There are two kinds of junior natural resource companies. When you analyze, it's critical to realize which one you're dealing with.
The first type are explorers. These are companies hoping to find something. Oil, gold, geothermal energy. They have not yet made a discovery, but they possess expertise that gives them a chance of doing so.
The second type are developers. Companies that have found something. And are now working on figuring out how big, how challenging and how costly that something will be to get out of the ground.
This is a basic distinction. But it provides some very useful grounds for analysis.
As Galileo reportedly said, "Measure what is measurable. Make measurable what is not." A development-stage company usually has a measurable asset. They hold data on the size and grade of the gold deposit, or the production rates of an oil pool.
With such a company it's a matter of putting the geologic data together, analyzing the economics, and determining whether the project meets thresholds for profitability. This of course requires skill, but we have the benefit of hard numbers that we can plug into our models.
Explorers, on the other hand, are largely unmeasurable. How do you put a value on a piece of greenfields property in Alberta or Chihuahua or Ghana that may or may not host an economic discovery?
As I've discussed in the past, expected monetary value (EMV) theory provides some pointers for valuing exploration projects. But it's a very inexact measure at best.
The challenge then is making the exploration business measurable. What metrics can we look at to determine which explorers are likely to succeed in making a discovery?
The mistake that many analysts make is trying to put metrics on the exploration projects themselves. Looking at alteration patterns or geophysical signatures or surface rock samples and attempting to correlate this data to the chances that a significant discovery lies at depth.
This is an extremely difficult enterprise. When you look at histories of major discoveries, there were plenty of great-looking alterations patterns and geophysical signatures that turned out to be nothing. There were also projects with very few signs of greatness that did prove to be important, economic finds.
The trick then is not in measuring a company's exploration projects, but rather in measuring the exploration team and method. And one of the most important metrics in this regard is "generative capacity". That is, does the company have the ability to come up with new project ideas on an ongoing basis?
Ask: How many projects has the company generated through the blood-and-sweat hardwork of the management team? We're not talking about projects that came from the CEO's best friend in Kyrgyzstan or the VP Exploration's connections in Nigeria. We're looking for projects that came out of the heads of management. Through good, sound geological thinking and analysis.
Good exploration teams come up with stables of projects. They ask, "What about that fault to the North that might be an offset of this mine?" Or, "Maybe we should hike around those old artisanal workings up on the hill to look for signs of something bigger?" Or, "Gee, when you look at these thin sections this reservoir rock isn't as tight as everyone thinks. Let's drill this." This sort of thinking keeps new projects constantly coming down the pipe.
And having a project pipeline is crucial in the exploration business. Most exploration projects fail. So you need to give yourself as many chances as possible to succeed. The team that takes $100,000 operating budget and turns out 10 projects has a much better chance of discovery than the one that generates 2. You never want to hang your hat (or your money) on a limited number of prospects.
Case in point is a small Alberta oil explorer I've been looking at over the past few weeks.
The company holds several sections in an identified pool with a large amount of oil in place. The problem being that wells drilled to date have flowed at uneconomic rates.
After much searching, the company recently attracted a farm-in partner for the project. The incoming group is going to drill new wells on the project using a different engineering approach. And they've agreed to pay 100% of the well costs in exchange for only a 50% interest. SmallCo gets 50% of every well, without paying a dime.
These are nearly unheard of terms in the oil patch. Suggesting that the incoming group sees something they really like in the play. And if the new wells flow at economic rates, the value will be several multiples of SmallCo's current market cap.
That's the good part. Here's the downside. Despite the fact that some information has been gathered on the oil pool, this still amounts to an exploration play. Because flow rates for the new wells are a completely unknown variable. We just don't know if the engineering will work. The wells might yield 5 barrels per day or 500. There's no way to measure this.
The question then becomes: what if it doesn't work? And the answer is not good. SmallCo has little in the way of other major projects. What's worse, the company is out of cash, meaning management won't even have the opportunity to generate new project ideas over the coming months. There's nothing coming down the pipe.
The final analysis being that while the upside for SmallCo is huge if the project works, the downside is equally large if it fails. And given that there's no way of measuring whether success is more likely than failure, an investment here can't be justified.
It all comes back to that famous question Buddy Guy asked in song: "Where is the next one coming from?"
Here's to the flow of ideas,
By. Dave Forest of Notela Resources