Whether you are investing in junior mining or major mining, mining stocks share some of the biggest risks. In this article, we will look at those risks and what they mean to investors.
Exploration risk is simply the risk that the material a mining company is looking for isn’t there. Exploration risk is also called assay risk because the assay results are the final verdict on whether or not a significant deposit exists. Although exploration risk affects both major and junior companies, the exploration risk for majors is often spread across a multitude of claims. For a major, having some assays come up empty is less damaging financially because of its large portfolio of claims and the capital cushion that can be used to finance more exploration.
For juniors holding a smaller portfolio of claims, each claim takes on more importance. This is why juniors usually have geologists on the management team; when they start spending money on developing and evaluating a claim, they want to focus on the claims that are most likely to yield, because they don’t have much money to waste.
Even when an assay confirms something is there, there is no guarantee that geological challenges, such as a low mining rate, the amount of dilution or some other factor won’t make the deposit unfeasible in the present market. Although this isn’t as bad as having nothing at all, it does leave the company holding on to a deposit that won’t come into play unless market prices go up. Making feasibility more of an issue is the fact that some nations levy a fee on all undeveloped claims or cancel claims after a certain period of inactivity.
Again, the impact of this risk is different between majors and minors. Majors are generally content to sit on deposits, as they usually already have productive mines that afford them the luxury of waiting for either extraction capabilities to improve or market prices to rise and make the deposit more feasible. Depending on the nation, the holding costs on a claim are usually reasonable for a large corporation. For juniors, a challenging mine often means partnering up with a major, or selling the claim at a discount to the probable reserves, in order to avoid losing money by holding the claim for an uncertain return in the future.
Management risk affects every company, but mining stocks are particularly prone to trouble from the bigwigs. At the major level, mining is a long-term business, so the effects of a bad management team can take years to realize and longer to reverse. The worst damage a management team can do is to the balance sheet. Mining is capital intensive, so if a company doesn’t have ready capital at hand, it can be difficult to increase operations to match increases in market prices.
In these situations, majors can turn to the debt market, but long-term debt comes with its own carrying costs. For juniors, the debt market is difficult to tap, so their last resort is usually another share offering that dilutes shareholders and eventually scares away other investors. There are situations where tapping the debt market or issuing more shares can be excellent moves in the long term, but a management team that consistently turns to these methods of financing is cause for worry.
A common valuation technique for mining stocks is to calculate how much of a commodity you are getting per dollar and then multiply that figure by the market price. In the right price environment, many junior mining stocks can go from a dog to a high flier with no change in their operations. In a rising market, the more leveraged a company is to the commodity gaining value, the better. However, if prices tank, the leveraged companies that look the best in rising markets will lead the pack in losses.
Majors are equally price sensitive, although the reaction isn’t as sudden. These large companies don’t stop production when prices fluctuate. Instead, they often pay out of reserves and raise capital to continue operating until market prices recover. If prices are in a long-term decline, majors will end up burning capital before they slowly scale back operations. Depending on how robust the balance sheet is, this capital burn can inhibit their ability to restart production, bringing it back to management risk.
Mining companies operate in different countries with varying regulations on mining claims, foreign property ownership and so on. The regulations in some countries rarely change, but others have more volatile legal systems. So, even if a mining company has a great deposit, the capital to develop it and a favorable market, a change in the political environment where the deposit is located can throw a wrench in successfully getting the minerals to market. Mining companies that operate in stable countries are preferable from a risk perspective, but mining companies go where the minerals are, so it is often a question of how much political risk an investor thinks is reasonable.
The Bottom Line
Knowing the risks facing mining companies allows you adjust for them. For example, looking at mining companies that operate mostly in stable regions, or have diverse operations in several countries rather than one risky play, can lessen political risk. Likewise, having experienced geologists on the management team can help reduce exploration risk. That said, you will never eliminate all the risk inherent in mining; in fact, you don’t want to. The big risks in the mining sector are the reason why – when all the important factors line up – the rewards can be equally large.