hole in the mining sector.
Allowing short selling on a down tick and algo trading in a fragile market such as resource venture capital is worsened by the regulatory environment that has been erected to "protect investors". In this context it is wrong to use the word "investors", because anybody who puts money into a resource junior is speculating on an uncertain outcome. Let's be blunt: he or she is gambling. But unlike conventional gambling forums which are a zero-sum game minus the operator's cut where all that is accomplished is the redistribution of existing wealth, the flow of capital into the treasuries of resource juniors who spend most of the money (hopefully) on testing their geological hypotheses has the potential to create new wealth in the form of raw material resources that can support global economic growth. The mining sector is not engaged in creating new methods to waste time such as social networks and iPhone apps; it creates the means to make physical differences in the lives of people. Gambling on the fundamental outcome of exploration plays is the mechanism by which risk capital gets allocated to the prospects with the best probability of generating this new wealth. And for this mechanism to be effective, the gamblers need to have a way to visualize the payout, assess the odds of its delivery, and decide when a bet is good, fair or poor.
Visualizing a target or an emerging discovery is a difficult and complex process, though not one that is impossible to master. The task of painting a potential outcome is now officially done with reams of 43-101 compliant data and graphics provided by qualified professionals to the juniors, which can enable investors to construct resource estimates using rectangular blocks, drill intersections and orebody arithmetic (length x width x thickness - in metres - times specific gravity) that come surprisingly close to the formal 43-101 estimates. But when it comes to turning that potential orebody into an economic number, the company's lips are sealed until it produces a preliminary economic assessment which is done after the initial inferred resource estimate is published, typically 2-3 years after the junior started drilling a promising target.
The problem is that industry professionals know how to quantify the economic value range potential well before the initial resource estimate is published, but they are restricted from publishing such "educated guesses" in the case of brokerage firm analysts, and inclined to keep such quantifications to themselves for competitive reasons in the case of mining company employees. Both groups share a common agenda of conspiring against the interests of the resource junior and its shareholders. In the case of the brokerage industry whose goal is to finance a junior as cheaply as possible with the position accruing primarily to its client base, it has at its disposal an intimidating arsenal in the form of trading accounts, related hedge funds, and offshore entities that can manipulate the price downwards. However, through its encouragement of a predatory trading culture involving "independents" with direct human access to the electronic order book, or even algorithmic access, the dirty work of hammering down a junior's stock price, and shattering the expectations and confidence of the fundamental investors to whom the company has privately pitched the potential outcome, has been shifted into a parallel universe whose complicity with the corporate finance departments of Canadian brokerage firms cannot be proven.
The visualization gap between the industry professionals and retail investors is a key reason why the Canadian junior resource sector will have a difficult time adapting to the shift from the resource feasibility demonstration cycle that characterized the last decade, to the discovery exploration cycle that must characterize the mining sector during the next five years while we wait for global economies to recover from the 2008 financial crisis, and to see to what extent the mobilization of new supply from all those failures of past exploration cycles matches demand once the global raw materials super cycle is back on track.
 The takeover chart above shows that since 2005 bigger companies have taken over 209 Canadian listed juniors in transactions worth $115 billion. Except for a handful of exceptions such as Virginia's Eleonore and Aurelian's Frutta del Norte which were grassroots discoveries, all of these companies owned deposits that were discovered during the 20th century, discarded as sub-economic also-rans, in effect exploration failures, were dragged out of the woodwork during the last decade and stuffed into publicly listed shells, and subjected to the advanced stages of the exploration and development cycle whose focus is to demonstrate the economic feasibility of the resource. These deposits came from land open to staking, private owners, and government mineral reserves.
The general public did not participate in these success stories because the "discovery" mechanism consisted of sophisticated investors and other elites acquiring the project through a private company, and merging that private company with a publicly listed capital pool or shell, of which there were a lot on the TSXV after the 1998-2002 metals bear market. These transactions took place while the public shell was halted, with multiple financing tiers slapped into place which tapped institutional and sophisticated investor capital pools.
The end-game was not to unload the paper onto unwitting retail investors who have yet to recover from the Bre-X Betrayal, and who are naturally averse to the sort of number-crunching required by the discounted cash flow valuation model that underpins advanced resource projects, and even less inclined to fret about the macroeconomic and geopolitical prognostication needed to make the 10-20 year metal price assumptions that must be plugged into the valuation models.
The end-game was to lure the bigger established mining companies into buying out these advanced projects for cash or highly liquid paper. And the street was very successful in this regard because during the 1998-2002 bear market the producers had downsized their exploration departments, and during the first half of the last decade, they did not recognize until 2006 that the emergence of China in a context of post-Communism globalized trade constituted a quantum demand shift that necessitated higher real prices that dragged many of the old exploration "failures" into the money. The juniors, not the majors, ended up owning these deposits, and the majors paid dearly for these assets in competition with Chinese state owned mining entities serving the additional mandate of securing China's long term raw material needs.
 Now the major producers have their hands full with copper, nickel, gold and iron deposits, many of whom have sagged back into the category of "exploration failures" as galloping capital and operating cost escalation in the mining sector during the past five years, estimated as high as 10% annually, has caught up to higher real metal prices which in the case of copper, silver and gold have persisted at near nominal record levels. In the long term gold chart above and copper chart below I have inflation adjusted the prices of copper and gold at the end of 1980 by the US CPI until 2008 when I have applied the 10% inflation rate pertinent to the mining sector's capital and operating costs that people like Goldfields CEO Nick Holland have been floating in their presentations.
 The real gains of 53% for gold and 26% for copper defined as the difference between the CPI inflated price from the 1980 base and the current spot price vanish when we apply the higher mining sector inflation rate. This, coupled with concern that the cost escalation is not done, partly explains why resource equities have fared so poorly since April 2011 despite metal prices in most cases holding near all time highs.
 Most of the existing copper supply has a cash cost in the $1.50-$2.00 per lb range as shown by the Brook Hunt cost curve above. The chart below plots 47 copper deposits as operating cost per tonne, as defined by the most recent PEA, PFS or BFS, against the copper grade, with the bubble size reflecting the mine plan projected annual copper output. The colored straight lines reflect the operating cost per tonne equal to the revenue per tonne generated by the grade at the indicated copper price, with grade adjusted 15% to reflect royalties and smelter fees. In simple terms, for a copper deposit to be economic it needs to plot to the right of a cost-grade curve for a particular copper price. The bulk of the copper deposits plot to the right of the $3/lb curve, implying that if the copper price can stay above $3/lb, 4.3 million tones of new annual copper supply could come on stream during the next five years, easily matching the Brook Hunt demand projection of about 20 million tonnes for 2017. These 47 deposits reflect only those owned by Canadian resource juniors, many of which were bought out by majors since 2005.
 Assuming the anxiety about a looming global recession or depression disappears after the United States has wandered over the "fiscal cliff" and discovers that there is no kaboom, the Republicans and Democrats finally get serious about negotiating away the worst aspects of the fiscal cliff, and the pent up desire among Americans to put four years of deleveraging behind them and start feeling good about the future again gets unleashed, we could expect copper to be stable in the $3-$4 range over the next few years. Once the mining industry gets comfortable that the world is not going into a depression, it will launch a round of mergers and acquisitions that will clean out the best of the remaining copper projects owned by the juniors. We will see something similar happen to the advanced gold deposits once the market accepts that $1,500-$2,000 per oz is the new reality for gold.
But what will not follow is the expectation that significantly higher real prices for gold or copper are around the corner. Such expectations will not become realistic until 2015 or later. Normally when a round of M&A cleans out the inventory of advanced deposits owned by the resource juniors one would expect the industry to dredge up a whole new batch of deposits from the private sector and stuff them into any one of the many shells listed on the TSXV. However, the inventory that is available will be of an even lower grade than the "exploration failures" resurrected during the last decade. In the absence of higher real metal price expectations there will be no appetite among institutional investors for projects that require positive macroeconomic developments in order to pay off. The abundance of undeveloped inventory coupled with expectations for stable metal prices are key reasons why I think the junior resource sector will shift from resource feasibility demonstration, which is in effect a speculation on higher future metal prices, to discovery exploration, which is a speculation that new deposits will be discovered that are very economic at current prices and even at considerably lower metal prices.
Unfortunately, this shift from resource feasibility demonstration to discovery exploration will pose a real problem for the Canadian junior resource sector. The 632 companies with less than $200,000 working capital have barely enough money to stay listed for another year while doing nothing to advance project fundamentals except in the case where the project is under option to another party. Filtering for companies that have Negative Working Capital generates 499 hits, close to the widely circulated number of 500 juniors on the extinction list. Many of these companies have more issued stock than the median for their price range, making it difficult to raise additional capital through equity financings. There are 409 companies trading below $0.20 with no money; who will finance them so that they can limp along for another year doing nothing? During 2013 there will be hundreds of rollbacks (reverse splits) followed by price retreats back below a dime. In a few cases these juniors will own advanced projects, "diamonds in the rough" that have some value, perhaps to be reinterpreted for brownfields exploration targeting a Big Anomaly. But the rest will join the 116 juniors with more than $200,0000 we classify as shells because they do not have a discernible flagship project worthy of additional exploration dollars. Because these shells will end up trading below a dime, insiders will have the opportunity to refinance so that the core group owns 90% of the paper at cheap prices, the traditional "tight shell" regarded as essential for a proper promotion and funding cycle.
The TSX/TSXV, however, is not the same as the OTCBB pump and dump machine. The potential audience for the resource juniors is small and sophisticated, even among retail investors. Liquidity is more valuable that illiquidity when it comes to place bets on real fundamental outcomes. Companies where the insiders own all the cheap paper will be shunned by the market. And when the corporate administrators discover that there is no need for shells, hundreds of them will simply disappear, either through the suspension-delisting cycle or by merging redundant members of a management stable into a single junior. The departure of 500 resource juniors would be a healthy development for the sector because when the retail investor does return to this sector, we want the field of choices not to be diluted with worthless distractions.
The group to watch during 2013 will be the 428 juniors with advanced projects undergoing feasibility demonstration. These may benefit from a slingshot effect if the market decides the macroeconomic glass is half full rather than half empty, rapidly boosting prices 100%-200% as M&A fever kicks in. But the really interesting companies to investigate will be the 506 juniors that have more than $200,000 working capital and have projects that could deliver a major discovery that provides 10, 20, 30-fold price gains from their current depressed levels. These are the ones which could attract the retail investor, but to attract the retail investor an antidote to the predatory spiders must be created, an antidote in the form of a system that facilitates visualization of the potential outcome in both physical and monetary terms, and externalizes it into a public forum through a wisdom of crowds process. Such a dynamic consensus outcome visualization will allow a resource junior to bend like a reed when the hurricane blows, snapping back to the equilibrium price as fundamentals oriented speculators rush in to take advantage of the temporary good speculative value created by the volatility traders. No longer will the resource junior be a fragile sapling easily broken by a destructive trading culture devoid of legitimate purpose. There will still be plenty of volatility, but it will revolve around competing visualizations of the potential outcome, making the Canadian junior resource sector stronger, perhaps "antifragile" in the sense intended by Nassim Taleb. I have developed a plan for how this can be done; its seeds are in the rational speculation model. |
