June 2018

Exploration activity is increasing, and with it greed and speculation

  • By Hedley Widdup, Analyst, Lion Selection Group

Investor appetite for risk-taking emerged in 2017, and consequently exploration is being funded again. The investment market is also ascribing substantial value to exploration opportunities, which is crucial for the future, as the share market now funds a large proportion of exploration through junior explorers.

The availability of exploration funding is an excellent barometer of the state of the mining cycle. The investment market reaction to exploration results and concepts also provides an indication of risk appetite – with a spectacular recent example coming from Australia’s north west, which may have been the spark that reignited investor interest in exploration.

Sentiment drives exploration – and activity is rebounding

In the modern resources sector, the vast majority of explorers are funded by the stock market – they don’t generate much (or any) cash so have to raise exploration funds from investors. To obtain funding, companies need to promote themselves – which is as much about clearly articulating the facts of a story as it is about selling a dream. Effective promotion of exploration concepts has become as influential as technical merit for allocation of funding from the investment market.

Australian Bureau of Statistics (2017) data for exploration expenditure and metres drilled shows a dramatic decline in exploration activity from mid-2012 through to early 2016 (Figure 1). Expenditure in the March quarter of 2016 was almost 25 per cent of that in the June 2012 quarter. A strong positive trend has since emerged, with the most recent numbers (December quarter 2017) up by 71 per cent from the 2016 low. This recent recovery in activity correlates with an increase in capital raisings by listed exploration companies, and the accumulation of cash on the balance sheets of many producing miners.

This trend highlights what most people in mining already know – the boom is back on, and activity is increasing commensurately. In short: risk investment is back on the menu.

The ‘value’ of an exploration concept – highly susceptible to promotion

A mine can be simply valued for expected revenue, minus costs, over the life of mine. Share prices of miners usually reflect these fundamentals, with an adjustment for performance in relation to expectations, or the outlook of the commodity being produced.

But investors treat exploration totally differently to mining operations. No matter what anyone tells you, you can’t value exploration – because you don’t know what you are buying, other than an opportunity. You can only put a price on it, and this comes down to how effectively the elusive prize that is being sought can be articulated, and the willingness or abundance of supporters to inject capital.

In a true technical sense, while ‘exploration’ companies are quite common, ‘discovery’ companies are scarce – few explorers make a discovery. Even so, the market may begin to ascribe some value as the ‘size of the prize’ is digested. As a result, exploration targets can become reasonably well priced – but this requires a receptive audience. Every so often, the collective speculative herd becomes so optimistic and greedy that pricing (with respect to risk) becomes well overdone.

Figure 1. Exploration expenditure (LHS) and exploration metres drilled (RHS) in Australia, quarterly basis, September 1998-December 2017. Data Source: Australian Bureau of Statistics.

Gold nuggets and racing pulses

During 2017, a modern-day gold rush began in the Pilbara region of Western Australia. The charge has been led by a Canadian listed company, Novo Resources, which has established a significant ground position in the region over several years and has championed an exploration target based on Witwatersrand-style conglomerate hosted gold. This is clearly a substantial prize – around one quarter of all gold ever mined has come from the Witwatersrand, so the analogy offers huge potential.

But the local geological and stockbroking community has remained reserved. Commentary regarding the ‘Pilbara gold rush’ has been conspicuously cautious. On hard evidence, it is too early for anyone to know for sure. Speculators, on the other hand, clearly hold a different view.

This article is not lining up to be another Novo knocker. Disparaging remarks have been made toward many exploration concepts in the past (eg copper in South Australia’s Gawler Craton). Exploration is a specialised endeavour, requiring scientific process to be laced with interpretation, creativity and optimism. While it is possible to empathise with the Australian geological community (there is an obvious pride aspect if a Canadian company makes a sizeable discovery under our noses), no one can rule out a discovery being made just yet.

That aside, by far the most fascinating aspect of this story is the substantial market capitalisations that were ascribed to Novo, which would not have occurred in a weak resources market.

Paying handsomely

Despite the years that explorers have conceived conglomerate-hosted gold targets in the Pilbara, from an investment market point of view the story takes place in the second half of 2017. In July, Novo announced the discovery of gold nuggets in a bulk sample from a locality known as Purdy’s Reward. By mid-October, the market was paying a collective capitalisation for Novo Resources, and the listed explorers surrounding them (no fewer than 15), in excess of A$1.65 billion – 70 per cent of which was Novo. Novo’s capitalisation at the time was larger than all but six of the gold producers in the ASX gold index.

The severe mismatch between the market capitalisation at stake (high), and actual data supporting the potential (very little) was the aspect that had technical people most concerned. The key information that had pulses racing was almost entirely surficial – principally the detection of patches of gold nuggets at the surface in shallow prospecting pits or trenches.

Delineation of future resources of gold within Pilbara conglomerates will depend on replicating gold occurrence beneath the surface, and due to the nuggety nature of the gold, will likely require large volumes of sample to be collected. There isn’t yet a detailed understanding of how gold concentrations are distributed or controlled – either by primary means or secondary enrichment (structural modification or weathering), so the best place to collect large samples is not yet known. No prospector ever said ‘it is exactly where you think it is’. While we need to wait and see what drilling will reveal, speculators have been prepared to discount these risks substantially. But why?

Figure 2. Percentage share of discoveries, per year, according to size / nature of company. Chart is reproduced from Schodde (2017).

Greed and speculation – key ingredients

Buying shares in an exploration outfit requires a leap of faith of sorts, irrespective of whether the price is high or low. There is inherent uncertainty associated with all sorts of exploration, but especially so in the early days of any project. You can’t really blame speculators for wanting to be involved – betting on a high-risk, high-reward outcome is certainly not uncommon. But how could speculators justify paying lofty amounts for such high-risk exploration in the Pilbara?

Buyers were clearly pricing a big gold find. Gold nuggets add an exotic quality – there is something instantly identifiable as precious in a nugget – and a large gold deposit, if it could be found, would surely be wonderfully valuable.

‘People will always pay more for what they don’t understand than what they do’ (taken from personal communication from Robin Widdup, roughly once a month for the last ten years) – especially when the market is greedy. When there is no metric by which to value something, there is no upper limit to what it could be worth. Speculators are susceptible to promotion – no doubt exacerbated by spectacular nuggets effortlessly detected at the surface – and can be infected by an acute sense of greed and ‘FOMO’ (fear of missing out). Gradient of a share market trend can sometimes be more important to speculators than fundamentals. When investors don’t understand fundamentals, or choose to ignore them, concepts of valuation evaporate and price has more to do with how much money is trying to buy the stock.

It is unthinkable that this could have occurred in a weak resources market, and is a great snapshot of investors’ willingness in the current climate to take on risk. It is tempting to dismiss examples of exuberance as a flash in the pan, but the mining industry depends on this sort of risk appetite because it is critical in attracting funding for exploration, which in turn is essential for the boom to progress. In fact, on a subjective assessment, prior to the Pilbara rush, risk appetite in the market for exploration was still almost non-existent – so rather than being a flash in the pan, the event has been more like a catalyst. Anyone who depends on the deployment of risk money into mining should take great comfort in this! We have not seen conditions so supportive of highly speculative exploration concepts for many years.

Who funds the finding these days?

Research by Richard Schodde (2017) demonstrates a growing proportion of discoveries being driven by junior companies (Figure 2). Exploration work by these companies is funded in part or totally (and certainly heavily influenced) by the stock market. This has replaced a large proportion of exploration formerly provided by large mining company revenues – so willingness of speculators to deploy funds into risky ventures has huge importance to the industry, and this will remain the case for the future. Investors will require a ‘good story’ to continue to support exploration ventures.Conclusion – speculation has come back to mining, and that is a good thing

Exploration work has restarted, commensurate with a return of funding for higher risk endeavours in mining. The market is also prepared to put a high price on pre-discovery concepts such as gold in conglomerates in the Pilbara, clearly indicating that market greed exists.

As much as this exposes a lack of sophistication of buyers, who are betting on an outcome rather than following fundamentals, appetite to support and fund risky ventures like exploration is essential for the modern mining industry.

There may be a worrisome aspect of the Pilbara example – just how might risk appetite be detrimentally affected if drilling evidence doesn’t deliver what the market hopes to see? So far, this does not appear to be the case, in fact the opposite may be true. Exploration plays elsewhere, which seemed overlooked during the Pilbara rush, are now obtaining market funding and increasing in price. Money flowing out of Pilbara gold excitement may well be finding a way into other, also risky (but not so valuable) exploration ventures.

One thing’s clear – risk-taking is back.

References

Australian Bureau of Statistics 2017, Data from: 8412.0 – Mineral and Petroleum Exploration, Australia, Sep 2017, electronic dataset, Table 1. PRIVATE EXPLORATION, Actual and Expected Expenditure, viewed 2 May 2018 http://www.abs.gov.au/ausstats/abs@.nsf/mf/8412.0

Schodde RC, ‘Recent Trends and Outlook for Global Exploration’, Presentation to the PDAC, Toronto, March 2017, viewed 24 January 2018 http://www.minexconsulting.com/publications/mar2017.html

Image: Adwo/Shutterstock.com.

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