| A Guide to Avoiding the Most Popular Mining Scam in the World | | How the unintended consequences of
Bre-X could cost you a fortune | | Inside This Issue | | • | How to Avoid theMost Popular Mining Scam in the World | | • | A Gold Project Selling for 57 Cents on the Dollar | | • | Investing With One of the Legends of Shale Oil | | • | Portfolio Review | | Editor: Matt Badiali | | | They found Michael de Guzman's body in the jungle. It was decomposed beyond recognition. Some people claimed he was murdered. Some claim he committed suicide because of a guilty conscience... In the mid-1990s, de Guzman's employer was a global sensation. A geologist, de Guzman served as the exploration manager for Bre-X Minerals... a small Canadian mining company that claimed to have found a large gold deposit in Indonesia. Actually, "large" only begins to describe the deposit de Guzman and his employers claimed to have found. A gold deposit of 10 million ounces is considered huge by today's standards. But Bre-X claimed it was sitting on over 70 million ounces of gold, with the potential for 200 million... which would have made it the largest untapped gold deposit on Earth. An outside company audited Bre-X's claims. It agreed that Bre-X had a stupendous find. Investors went wild. Wall Street funds bought up shares. Canadian pension plans bought up shares. Giant mining companies wrestled to get control of possibly the largest gold find in human history. Bre-X shares climbed from C$0.45 to C$28 from June 1995 to May 1996... a gain of 6,122% in under a year. Then, the truth came out... On March 19, 1997, de Guzman fell to his death from a helicopter 800 feet above the jungle. His body was found four days later, decomposed and partially eaten by jungle creatures. A great unraveling of the story followed... De Guzman had faked Bre-X's drill samples. He'd "salted" thousands of rocks with gold flakes before they were tested. The company had duped everyone. As you can see in the chart below, shares fell from C$15.80 to C$0.08 in just 28 days. That's a 99% loss in less than a month.  The industry considers it the greatest mining fraud in history. If you're a longtime resource investor, you know the Bre-X story. You know it was an incredible hoax. You know about de Guzman's suspicious death. What you may not know is that in the aftermath of Bre-X, the Canadian Securities Administrators (the Canadian equivalent to the SEC) created something called "National Instrument 43-101" (NI 43-101). NI 43-101 is a set of rules public companies in Canada must follow when reporting information related to their mineral properties. It was intended to protect investors from mining frauds... But it has likely led to more investor losses than anything Bre-X ever did. It is one of the most dangerous things a resource investor will encounter... ever. What follows is a brief history of NI 43-101... how mining companies use it to defraud investors... and what you need to know to protect yourself. This issue isn't going to win me any friends in the mining industry... but it could save you a fortune. "It's a Joke..." "It's a joke. It's not protecting you guys in any way, shape, or form." Joseph Conway doesn't think much of NI 43-101. He's the CEO of Primero Mining, a billion-dollar gold and silver producer. Conway has decades of high-level mining experience. In September 2013, at banking giant Scotiabank's big mining conference, he gave investors the warning above. Over the past three months, I've talked with dozens of mining executives, insiders, and analysts. Many echo Conway's thoughts on NI 43-101. But as you can imagine, not everyone in mining wants to be on the record criticizing securities laws. It's best to keep your head down, run your projects, and avoid rocking the boat. However, many insiders have allowed me to quote them on the condition of anonymity. One CEO of a well-known exploration firm put it like this: | The NI 43-101 report was thought to be the end-all, be-all of disclosure and we would never have frauds like Bre-X again. Wrong. Frauds will happen again because crooks don't play by the rules. The illusion of [NI 43-101] being a safety blanket that financial analysts could use to plug into their spreadsheets has collectively been more damaging then the out-and-out frauds. | | How could such a well-intentioned idea – protecting investors – generate such criticism? How could it cost investors millions of dollars every year? How can it be more dangerous than the greatest mining scam of all time? To get the answers, we need to cover exactly what NI 43-101 is supposed to do... The goal of the NI 43-101 is to "ensure that misleading, erroneous, or fraudulent information... is not published and promoted on the stock exchanges overseen by the Canadian Securities Administrators." NI 43-101 requires that mining companies publish the details of their mining projects in three different kinds of independent reports: a preliminary economic assessment (PEA), a pre-feasibility study, and a feasibility study. Investors can find these reports on the companies' websites. Each provides the same information in increasing detail: the amount of metal in the ground ("resources"), the amount of metal that can be mined economically ("reserves"), and the economic value of the project. These reports are spaced out over the life of a project… Companies can go years between publishing them. These documents assign a dollar amount to the mining project. Investors can – and are encouraged to – use that value to estimate how much the company is worth. On the surface, the numbers appear legitimate. The rules require that the three reports be produced and certified by independent experts. But every year, stockbrokers, investor-relations firms, and even mining companies themselves use these reports to push up the share price. It has reached epidemic proportions because it's so easy to do... and so persuasive to investors. While the NI 43-101 requirements make investors feel good, they've actually made it more dangerous for investors today than things were before Bre-X. In this issue, we're going to focus on the biggest "cheat sheets" in the mining industry... the PEA. Although pre-feasibility and feasibility reports are just as likely to have flaws, the PEA is the least-expensive report to create and requires the least detail... So it is the easiest to "fudge." It's an open secret in the mining business that many PEAs contain exaggerations, misleading statements, and outright falsehoods. Companies can usually find an incompetent or amoral engineer to certify the information. As another CEO remarked: | These documents are an average investor's worst nightmare... [The mining sector] is probably the most specialist type of investing that exists. It can gobble up generalists faster than lightning, all under the guise of "professionally certified" data! | | My team and I spent hundreds of hours on these documents over the past few years. What I found made me so angry that I decided to dedicate this issue to showing you how to tell a good PEA from a bad one. I want you, my readers, to be the best-informed investors out there. I want investor-relations folks to stammer and stutter when they talk PEAs with you. Below, we'll go over all the ways that mining executives can (deliberately or not) use a PEA to dupe investors... And I'll use an example that shows just how easy it is for even a well-known company to fool you. Finally, I'll highlight projects with good PEAs that we can own right now... and potentially make a lot of money on. How NI 43-101 Fools Investors In the August 2013 issue, "Buying at the Bottom – Your Guide to Making Triple-Digit Returns in Cheap Gold Stocks," I told you about junior gold miner International Tower Hill Mines (ITH)… Back in 2011, this mining company's Livengood gold project near Fairbanks, Alaska was worth an estimated $900 million. Gold's bull market was in its tenth year. The gold price was up to $1,500 per ounce. Shares of ITH were trading for over $10 per share. But in July 2013, ITH announced a new feasibility study on Livengood. It showed the world that the project was terrible. The results were so bad that the study couldn't make it any prettier. Investors who had purchased shares based on the PEA and previous information from management suffered large losses upon the release of the new study. The problem was Livengood's fundamentals. It is a giant, low-grade gold deposit with a huge price tag. It was going to cost $2.8 billion to build the mine. Over the life of the mine, it would cost $1,450 per ounce to operate... That's a huge hurdle for any mine, but if the price of gold kept going up, it would be worth all the work... According to the report, if the gold price was $2,200 per ounce, the project was worth about $2.2 billion. If the price of gold was $1,600 per ounce, the project was worthless. But at the time, gold was around $1,300 per ounce. At that price, the value of the project was -$1.3 billion. If we used $1,200 per ounce of gold as our price, the project was worth -$1.8 billion. That is the kind of critical information we can glean from PEAs. The engineers who write these reports estimate all kinds of things, from the price of diesel fuel to the price of metals to the cost of construction. And they must disclose those estimates to us. That's why one of the largest stock brokers in Canada told me: The assumptions page is far more important than the executive summary. It's in the assumptions that most companies try to fool us. That's where they "put the lipstick on the pigs" to make them attractive to unwary investors. Remember, if we just assumed that the gold price was going to $2,200 per ounce, then Livengood was a worthwhile project. But by mid-2013, the price of gold had collapsed to around $1,200 per ounce and capital costs soared. The Livengood project was worthless. ITH was not trying to defraud investors. It did something many mining companies have done over the years. It followed a bull market in gold and went after a bad project. For investors like us, understanding the problems with assumptions is the only way to approach PEA reports. We lack the technical expertise to make informed investment decisions based on the details of the deposits. However, we can look for potentially disastrous estimates, like a gold price that's too high or a discount rate that's too low. The next section digs into the important assumptions in these reports. It will get a little dense, but stay with me. If you invest in mining companies on your own, this will be the most valuable information you read this year. The Two Places That Tell the Truth in Every PEA For all three reports – PEA, pre-feasibility, and feasibility – we want to know the assumptions the company is making about the project. What is the price of the metal or metals? What discount rate does the company use? What is the value of the project after taxes? We'll continue to use the Livengood gold project as an example, but you can apply these guidelines to any NI 43-101 reports that contain net present value (NPV). To find the two places that tell the truth in every PEA, go straight to the "Net Present Value" calculations. First, check the gold price. Anything over the current gold price is too high. Next, check the "discount rate." If it's under 10%, it's too low. And make sure you're looking at values after taxes. Here's why... The table below comes straight out of Livengood's feasibility report from July 2013. It shows just how sensitive a big mining project can be to changes in the gold price. | Gold Price (per oz.) | Net Present Value | Change in Value | | $2,200 | $2.2 billion | - | | $2,100 | $1.9 billion | -$300 million | | $2,000 | $1.5 billion | -$400 million | | $1,900 | $1.1 billion | -$400 million | | $1,800 | $723 million | -$377 million | | $1,700 | $336 million | -$387 million | | $1,600 | -$50 million | -$386 million | | $1,500 | -$440 million | -$390 million | | $1,400 | -$854 million | -$414 million | | $1,300 | -$1.3 billion | -$446 million | | $1,200 | -$1.8 billion | -$500 million | | As you can see, each $100-per-ounce decline in the gold price knocked about $400 million off the value of the project. For example, if we use $2,000 per ounce for the gold price, this project appears to be worth $1.5 billion. At a market value of under $100 million, the company would appear to be an incredibly good investment... But as we know, at the current gold price ($1,290 per ounce), this project – and ITH – is worthless. In December 2010, the company's shares traded for $10. Today, shares are just $0.91. That's a 91% loss. And that's exactly what we want to avoid. How to Find the "Right" Gold Price The first question we should ask of every project is what would it be worth at different metal prices? What would it be worth at $1,100 per ounce of gold? How about $1,000 per ounce? Goldman Sachs' gold analysts predict the price of gold will fall to $1,050 per ounce in 2014. The Livengood report didn't even consider that gold price. When $1,200 per ounce of gold would sink the project, there isn't much reason to use a lower gold price. The industry usually uses a trailing three-year average gold price as a rule of thumb. That has worked out to be a great price for them, since gold spent 11 years in a bull market roaring straight up. But today, the trailing average is $1,542 per ounce. And with the actual price of gold around $1,290, that average is useless. In the Livengood example, the difference between the three-year gold price and today's price is over $1 billion in value. This is a big problem in many of the recently published PEA reports. At the current gold price, particularly with low-grade (under one gram of gold per ton of rock) projects like Livengood, the projects are actually worthless. How to Find the "Right" Net Present Value The second question to ask is how the value of the project is calculated. NPV is an estimate of the value of a project today. Some investors just assume that the NPV is equal to the numbers presented... but that's not the case. Investors must dig into the details. Not doing so is a great way to lose a lot of money. To be successful mining investors, we have to understand how companies can manipulate the NPV. There are three major ways for companies to cheat on that calculation: cash flows, discount rate, and gold price. We've already discussed gold price, so let's look at the other two. A project becomes more valuable as its net cash flows (revenues minus expenditures) increase. A company can intentionally increase the value of a project by showing higher cash inflows and/or lower cash outflows than it really expects. Of course, these are forecasts. No one really knows what will happen in the future. We've seen how small changes to the gold price can have gigantic effects on the cash flow. There are two areas where companies can "pad" their net cash flows: capital expenditures and taxes. Global consulting firm Accenture conducted interviews of 31 mining and metals executives in 2012. The purpose of the talks was to assess how well metals and mining companies could build projects. A huge majority of respondents – 78% – said completing projects on time and on budget is critical to performing well. However, only 30% of them were able to deliver projects within 25% of their budget. That means if a company expected to build a mine for $2 billion, less than a third of them got it done for under $2.5 billion. Only 17% of the executives said they were able to complete the project within 10% of budget. We can take that to mean most of these PEAs underestimate capital expenditures. When you are looking at forecasted capital costs on PEAs, add at least 25% to the total to be conservative. The result will be a lower project value, but it will likely be more accurate based on recent history. Companies can also pad their values through taxes. PEAs generally present the value of a project before and after taxes. Taxes on mines vary from region to region and country to country. A company can inflate the value of its projects by showing investors a pre-tax NPV. Make sure you find the after-tax NPV in the study. The most common way that companies can fool us is through the "discount rate." Technically, the discount rate is the rate of return required by lenders to compensate them for the use of their money. Think of this as the interest rates charged on mine construction loans. The higher the discount rate, the more expensive the use of the money is… and the lower the current value of a project. The discount rate should also reflect the risk of the specific project... But it almost never does. Mining projects are risky. The projects take too long to build, are often over budget, and last just a few years before they are mined out. That's if they are built at all. These kinds of risks would send most lenders running. But the "official" value of most projects, certified by outside experts, is based on a discount rate suitable for a nearly risk-free lending situation. The mining industry discount rate ranges from 0% to 10% in nearly all PEAs. I believe it's one of those, "this is how we've always done it" rationales. And the lower the discount rate, the higher the value. I spoke with a mining finance expert who reviews these numbers all the time. He uses a complex system to determine the appropriate project discount rates, but it's rarely under 10%. Given his impressive success rate, we want to follow his lead. When reviewing a PEA, you should use the highest discount rate presented, or at least 10%. This will give you a conservative estimate for the project. Some knowledgeable resource financiers use higher discount rates in their private, in-house valuation calculations. But mining companies themselves often use ridiculously low discount rates to make the projects look more valuable. Again, we can use a real table from the Livengood PEA for an example of how a higher discount rate (one that makes more sense) drastically changes the value of a project. Notice how much the value changes even when the gold price is the same. | | No Discount | 5% | 7.5% | 10% | | Pre-Tax NPV | $532 million | -$300 million | -$552 million | -$735 million | | After Tax NPV | $304 million | -$440 million | -$665 million | -$828 million | | The difference between an undiscounted pre-tax NPV and the after-tax, 10% discounted NPV was a staggering $1.4 billion. With gold at $1,500 per ounce, this project is worth $532 million... as long as we don't use a discount rate or consider taxes. If we use the same gold price, but a conservative discount rate of 10% and factor in taxes... this project loses $828 million! As you can see, simple changes in the assumptions take this from a project worth owning to something we need to avoid at all costs. In the next section, we'll apply what we've learned above to a real-life mining company. I'll show you the NI 43-101 data. Then I'll show you how we use it to arrive at our own value. The good news is that our conservative estimate still comes up with a value nearly twice the company's current market value. |