Eritrea Mining: Stefan I & The Gold Report
"The Eritrean government recognized early on that it had to work with foreign investment to make a mining industry a reality."
"I give the Eritrean government a lot of credit. It has been very pragmatic. The government recognized early on that it had to work with foreign investment to make a mining industry a reality, and not just with Nevsun. The last time I checked there were about 15 exploration companies active in Eritrea. I have been to Eritrea twice now and had very good experiences both times. The common sentiment among visitors is that it was safer than they expected."
More on Eritrea Mining follows on the The Gold Report (TGR) with Haywood Securities' Stefan Ioannou (SI)
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The Gold Report: Stefan, what is your 2013 outlook for copper?
Stefan Ioannou: Strong fundamentals underpin the copper price going into 2013. Despite a tough copper equity market in 2012, the metal price itself has been pretty solid, averaging around $3.60 per pound ($3.60/lb). Improving automobile numbers out of the U.S. and stronger manufacturing numbers out of China will both have a positive near-term impact on the copper price. We expect copper prices to move a bit higher in 2013.
"Strong fundamentals underpin the copper price going into 2013."
TGR: How far off is a return to $4/lb copper?
SI: I think 2013 is too soon for a sustained $4/lb price, but it will likely test that mark a few times in the coming year. There is a stronger argument for a long-term $4/lb copper price.
TGR: Many of the copper companies you cover also have a zinc component. Zinc started 2012 near $2,200 per metric ton ($2,200/mt), dipped to $1,750/mt at midyear and now hovers around $2,000/mt. What is behind the volatility?
SI: Primarily negative sentiment. London Metal Exchange inventories remain near an all-time high of ~1.2 mt and there is continued concern that China could flood the market at any time. Hence, the near-term outlook on zinc has been weak. However, there is an interesting dynamic taking place: As we move toward 2014, the market will be faced with a potential longer-term supply deficit.
A number of large zinc mines, which combined account for ~10% of global zinc supply, are scheduled to shut down within the next two to three years when their reserves become depleted. There are very few large, advance-stage zinc projects available to fill in the supply gap. When the big mines close down, the squeeze on the supply side will move the zinc price higher.
"A number of large zinc mines are scheduled to shut down within the next two to three years. There are very few zinc projects to fill in the supply gap."
The first big project slated to shut down is Xstrata Plc's (XTA:LSE) Brunswick mine, which alone accounts for almost 2% of global supply. The company has talked about shutting the mine down for the last several years, but every year Xstrata seemed to squeeze a little more zinc out. However, in March 2012, the company formally notified Brunswick's union of a planned shutdown, as per a legally required one-year notice period. Hence, the writing is on the wall.
The key is that there are very few ways to play the zinc space¥arguably only five or six quality development projects. Even the majors are scrambling to find new zinc assets. Given the limited number of publicly traded zinc-focused companies, all are poised to do well in the event of a zinc price run.
TGR: In light of the impending supply squeeze, what is your predicted zinc price average for 2013?
SI: We expect 2013 to be a transitional year, so near-term pricing will likely remain in the $0.90¥$1/lb range. As for stock prices, we anticipate people will start paying attention to the zinc space as the supply/demand dynamic becomes more apparent, probably in the latter half of 2013. Looking further down the road into 2014¥2015, we could easily see prices jump up to $1.25/lb pretty quickly. From there, the sky is the limit.
TGR: What is the industry average in terms of cash costs of per payable pound of zinc?
SI: That is another important consideration. With a copper price at $3.50/lb, hypothetically almost every copper project on the planet could or should make money, even the very low-grade ones. Even high-cost copper producers have costs on the order of $2.00¥2.50/lb, which generates a solid margin at today's prices.
Margins are a lot tighter in the zinc space. Most zinc projects carry total cash costs north of $0.50/lb net of byproduct credits, and a number are even higher at $0.70¥0.80/lb. If zinc were to drop below $0.75¥0.80/lb, we would likely see a number of higher-cost mines shut down because they would not be economic.
"There is one wild card at play in the zinc space: China."
There is one wild card at play in the zinc space: China. The country is able to bring a lot of new supply into the market quickly. However, exact numbers are difficult to forecast. That said, a lot of the Chinese production comes from smaller, "mom-and-pop" mines, which carry higher costs. Thus, even though there is potential Chinese production out there, it will likely take a zinc price north of $1.00/lb to get it out of the ground profitably. At a $0.90/lb price, most of this Chinese production is arguably marginally economic at best.
TGR: Should investors avoid zinc plays until the latter half of 2013, when they can start to position themselves for the shutdowns in 2014, or are there opportunities in the near term?
SI: This is the time to do your homework and figure out where you want to be when the zinc price starts gaining momentum. I am telling clients to be aware of the zinc stories out there; know now where you might want to put your money. You do not have to buy them today or tomorrow, but be prepared to invest when the market turns, because in the case of zinc it could turn quickly.
TGR: You mentioned earlier the high margins on copper. What are the cash costs per payable pound of copper?
SI: There is definitely a range. The low-cost producers¥especially those with a big gold or other byproduct credits¥are under $1/lb, net of credits. My guess is that the average is closer to $1.25¥1.75/lb. High-cost producers would be on the order of $2¥2.50/lb.
TGR: If a company's management, jurisdiction and net asset value are for the most part equal, why should an investor choose a base metals play rather than a precious metals play trading at similar prices?
"This is the time to do your homework and figure out where you want to be when the zinc price starts gaining momentum."
SI: The answer to that question depends on your outlook on the global economy. Growth in Asia, namely China, and recovery in the U.S. will require a lot of materials. If you believe that will happen, a portfolio slanted toward base metals stands to gain a lot.
But if you are more worried about the economic situation in the U.S. and Europe, then there is an argument to be more focused on gold, primarily as a hedge against inflation. Investors need to ask themselves which story they are positioning themselves for and tailor their portfolios appropriately.
Of course, historically, precious metals¥namely gold stocks¥do trade at higher multiples relative to base metals. Over the last 10 years, established base metal producers have, on average, typically traded around 5 times cash flow, whereas gold stocks have traded at over 12 times cash flow. That said, gold multiples have contracted more than those of base metal over the last year or so.
TGR: What is Haywood's prediction for gold's trading range in the first half of 2013?
SI: We expect levels will stay stable in the $1,700¥1,800 per ounce ($1,700¥1,800/oz) range. Taking a longer-term perspective, we see costs creeping up across the board for base metal and gold projects. Five years ago if you talked about a gold mine that had a cash cost on the order of $800-900/oz, people would have been shocked. Today, that is not uncommon. Higher costs will only drive the gold price higher over the long term.
TGR: How are companies coping with the cost problem?
SI: Majors are focusing efforts on cutting costs at existing operations, which has prompted them to shelve large, longer-term development projects that have been plagued by capital cost overruns and, in some cases, political challenges. There's a greater focus on what is in production today. However, if anything, this type of action will only lead to a supply issue in the future¥which bodes well for higher long-term metal prices.
TGR: Can you give our readers the essentials of your thesis for the base metals plays you cover?
SI: In the short-term, the most relevant base metal to watch is copper. It is the most widely used metal and is the best indicator of the overall sector. With stronger auto sales in the U.S. and stronger manufacturing in China, I see no reason why copper would not trade north of $3.50/lb in early 2013. At that price, copper producers will make a lot of money.
Of course, if a company is in production and is generating good cash flow, investors will start to ask what management is going to do with that money. I think the stage is set for a significant amount of merger and acquisition (M&A) activity in the base metals space, especially copper. Producing copper companies will establish strong balance sheets pretty quickly. People do not invest in mining companies so management can sit on cash. Investors want to see cash redeployed for growth or delivered to shareholders as a dividend.
TGR: Let's move on to the companies you cover. You have a Sector Perform rating on Nevsun Resources Ltd. (NSU:TSX; NSU:NYSE.MKT), despite the fact that it is expected to halt production for perhaps as long as six months at its 60%-owned Bisha gold, copper and zinc mine in Eritrea. Why did you revise your target upward after this news?
SI: The recent target price revision was fairly modest, from $4.75 to $5. It was little more than some model tweaking based on the company's Q3/12 financial and operating results. The overall thesis remains intact. Bisha is a world-class volcanogenic mass of sulfide deposit (VMS). It is quite high-grade, open-pittable and has been in production since 2011. The initial focus was on a very rich oxide gold cap. That is scheduled to be completely mined out in Q1/13 or Q2/13.
From there, Nevsun will move to processing supergene copper and, eventually, primary copper and zinc sulfide material. During the transition, there will likely be a production hiatus of at least three months. There are several moving parts, including construction of a port facility to ship concentrate. The key thing to be aware of is that, on paper, 2013 will be a lackluster year for Nevsun. The company will likely have at least one quarter without any significant positive cash flow from Bisha.
TGR: Does Nevsun have the cash to withstand the hiatus?
SI: Yes. The company's strong balance sheet included almost $380M in cash and no long-term debt at the end of September. As we get into 2014, Nevsun will have a pretty rich base metals mine. Our $5 target will require patience next year, and is more a reflection of the company's anticipated position going into 2014, namely as an established base metals producer.
TGR: Why do we hear so little about the geological and mining potential in Eritrea?
"The Eritrean government recognized early on that it had to work with foreign investment to make a mining industry a reality."
SI: People are not familiar with Eritrea, and red flags typically go up when anything related to Northeast Africa is mentioned. Nevsun was basically the first publicly traded company to get into Eritrea. It made the Bisha discovery and over 10 years, took it through exploration, permitting, development, construction and into production. Along the way skeptics pointed to the risk of the government taking more than its fair share of the project.
I give the Eritrean government a lot of credit. It has been very pragmatic. The government recognized early on that it had to work with foreign investment to make a mining industry a reality, and not just with Nevsun. The last time I checked there were about 15 exploration companies active in Eritrea. I have been to Eritrea twice now and had very good experiences both times. The common sentiment among visitors is that it was safer than they expected.
Sunridge Gold Corp. (SGC:TSX.V) is also active in Eritrea, as is Chalice Gold Mines Ltd. (CXN:TSX; CHN:ASX). The latter is exploring for VMS deposits along the same belt that hosts Bisha, and recently announced a discovery.
TGR: Sunridge just published a resource estimate for its Adi Rassi discovery. Given the size and scope of the deposit and Sunridge's lack of cash, could this be a takeover target?
SI: I think the Eritrean government would like to see more than one foreign player developing the mining industry in Eritrea.
With respect to takeover potential, I think the completion of a feasibility study, expected in Q2/13, on the company's Asmara project will be key. The feasibility study will not include Adi Rassi. It is based on four other projects, the Emba Derho, Debarwa and Adi Nefas copper-zinc-gold and silver deposits and the Gupo gold deposit. That said, Adi Rassi is located near Debarwa and could ultimately develop into the Asmara project's fifth deposit.
Also important for Sunridge is the Eritrean government's intention to buy upwards of a 30% interest in the project, similar to what it did with Nevsun at Bisha. The price still needs to be determined. That may happen before the feasibility comes out or the government may use the feasibility study as the basis of the valuation.
The government paid fair value to Nevsun and we expect the same to happen with Sunridge. Once the government does that, it will signal a vote of confidence to the investment community that things are moving in the right direction.
The feasibility study, of course, will give us a better handle on the project's economics and what it should be worth. The big questions include what it will cost to build it, how much money Sunridge will have to raise, and what that means from a dilution point of view.
TGR: What other companies would you like to share with our readers today?
SI: The whole base metals space was beaten up this year, so it's a good time to move higher up the food chain. Producers are typically safer than exploration companies.
Copper Mountain Mining Corp. (CUM:TSX) has a mine of the same name in British Columbia. It restarted production at the brown fields project in mid-2011 and ramp-up has been slow. Issues getting the mill up to capacity caused some market frustration. But those issues seem to have been addressed through the latter half of Q3/12.
Once we see the company's Q4/12 numbers, we should have a much better idea of what Copper Mountain will look like in terms of steady-state metrics. We hope to see the stock rerated on the back of that news. Right now, it is not trading like an established base metal producer, even though it effectively is.
Copper Mountain owns 75% of the mine. Mitsubishi Materials Corp. (MMC:FSE) purchased the other 25% interest from Copper Mountain in 2009 for $29M and concentrate offtake, and arranged debt financing to cover a significant portion of the project's $438M capital cost.
TGR: How about some names in the zinc space?
SI: As we discussed, zinc will be lot more attractive in late 2013. Now is the time to identify stories with potential. I would suggest investors look at companies like Trevali Mining Corp. (TV:TSX; TREVF:OTCQX)and Donner Metals Ltd. (DON:TSX.V). Both are near-term producers that will be well-positioned to benefit from a zinc price run in 2014 or 2015.
Moving a little bit down the food chain to the developers, Foran Mining Corp. (FOM:TSX.V) has a VMS project, McIlvenna Bay, with a significant zinc component. The deposit is in the Flin Flon mining belt, the stomping ground of HudBay Minerals Inc. (HBM:TSX; HBM:NYSE). This area is home to the 777 and Trout Lake mines, and the $700M Lalor project, which is under construction. McIlvenna Bay is located in east central Saskatchewan, but it is the same geology that hosts the Manitoba-based Flin Flon deposits.
What distinguishes Foran is that the company owns 100% of McIlvenna Bay. Most of the other juniors in the area are underpinned by joint ventures with Hudbay. If they discover anything of significance, Hudbay has the option to back into the lion's share of those projects. It is not unfathomable to think that one day Hudbay may be interested in McIlvenna Bay, but the mid-tier won't have the luxury of low costs right now.
The current resource at McIlvenna Bay in all categories totals over 20 Mt. That puts it in the top five largest deposits ever found in the world-class camp. Given that it is within 60 kilometers of the town of Flin Flon, Hudbay's home base, there is plenty of established infrastructure in place, and most importantly, a hungry smelter.
TGR: Would Hudbay have to make any changes to its process circuit at Triple 7 to process that ore?
SI: It is a bit too soon to say. Foran completed some initial metallurgical test work earlier this year and the results were promising. Because it is a typical VMS deposit, in theory it would be a standard froth floatation flow sheet: crush, grind, float and thicken to produced copper and zinc concentrates. There might be some tweaking needed to fine-tune recoveries, but it will not require a completely different process.
TGR: To finish, what should our readers look forward to in 2013?
"With a bit of improved sentiment, I think you will see the prices move higher."
SI: Improved sentiment. This was a tough year, underpinned by a presidential election and economic uncertainty in the U.S., the European debt crisis and mixed economic signals coming out of China. At least now the direction is a little clearer and the numbers coming out of China are improving.
That said, look at what copper did even in a tough year. It managed to average around $3.60/lb¥a pretty robust price in the grand scheme of things. With a bit of improved sentiment, I think you will see the prices move higher. With any luck, that will take the equities along for a ride as well.
TGR: Stefan, thanks for your time and your insights.
Stefan Ioannou has spent the last seven years as a mining analyst covering mid-cap base metal companies at Haywood Securities. Prior to joining Haywood, he worked with a number of exploration and mining companies, as well as government agencies as a field geologist in Nevada and throughout the Canadian Shield in both the gold and base metal sectors.
Received on Sun Jan 06 2013 - 13:09:53 EST
