Is Zinc Deleveraging?

An article, Shanghai Exchange More Than Doubles Zinc Price Limits, describes how the margins for zinc contract have been increased and how price controls have been relaxed, if my understanding of the article is correct.

To enter a contract you needed 5% down, but that changed on November 19th to 9% down and it is increasing to 14% on November 22. That is almost three times the margin requirement and three times the amount of money down.

The price control limited the change in any single day to 6% and that has been raised to 13%.

The changes to margin are enormous.

Frank Veneroso has maintained that metal prices increased beyond reasonable levels partly due to hedge funds buying metals without ever planning to take possession of metal. With a 5% margin requirement, they could tie up 20 times the deposit on any commodity trade. Increasing the margin dropped the leverage to 11 times and the final increase drops the leverage to 7 times. Essentially traders now require about 3 times the money to enter a contract. If hedge funds are indeed responsible for the huge increases in price, that leveraging has got to fall apart pretty quickly with such enormous increases to the margin.

Zinc exports from China increased by 47% during the first 10 months of this year, which really doesn't say much unless you have an idea of how much of the world zinc market they produce and how much they export. Data from the US Geological survey suggests that China produced about 25% of the world production, about 3 times what the US produces. This certainly suggests China is a big enough producers of zinc to be dramatically influencing the price down with such huge increases in exports.

The price declines will result in enormous downward pressure on zinc stocks I've previously followed.

When I looked at Zinifex in July the P/E was around 8.6. The metal values per ton of their Rosebury mine that they were mining was about $610/ton, but the reserves for future mining were a higher grade at about $800/ton. Having a higher grade coming up, and not an outrageous P/E to start gave Zinifex room for downward pressure from prices. The downward pressure on zinc prices have been enormous, however, at today's prices that higher grade reserve still has metal values of over $650/ton. The Century mine also had higher grade in reserves to be mined. Costs are in Australian dollars. The higher grades to be mined are protective, however, zinc prices have come down enough to be cautious with this one now.

I didn't care much for Tamberlane, Breakwater or Acadian. Tamberlane only had one deposit out of the 34 that had very nice revenue potential and that would only last 1-2 years and the other deposits were questionable. Breakwater's best mine had metal values of about $410/ton and those are now below $300/ton. The metal values in El Toqui are down to about $230/ton. El Mochito's values are down to about $275/ton and Myra Falls about $320/ton. Myra Falls is showing $1.10 per pound cash costs last quarter. With zinc below that the mine doesn't look very good at all. Toqui has $0.76 cash costs per payable zinc sold. The costs appear to have gone up enormously, from $0.39 per pound payable in 2005. There has been share dilution to bring the fully diluted count from about 395 million to 461 million. Acadian estimates 8 million pounds of zinc and 3.5 million pounds of lead. The costs are estimated to be $12 million. They estimated $13 million of revenue, but the price declines of just the past days brings that down to $12.3 million. At best that might give just under a penny per share for full year production. It might even run at a loss.

Hudbay minerals looked to be valued at about 2-3x the valuation of Blue Note when I looked at them together. Today Hudbay's earning look to me like they are heading to the 50c/share for a full year range, and that won't show up on the next quarter, but Q1 2008 would have earnings in the 10-13c/share range based on today's metal prices and exchange rates. Q4 already has some better metal prices rounded into the quarter. I saw some serious reasons to see earnings declines when I reported on this stock and they have shown up and further declines will likely happen.

Blue Note's metal values are down to about $315/ton. They have have not met 2007 production goals, and there has been more dilution. Production costs are supposed to be in the $66 million range. The gross revenue potential is still in the $190-200 million per year, but that up to 4c/share earning potential in a quarter is mostly likely gone. The numbers still look like it has the potential for 1-2c eps for their first full quarter of production, but the first full quarter of production is not likely until 2008 due to problems getting the zinc circuit functioning.

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The Abundance of Minerals

In “Earth for Sale” I did a very rough calculation to determine the values of metals in the Earth’s crust for copper and uranium. The point of the post was that there are such enormous amounts of minerals in the ground, giving value to that which is in the ground at strong prices is imprudent, as that was the only “fundamental” behind the vertical ascent of uranium stocks.

This post will look closer at relative abundance of metals and how they are currently valued. I used the abundance values from Jefferson Lab and calculated the percent of the Earth’s crust each mineral would make up. I then calculated the volume of 1 km of the Earth’s crust taking the difference in volume of the Earth and a sphere 1km smaller. I used a density of 2.7g/cm^3 and 30% land area. For each metal I multiplied by the percent abundance and divided by either 454g for pounds or 31.1g for troy ounces and multiplied by the metal price.

Mineral	Abundance	% of Crust	Spot Price 09/26/07	"Value"
Aluminum	82300 ppm	8.2%	$1.09/lb	$8*10^19
Copper	60 ppm	0.006%	$3.64/lb	$2*10^17
Gold	4 ppb	0.0000004%	$728/oz	$4*10^16
Lead	14 ppm	0.0014%	$1.60/lb	$2*10^16
Molybdenum	1.2 ppm	0.00012%	$32.25 /lb	$3.5*10^16
Nickel	84 ppm	0.0084%	$14.61 /lb	$1*10^18
Palladium	15 ppb	0.0000015%	$342/oz	$7*10^16
Platinum	5 ppb	0.0000005%	$1349/oz	$9*10^16
Rhodium	1 ppb	0.0000001%	$6225/oz	$8*10^16
Silver	75 ppb	0.0000075%	$12.53/oz	$1.3*10^16
Zinc	70 ppm	0.007%	$1.36/lb	$9*10^16
Iridium	1 ppb	0.0000001%	$450/oz	$6*10^15
Uranium	2.7 ppm	0.00027%	$85/lb	$2*10^17

The “value” of metals in the Earth’s crust is grossly out of line with reality. The “value” of aluminum in the 1st km of the Earth’s crust is “worth” 80 quintillions (80 million trillions) – about 200,000 times the $415 trillion in derivative contracts that existed at the end of 2006. The lesson here is you are going to get in trouble with investments if you value metal equities based on what is in the ground. Not all minerals in the ground can be mined, but if you assumed only 1% of each mineral, or even 1/10th of 1% is recoverable, the numbers are still enormous. The metals of your commodity investment are only worth those prices if they make it to market and get sold at those prices.

Each mineral on the list is subject to supply and demand based on the mineral. Take a look going back 15 years at the price of Aluminum, which is the metal with the highest “value” in the Earth’s crust, and you see that the current price is about double the 15 year low.



Aluminum has not done the same degree of outrageous price increases and spikes as other metals. I would suggest the reason is that there is so much aluminum, the market can respond far faster to under and over supply situations. At 8.2% of the earth’s crust, aluminum is a macro element. The price of aluminum temporarily spiked to about 3 times the 15-year-low. It is currently about double the price of 15 years ago. The current price is still on the strong side in comparison to historical prices, but if you think about it from just an inflation perspective, many things have doubled in the past 15 years.

Iridium, which is the least followed and known metal on the list, also has the smallest relative valuation. It has limited applications. It is the most corrosive resistant metal known. It is also tied with Rhodium in terms of how rare it is on Earth, yet Rhodium has about 14 times the price, and relative valuation in the Earth’s crust. The following graph shows that Rhodium was not always so dearly valued; it is up about 16x what it was just a few years ago.



One has to ask if new applications and demand for rhodium really justify the increase. Rhodium tends to be mined with platinum group metals. Has world demand for rhodium increased that significantly relative to platinum? How sustainable is the demand at that price? I don’t know the answers, but I would be researching them if my investments were dependent on Rhodium price.

Nickel, uranium and copper are the next strongest valued metals. Nickel and uranium have had tremendous hype, hysteria, and speculation, very much like the tech boom of the late 90s. There is absolutely no shortage of these elements in the Earth’s crust, none what-so-ever.

Uranium consumption is about 150 million pounds per year. Say it increases 7-fold, to 1 billion pounds per year, and only 1/10th of 1% could be mined, well, that would mean the Earth has about a 2 thousand year supply. A price boom on uranium in the 70s resulted in about 50 years of uranium reserves being found. The current market is under 100,000 tons per year, which is very small compared to other metals. At the current rate that uranium is being used, current world resources would last 70 years. (http://www.uic.com.au/nip75.htm)

The shortage of uranium has nothing to do with its availability to in the ground, but rather the special licensing and controls that uranium mining is subject to do due to its inherently dangerous nature. Building uranium mines takes an extra 2-5 years longer than other mines because of the extra controls and safety concerns. Uranium spiked to about 13x its lows and as little as 2-3 years ago mining companies were bidding to supply uranium in the $10-15/lb range. Those who cash in on uranium will be those who enter long-term uranium contacts at higher prices, and those who are already in the process of building mines. The price of uranium will probably remain stronger for longer not because uranium deposits are unknown, but because the mines are not built and they take longer to build. When you consider the price was $10-15 just two to three years ago, even $40-50/lb is a very strong price.

Nickel is 1.4 times more abundant than copper and 30 times more abundant than Uranium in the Earth’s crust. The 15-year price chart for nickel shows it had a price around $3/lb, for years.



BHP’s financial results shows they made a good profit on nickel in 2006 at price around $7/lb and they more than tripled their earnings from nickel with nickel averaging around $20/lb. Nickel price is up because there was a supply squeeze, and it is unlikely that the price drop is finished when companies were able to make good profits at $7/lb. Nickel is highly abundant, and world demand is relatively small, about 1.5 million tonnes per year. Apparently some nickel supply is now coming from ore being imported into China and producing nickel at $8/lb. This new source of supply appears to be increasing rapidly.

Copper has a high value, but it has a much higher demand, about 16-18 million tonnes per year. This is about 10-12 times the demand of nickel. Relatively speaking, nickel has about 15x the abundance when contrasted to the relative size of world demand. Nickel completely lacks scarcity yet the price spiked to 8x that 10-year average price from about 93 to 03.

Copper price has spiked, but not as much as nickel in relative terms.



Clearly there is a price dip from 1998 to 2003. It is a time when companies were choosing to sell off valuable holding because of carrying costs and many new companies have made a fortune off what were previously cast-offs, some strictly on speculation, but quite a few by building mines. Copper price spiked to about 6x the weakest price in its history. Copper had a much stronger downward price trend that the other metals. Copper prices are strong and susceptible to downward price corrects. There are many strong “bears” about the copper market and there will be a downward price correction at some point, there always is, but the relative abundance to nickel and uranium when the size of the world market is considered makes me think that nickel and uranium are susceptible to stronger price corrections, but the uranium price corrections will lag due to the differences in building mines.

What has bigger implications for the price of copper is how many deposits like the recently discovered Noront drill results. Drill results on a press release today identify 68 meters averaging 5.9% nickel, 3.1% copper, 2.87 g/t platinum, 9.78 g/t palladium, 0.61 g/t gold and 8.5 g/t silver. In prior posts I talk about declining grade and how it is increasing costs so prices have a much higher cost support. I do not know how big this deposit will be, but if it were big, it would be profitable at very, very low copper prices. It does make me wonder if the declining grade being mined that seems apparent in report after report that I read is because mining efforts have focused on what resources that were known and real new exploration that would find high quality grades has been limited. This discovery should make investors in low quality grades very uncomfortable.

The value of gold surprised me. For something “scarce” the metal values in the ground are awfully high, $40 quadrillion dollars, or forty thousand trillions. Are there not these big market fears around the over $400 trillion in derivatives and somehow gold is supposed to prevent this by limiting the money supply? I pulled up a web page (http://www.gold.org/value/stats/statistics/gold_demand/index.html) that states that global demand for gold reached a record $14.5 billion last quarter. That’s about 1/300 millionth of the value of the metal in the ground. If 1/10th of one percent is recoverable, then that is $40 trillion available, or the supply can be expanded about 10-fold. At the current rate of mining the out of the ground gold supply is increasing by about 1.6% per year. Current the rate of mining seems small compared to the amount of gold that can potentially be mined. Infomine shows 1880 companies in their database involved with gold. I would think that strong gold prices would increase the mining and exploration activity of these companies and eventually increase output.

In order for price to go up you need to have more people/corporations wanting to hold gold as an investment. Currently more people seem to want to own the gold stocks as opposed to the bullion and the gold stock bugs seem utterly confused that the price of gold does not go up as they expect. It seems to me that until such time as there is a shift and the so called believers in gold actually own gold and/or the gold companies stop selling their gold there will be continued restraint on gold prices. Truly, the theory that banks are weak because they lack a gold standard because they’ve sold their gold equally applies to gold stocks as they sell off their hard assets for fiat currency.

Looking further, I find that at the end of 2005 there was around 155,000 tonnes of gold being stored in either jewelery or bars, or roughly $3.6 trillion dollars worth of gold, and they mining about $60 billion worth of gold each year. The value of gold per person from that 155,000 ton stockpile is about $500 and keeping prices constant, it is increasing by about $10/year per person from new mining. Certainly if people lose faith in paper money there is not a lot of already mined gold to go around, but there are many other hard assets that people can chose as investments that can also protect wealth. Gold does not appear to have the same degree of asset price inflation as other investments. Certainly if your country’s currency is declining, or at risk of declining relative to other currencies gold is probably a good currency hedge.



The above graph shows that if you are American and bought gold six months ago the US dollar value of your investment is up over 10%. However, if you are Canadian, the value of your investment relative to the Canadian dollar is down 4.5%.

As investors I think it is a good idea to be aware of how much actual metals exist and to use this kind of knowledge in assessing real value as opposed to apparent value in the assumption that metals in the ground today will be worth the same forever or even be stronger forever.

Looking at this makes me wonder more about iridium. It seems that the most corrosive resistant element would have market growth potential and it does not seem to have the same speculative pricing built into it.

In any event, I did quite a bit of traveling in the summer and now I am in the process of moving so I have not had the same kind of time to look at investments. So, I am still around, but not as able to be actively posting. I will probably work on shorter and less time consuming posts in the future.

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Looking at Lead - ADA, BN, BWR, TAM, Zinifex

Lead has reached an all time high, about 6 times its low since the start of this bull run. It is a strong price, but it isn’t as strong as say molybdenum which peaked about 18 times its low, or nickel, which peaked at around 12 times its low, or uranium which is about 15 times its low. Strong lead prices will mean unexpected profits for lead producers.

The market is tight for lead Lead Rises to Record for Third Day in London.

Lead deposits tend to exist with zinc deposits, this post looks at 5 companies that have some lead, Acadian Mining, Blue Note, Breakwater, Tamerlane and the Australian Zinifex. Metal prices are highly volatile and many calculations giving metal values are done here. They are intended to give a relative magnitude for comparison purposes--how good are grades relative to each other; how big are deposits relative to market cap; how much gross income can they bring in relative to each other. Higher grades and larger deposits tend to be more profitable. I have given valuations for metals in the ground at today's prices. In general, I believe that is a poor way to assess the value of a mining company and I look at it purely for a relative valuation. Prices used for metal values per ton calculated are $650/oz for gold, $12.40/oz for silver, $1.50/lb for zinc, $3.50/lb for copper and $1.20/lb for lead.

Zinifex

Zinifex is the largest of the companies and it produced about 5% of the world's 2006 zinc supply, 1.4 billion pounds of zinc, and about 230 million pounds of lead. As with the Australian mining practice, they maintain about a 6-year life-of-mine, and they have one mine has had a six-year LOF since 1893.

Few mines have a higher resource grade than their Rosebery mine, with an average resource of 15.3% zinc, 4.7% lead, 180 g/ton silver, 2.5 g/ton gold and 0.5% copper for an amazing $800/ton in metal values. They have 7.1 million tons of measured, indicated and inferred reserves for close to $5.6 billion in metal values at this grade. The reserves they are currently mining have about $610/ton in metal values.

Their other big property is their Century mine. The resources averages 12.7% zinc, 1.4% lead and 34 g/ton silver, for $470/ton metal values and with 60 million tonnes that’s $28 billion in metal values. Their reserves suggest metal value currently being mined are about $420/ton.

Zinifex’s properties are exceptional and they have further development prospects with their recently acquired Wolfden in Canada’s north, which has properties with metal values per ton of $250-700. They also have Dugald River and South Hercules for development.

In Australian dollars, last year the revenues were over $3 billion and of that $1.1 billion was profit, making $2.20 per share and shares are currently priced at about $19, for a P/E of about 8.6. Zinc prices peaked during this reporting period and have declined, but lead prices are up.

In the US, under the ticker ZFEXF.PK, it trades at $15.90/share and with 488 million shares, it has a US market cap of about $7.7 billion. At $1.50/lb zinc and $1.20/lb lead 1.4 billion pounds of zinc and 230 million pounds of lead would fetch $2.4 billion US gross revenue, or $2.9 billion Australian. Gross revenue potential is close to 1/3rd of market cap. Relatively speaking, with lead production potential of 230 million pounds their leverage to lead is not high; they are about six time more leveraged to zinc, but there is no question that lead’s ascent will be contributing nicely to their bottom line.

Tamerlane

Tamerlane is a junior explorer with a fully diluted market cap of about $67 million. Their prize property is the old northern Pine Point Mine, which historical records show they mined 64 million tonnes from 52 deposits with an average grade of 3.1% lead and 7% zinc, or about $310/ton metal values at today’s prices. Currently they have 34 known deposits from non-compliant historical data indicating 70 million tonnes of ore with 4.19% zinc and 1.59% lead, or about $180/ton of metal values at today’s prices. The grades and sizes of the deposits vary greatly.

Their flagship deposit, R190, has grades of 6.3% lead and 12.1% zinc for about $570/ton metal values and there are about 1 million tonnes of ore in this deposit, or about $570 million in metal values.

Tamerlane has plans to start building the mine in Q4/07 and to be in full operation for Q1 2009 and to mine the 240 million pounds of zinc and 120 million pounds of lead from R190 in 12-15 months, or half a billion at today's prices. Six of the 34 deposits are close by and have metal values/ton about $290/ton, so without milling upgrades their second year of production rates would be about half what they get with the R190 deposit.

Financing the mill construction has not been arranged. They are looking to forward sell some of their production to prevent further dilution, and appear to be looking at issuing 30 million in equity and 100 million in financing to move the project forward. They have already run into obstacle in terms of implementing their plan as in April 2006 the plan was to start building in January 07 and be producing in December 07 of this year.

Tamerlane was closed down due to declining metal prices and increased costs due to flooding, and the high cost of maintaining a town for workers in the north. They plan to deal with the flooding by implementing freezing technology around the deposits. As the size of a deposit decreases the relative cost of the freezing technology increases exponentially, just as a ratio of surface area to volume increases as the volume decreases. The economics of each deposit will be highly variable.

Breakwater Resources

Breakwater Resources has a fully diluted share capitalization of 460 million shares for a market cap of $1.5 billion. Their 2007 production forecast is 268 million pounds zinc, 18 million pounds copper, 28 million pounds lead, 2 million ounces silver and 43,000 oz gold or total metal values of $550 million. They also have an interest in Blue Note, which can be taken as shares or as 20% interest of their Caribou mine. At current metal prices that interest could bring an additional $30 million in gross revenue for 2007. Gross revenue has the potential to be around 40% of market cap.

Their Langlois property starting production this year and has a reserve with 10.1% zinc, 0.8% copper and 49g/ton silver, for metal values of $410/ton, for about $1.5 billion in metal values. The resource has comparable metal values/ton and is about twice as big as the reserve for a combined total of about $4.5 billion. The goal for this property is 62 million pounds of zinc, 3 million pounds of copper and 12,000 oz of silver. Metal values per ton mined in Q1 were about $250/ton.

El Toqui has 8.9% zinc and 1.3g/ton of gold for $320/ton in metal values and is also projected to start production for 2007 with a goal of 61 million pounds of zinc, 6 million pounds of lead, 10,000 oz of silver and 2,600 oz of gold. Metal values per ton mined Q1 were about $300/ton. Total reserve/resources is about $4.5 billion.

El Mochito has 6.7% zinc, 2.8% lead, and 97 g/ton silver for $330/ton in metal values. It is projected to produce 60 million pounds of zinc, 20 million pounds of lead and 1.1 million ounces of silver. Actual grades mined in Q1 had metal values of $300/ton. This property holds about $3 billion in metal values.

Myra Falls has resource with 7.2% zinc, 1.2% copper, 55g/ton silver, 0.6% lead and 1.7g/ton gold for metal values of $400/ton and has about $7 billion in reserves/resource. It is projected to produce 84 million pounds of zinc, 15 million pounds of copper, 2 million pounds of lead, 660,000 oz of silver, and 17,000 oz of gold. Actual grades mined in Q1 had metal values of $220/ton.

For Q1 prices Breakwater obtained in $US were $1.56/lb for zinc, $2.70/lb for copper, $0.81/lb for lead, $647/oz for gold and $13.03/oz for silver. Earnings on $78 million of gross revenue were $15 million. They are about 9-10 times more leveraged to zinc than to lead.

Blue Note

Blue Note is an almost producer, currently in the start-up phase of their newly refurbished/built Caribou mine that Breakwater has an 20% interest in. Figuring out their “true” fully diluted market cap is more complicated than for other companies because of the Breakwater interest, which gives Breakwater choices about how they cash in on their interest, either 20% of Caribou or about 42 million shares, and there are hidden shares with debentures that are easily missed. Breakwater must make a decision within one year providing Blue Note does $1.5 million in further exploration on the Caribou property. Fully diluted excluding Breakwater’s interest Blue Note has a market cap of about $172 million. As shares Breakwater’s interest adds an addition $22 million to the market cap.

For 2007 projected production is 68 million pounds of zinc, 35 million pounds of lead, 0.8 million pounds of copper and 850,000 oz of silver, for total metal values of $157 million of which 80% is $126 million or about 3/4rds of the market cap excluding Breakwater. For 2008, with full production, the projection is 104 million pounds of zinc, 57 million pounds of lead, 1.3 million pounds of copper and 1.3 million ounces of silver for $245 million, of which 80% is $196 million and exceeds the market cap.

Metal values per ton in the Caribou/Restigouche reserves are about $370/ton with a total reserve value of about $1.8 billion at today’s prices and the resource, where the life-of-the mine is extended beyond 5 years from, has about $380/ton in resource metal values and about $1.4 billion at today's prices. There is no measure for copper values in the resource, which is 0.34% in the reserves. The cut-off grade used was a profitable 9% combined lead and zinc.

Breakwater previously had problems with poor recovery rates and poor metal prices. Metal prices were low when they decided to sell. Blue Note has installed a milling process shown to dramatically improve recovery rates developed in the last 15 years by Xstrata. Xstrata has used the technology long enough to prove it works and Blue Note has a contract with Xstrata to buy half its zinc concentrate and all of its lead concentrate. Blue Note is still very much priced as a junior explorer. It is in start-up operations currently testing their milling process and will soon be a producer eligible to move to the Toronto exchange. As a new start-up it runs the risks that things will not go as management plans and there are no operational financial reports to review and evaluate.

Blue Note has several exploration properties in the vicinity of the Caribou mine including Armstrong, California Lake, McMaster, Orvan Brook, Rio Road and Woodside Brook.

Blue Note’s relative leverage to metal prices means that every 2c change in lead price has about the same effect as 1c change in zinc price.

Acadian Mining

Acadian Mining is a small new producer with 159 million shares fully diluted as of May 31, 2007, giving it a fully diluted market cap of $191 million. They have two main projects of interest, Scotia Zinc and Scotia Goldfields, and they own about half of Royal Roads, which owns about half of Buchans River.

Scotia Zinc has a 2007 production target of 23 million pounds of zinc and 8 million pounds of lead and a 2008 production target of 45 million pounds of zinc and 19 million pounds of lead, for $44 million of gross revenue in 2007, 1/4 of market cap and $90 million for 2008, almost half of market. The reserves have a zinc grade 3.6% zinc and 1.7% lead, for $160/ton metal values. Total reserves are about $750 million to be mined over 7.5 years. As a new start-up it runs the risks that things will not go as management plans and there are no operational financial reports to review and evaluate.

Goldfields has several properties with about 1.35 million ounces of gold contained in resources that have metal values ranging from about $60/ton with the Beaver Dam property which has about 600,000 oz of gold, to about $350/ton with Goldenville with about 265,000 oz. The metal values may be worth about $900 million, but low grades spread out in several deposits means high extraction costs.

The Royal Roads holding has given them an interest in the Tulks North property. It currently has inferred resources with metal values of about $530/ton, or about $900 million in metal values. With the 1% zinc cut off instead of a 2% zinc there is 2.5 times as many tons of ore, but metal values per ton of ore decline to about $250/ton. This only adds $100 million in metal values to the deposit for an extra 2.5 million tonnes of ore that would need to be processed. This extra could quite possibly cost more to mine and process than the value of the recoverable metals. Acadian's interest is about half of this deposit.

How do they compare?

Zinifex by far has the best grades and looking at their financial data, you can see that about 1/3 of the gross sales ended up as earnings. Contrast that to Breakwater's lower grades and about 20% of their sales ended up as earnings, although Breakwater's earnings were pulled down by Myra Falls' lower grade during the quarter and will likely increase to more like 25% of gross revenue. Zinifex's higher grades and endless deposits justify a higher P/E than Breakwater, but both are nice looking companies. With strong prices there is always more downside risk that prices will decline, so commodity companies in this market commodity companies should never be priced the way a company like Pepsi might be priced, with an expectation the prices will generally always increase. So, 5% earnings might be great for Pepsi, but is a good way to potentially lose your capital with commodity companies. Zinifex currently has earnings of about 11%, which has a safety margin built in and gives them cash flow to fund future growth and exploration.

Breakwater has lower grade and is priced lower relative to market cap. Earnings for Q1 were low, about 5%, but should improve, most likely doubling when their new production that has started shows up in the financial reports. Also, Myra Falls contribution to operational earnings was relatively small as the grade they actually mined for the quarter was much lower than the overall grade their reserves/resources indicate they hold. Breakwater has a safety margin built in and they have good cash flow to fund future growth and exploration.

Tamerlane has a beauty deposit with that R190 deposit but they have a lot of steps to go through to actually get that deposit producing and any revenue possibility is about two years out. The economics of the R190 deposit at today's prices are nice, but it is a minimum of two year out and the further out you go, the more likely projections on everything are going to be wrong.

Blue Note has high grade to mine, an exceptionally high gross revenue potential relative to market cap and good reserves/resources relative to market cap. On this basis it is currently priced at about 1/3rd to 1/2 of the valuation given to Zinifex or Breakwater. The metal values per ton are very comparable to Breakwater's grade, so the simplest projection on earnings by contrasting is that they will be about 20-25% of gross revenue. Octagon has an estimate of 15c/share, or about 30% for this year, and 25c next year, for about 50%, or a P/E of about 2.

Acadian Mining has the lowest start-up production relative to market cap and the lowest grades, less than half that of the other companies profiled. Blue Note has combined open pit and underground mining operation, as does Acadian. In general high grade is what makes a company profitable and low grade is what limits profitability. For Acadian the gold deposits also tend to be low grade and/or small deposits, both of which rarely make money. It has a grade that with a large operation and economies of scale can make money but from reviewing many financial reports of other operations my conclusions are that its small size makes it questionable as to whether it can make money. This one I'd definitely want to see proof of earnings because of the lower grades.

Other details I picked up from looking at the relative deposit size is that Acadian's information indicates that they expect to recover about 90% of their deposit in 7.5 years. Blue Note's numbers indicated about 60% of their deposit will be recovered in 5 years. It is strictly a perception it gives me that there is not much room for error built into Acadian's numbers. Blue Note uses a 9% zinc-lead equivalent cut off which builds in a safety margin for investors in their evaluation. The 1% zinc cut off used for Royal Roads does not.

Note: I am not an investment adviser and I write about investments to help me to evaluate my own investments or potential investments or to better understand investments as a whole. For this post, because I own Blue Note, it was time for me to re-assess it's valuation relative to other companies in the sector. If you've seen something of interest you need to do your own due diligence. Current prices, Blue Note 53c, Acadian $1.20, Breakwater $3.19, Tamerlane $1.62.

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Yamana, Northern Orion, and Meridian Gold Merger

Northern Orion first got my attention last fall when it was trading at about $4 Canadian at the beginning of October 2006, and given its under valuation, the upward march in October made sense. Then it gradually declined, again touching just under the $4 mark at the beginning of January.

It was during that descent that I started to contrast how it was being valued relatively in the market to ensure my perspective was reasonable and because of the joint ownership of the Alumbrera mine, Goldcorp was the most logical company to contrast relative valuations. The result was How I discovered the Gold Bubble and I came to the conclusion that Northern OrionLoading... was a buy to $7 based on its property holdings.

Wednesday’s joint news release announces a proposal to merger between Yamana Gold, and Northern OrionLoading... with an offer for Meridian Gold to be a part of the deal. The effective price for Northern OrionLoading... is $7.07 per share, a 21.3% premium over the day’s closing price, the same valuation that I came up with for Northern OrionLoading... without development of the Auga Rica property.

Northern Orion also has two types of warrants. The regular warrant holders closed at $4/share on Wednesday, so with an exercise price of $2, they have a 27% premium on the close, and still have until May 29, 2008 to exercise their warrants. The A warrants were not “in the money” warrants. They are exercisable until February 17, 2010. If Northern Orion managed to get their Auga Rica property developed in time for the A warrants, the roughly 600% growth in production meant that those out of the money warrants had a potentially very nice risk-reward ratio. The A warrants transfer to buy 0.543 of a Yamana share for $6. It means that Yamana’s share value must increase to $14.42, or $1.40 over the $13.02 close, in order for the A warrants to be in the money at their $1.83 price. Without this offer Northern Orion’s share price would have to increase $2 to $7.83 for the A warrants to be in the money. Relatively speaking, before the deal Northern Orion’s shares had to increase 34% to break even and at the time of the press release Yamana’s shares have to increase by 11% to break even.

But, that was before today’s Yamana’s share price declined. With the decline to $11.83 the take-over price works out to $6.42 for Northern Orion, and for the A warrants the Yamana share price needs to increase 23% to $14.54 to be in the money from today’s $1.90 close.

Before any merger fully diluted Yamana Gold has 381.9 million shares. The merge adds 309.4 million shares for shares and if all Northern Orion warrants and options were exercised, another 37.5 million. A real plus for Meridan Gold is they state they’ve only had 36% stock dilution compared to an average of 417% among their peers since 2000. There appears to be only an extra 820,830 options, so very little dilution. If all options were exercised there would be an additional 1.8 million shares, for a total of 730.6 million shares. Going with Wednesday’s close of $13.02, that would give a fully diluted market cap of $9.5 billion, which has declined to $8.6 billion with today’s price decline.

Production

So, putting together the total of the three company’s production, and you have:

Northern Orion

• Alumbrera, Argentina, about 50 million pounds of copper, 75,000 oz gold

Northern Orion can expect about $160 million of gross revenue, Q1 gross sales were $34.8 million. The royalty that kicked last year is costing 96c/lb of copper for Q1.

Meridian Gold

• Rossi/Storm JV, Nevada, 25,000 oz gold for 2007, 30-40,000 oz for 2008
• El Penon, Chili, 230,000 oz gold, 6 million oz silver
• Minera Florida, Chili, 70,000 oz gold
• Zinc production, 8 million pounds, my estimate from Q1 financial report

Meridian Gold can expect about $300 million gross revenue, Q1 gross sales were $66.4 million.
Yamana

• 600,000 oz gold, 140 million pounds of copper.

Yamana can expect about $840 million gross revenue, Q1’s gross were $145.1 million.
Combined production is about 1 million ounces gold, 6 million ounces silver, 8 million pounds zinc and 190 million pounds of copper. At $650/oz for gold, $12.50/oz for silver, $1.50/lb for zinc and $3.20/lb for copper it gives about $1.3 billion in gross sales without hedges.
Q1 earnings were $27.4 million for Yamana, $9.5 million for Northern Orion, and $18.9 million for Meridian Gold, or $55.8 million.
Quality of Reserves
Grade quality of reserves and resources must also be considered.
Yamana
At December 2006 Yamana had 6.9 million ounces of gold at 0.49 g/ton, or metal values of $10/ton. Additionally there is 2.3 billion pounds of copper at 0.35% or about $25/ton. As some of the copper metal values overlap with the gold, weighted average metal values of copper and gold combined work out to $28/ton. The 13.7 million ounce of gold and 2.8 billion pounds of copper in the mineral resource has smaller average metal values, about $23/ton.
If you could master 100% recovery, at these grades you need to mine over 63 tonnes of ore to produce a single ounce of gold with 0.49 g/ton. Chances are they have higher grade veins to mine first, but the sheer magnitude of the amount of ore per ounce of gold suggests high production costs, or grossly increasing production costs as the grade mined declines.
To put it into perspective, the Chapada property has both the copper and gold and its metal values work out to $37/ton in the proven reserves and $30/ton in the probable reserves, essentially a 20% decline in metal values as the mine life proceeds and they move from mining the proven reserves to the probable reserves. At 0.34 g/ton 92 tonnes of ore must be mined for an ounce of gold. Take the grade down to the 0.26 g/ton and you need 120 tonnes of ore. Compounding this problem is that recovery rates also tend to decline as the grade declines, so where you might have had 90% recovery, you now have 80 or 85% recovery, the 92 tonnes required becomes 102 tonnes required at 90% recovery and the 120 tonnes required becomes 142 tonnes at 85% recovery.
You can take copper production and take those dollars and apply them to gold production and give the appearance of low cost gold production, but what you’ve essentially done is allow copper production to trade at gold multiples. With Q1/07 dilute earnings of 7c/share multiplied forward by 4 quarters you get 28c/share. That gives a P/E of 46, so copper sales are trading at a P/E multiple of 46.
Looking further, for Q1 the Chapada mine produced 38,954 oz gold and 27.5 million pounds of copper. That is about 32% of the gold production. Chapada was responsible for 60.6% of the net revenue, which leveraged to 87.4% of the operating earnings. That detail screams that the other mines are not making much money. For Q1 the grade mined at Chapada was 0.57 g/ton gold and 0.47% copper, the metal values per tonne mined were $45/ton, way more than the $37/ton metal values for the remainder of the proven reserves, and the $30/ton of the probable reserves.
Northern Orion
Alumbrera has a life of mine until 2016 and has 0.45% copper, 0.014% molybdenum and 0.47g/ton of gold for metal values of about $51/ton. Alumbrera has a 20% royalty that kicked in last year.
Agua Rica has reserves of 0.50% copper, 0.033% molybdenum and 0.23g/ton gold for metal values of about $61/ton. The Agua reserve has 8 billion pounds contained copper, 531 million pounds molybdenum and 5.4 million ounces of gold.
Meridian Gold
Meridian’s El Penon is stellar, 6.6 g/ton of gold and 275 g/ton of silver in the proven and probable reserves. At $640/oz for gold and $12/oz for silver, that’s a very nice $242/ton in metal values.
Minera Florida has 1.5% zinc, 27 g/ton silver and 5.3 g/ton gold for $169/ton metal values.
Rossi has a resource grade of 15.4 g/ton of gold for $317/ton, but the deposit is very small.
Esquel is has a stellar grade of 23g/ton of silver and 15g/ton of gold for $317/ton.
Of the three, Meridian Gold has the smallest reserve/resource contribution, but it has more profitable grades, even for the more costly underground mining.
The Growth Profile
Checking out their presentation, the two-year plan is to move from 1 million ounces of production this year to 1.5 million ounce by 2009, or a 50% increase in gold production. Say gold is $650/oz, that’s an extra $325 million/year of gross revenue. A move from 1 million ounces to 1.5 million ounces would only increase the gross revenue by about 25% as about half the revenue is from the zinc, copper and silver. There may be plans to increase production of these metals, but that information was not included in their presentation.
The increased production plan does not include developing Agua Rica, or Esquel. Agua Rica has a feasibility study to produce 365 million pounds of copper, 125,000 oz of gold and 16 million pounds of molybdenum. Say copper was $2/lb and molybdenum was $15/lb and gold $700/oz, that would give $1 billion of gross revenue. There would be no outrageous 96c/lb royalty on this production. There could also be the option of partnering with Alumbrera for some other kind of production arrangements as they are close together.
Conclusion
Just because you label a company a gold producer or a base metal producer is not justification to accept different valuations for producing an identical product, such as copper, silver and zinc and for Yamana the market is grossly overvaluing production from producing these metals in comparison to if they’d been produced by say, Quadra.
Also, the market tends to fail to adjust valuation for reserves based on the quality of the reserves. The low metal values per ton for Yamana suggest that the reserves should be valued at a significant discount when you consider that the mining costs per ton tend to be fairly fixed costs. When grades are $50/ton, $10 processing per ton is 20%. At $25/ton it is 40%.
The gold grades are low and the actual production costs without metals credits are high. When Chapada’s costs are fairly allocated between copper and gold you get 66c/lb production costs for copper and $187/oz for gold.
Yamana is sufficiently overvalued that the “premium” offered to Northern Orionand Meridian is completely fiat.
Do your own due diligence, these are strictly my opinions. For the record, I owned Northern Orion until I realized it could very well be taken over by some bubble-valued gold producer.

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Commodity Prices - The 50-year low and 20-year average

In 2002 commodity prices were at a 50-year low, and with zinc, for example, the price was about half of the 20-year average price.

That 20-year average price was mostly in a bear cycle. Bear cycles lead to under investment. Existing mining companies are sustain operations without replacement investment. For example, the mines are already built; so only maintenance costs required. They already have drill results telling them where to mine, so exploration budgets can be cut, and that was happening. Individual mines depreciate in value as the minerals are mined and the life of the mine declines, so in real terms, without re-investment the value of mining companies was declining during the bear cycle.

Furthermore, if you look at what happened when prices hit that 50-year low in 2002, well, companies went into bankruptcy. Other companies sold off valuable assets at bargain basement prices. Look at how Roca (ROK-V), Northern Orion (NNO-T) and Eastern Platinum (ELR-T) all got started. The assets they control they got for probably 10c on the dollar.

Another example, Silver Wheaton purchased 37.5% of the Alumbrera mine in 2003 for $270.5 million, which was later acquired by Goldcorp. In 2006 that 37.5% interest accounted for $334 of the $455 million of operation earnings from the 15 mines listed with operations for Goldcorp. Alumbrera is in Argentina, where costs are relatively low and it was sold in a fire sale!

The mining industry in BC, where I live, practically died at those 20-year average prices, even where the mines were already built. And it was happening across Canada. Look at Teck Cominco’s (TCK.A-T) old Pine Point mine, the property now owned by Tamerlane (TAM-V). It was the site of one of Canada’s most profitable mines and it was shut down and practically given away with 70 million tonnes of historical, ie, not NI 43-101 compliant, resources with 1.59% lead and 4.19% zinc in 34 deposits. That is about 2.5 billion pounds of lead and 6.5 billion pounds of zinc.

Competition from countries with cheaper wages and costs played a significant roll in the demise of Canada’s mining industry. With those 20-year average prices gems were treated as pyrite. And that should be a wake up call for just how much relative value you should give to metals in the ground versus a company’s earnings in your own investment portfolio.

It seems to me that using that 20-year average price as a meter stick to come up with long term price projections is not reasonable given that it was a period of cannibalism of assets to maintain operations and I think that is partly why some analysts keep under estimating the strength of future commodity prices.

And, if you take a look around at what is happening in other countries that have developed a strong mining economy, the standard of living is rising, as are their wages. The proliferation of news releases about strikes is enormous, and wages are going up. The wage discrepancy is shrinking and the world is running out of countries where you can build a mine for slave labour wages.

And with increasing standards of living, when workers can actually participate in the economy rather than just exist in the economy, they stimulate the economy in a way that gives the enormous rates of economic growth that we are seeing in developing countries.

Those in the mining industry and those highly bullish on commodities insist that it will take years of new investment to meet current demand and that we are in a super cycle for commodities because of the gross level of under investment and because of the economic growth in developing countries. The bears of the market look at that 50-year low and the 20-year average price and use that as a meter.

There is no question that the high commodity prices we are seeing today are unsustainable in the long term, and the further out the prediction on where prices will be the more likely it will be wrong, but it makes far more sense to me that the next 20-year average price will be significantly higher than the previous 20-year average price.

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Hudbay vs Blue Note, experience vs new

Hudbay Minerals is Canada's third largest producer of copper and zinc and also produces some silver and gold. They are highly integrated in that they own a copper smelter, a zinc plant and they convert some of their zinc to zinc oxide. Their product is marketed by Considar Metal Marketing, of which they own 50%. Being fully integrated gives them autonomy over the entire process.

Fully diluted warrants and stock options they have 129,284,210 shares, and at today's closing price of $20.77, it gives them a fully diluted market cap of $2.69 billion. Hudbay has a history of successful mining production, and their financial reports fully breakdown their costs and production.

By contrast, Blue Note is a small soon to be producing mine acquired from Breakwater when zinc price was down. Breakwater had spent $100 million on infrastructure and shut down in 1998 due to zinc prices and recovery rates. Blue Note has refurbished with mining technology developed since then. Their mine is scheduled for start-up in June/July and their unproven production plan relative to their market cap is stellar, but as a start-up it is still unproven.

Blue Note has 312,930,175 shares and Breakwater has the option to convert a $15 million debenture into 41.7 million shares, or 20% of the Cariboo and Restigouche mines. Additionally a $30 million debt offering adds an additional 4.5 million shares. For comparison purposes, it works out to about 360 million shares fully diluted. At today's close of 46c, the fully diluted market cap is about $166 million.

The market currently values Hudbay at about 16 times that of Blue Note.

Mining Production to Concentrate

Hudbay has 4 producing mines and with one increase production this year. The totals are from the financial reports but the reports do not specifically break down production by mine, so the estimates are mine based on given recovery and production rates given. They give a general picture of production.

	Zinc (lbs)	Copper (lbs)	Silver (oz)	Gold (oz)	End of Mine *$ (millions)
Mine 777	120,000,000	84,000,000	725,000	75,000	2017 $527
Trout Lake	57,000,000	40,000,000	236,000	24,000	2009 $242
Chisel North	51,000,000				2011 $77
Balmat*	20,000,000				2014 $30+$75 +$82
Total	250,000,000	125,000,000	963,000	96,000
Market Value* (millions)	$375 + $75*	$425	$12	$65	Total $952

*Production to about 70 million pounds for 2007 and 125 million pounds for 2008.
*Prices I used are $1.50 zinc, $3.40 copper, $13.50 silver, $680 gold, and $0.85 lead.

Additionally, Hudbay buys other concentrates that they process through their smelter and zinc plants, further producing from concentrate about 70 million pounds of copper, 10 million pounds of zinc, 2,000 oz of gold and 380,000 oz of silver.

What they mine and what they produce from concentrate needs to be evaluated separately.

Blue Note has one mine set to start producing this year. Their first full year production plan is:

	Zinc (lbs)	Lead (lbs)	Copper (lbs)	Silver (oz)	End of Mine
Cariboo	104,000,000	57,000,000	1,300,000	1,300,000	2011
Market Value* (millions)	$156	$48	$4	$18	Total $226

Contrasting mining production only, Hudbay has 4.2 times the gross revenue potential from mining production.

In both companies the end of mine life is of concern for future income. Trout Lake has 3 years of operations left which is 20-25% of production. Whether there is opportunity to extend this LOM was unclear reading the reports. Their next mining project will not be a growth project but will be a replacement project.

Hudbay has significant exploration potential around their 777 mine. According to a 2004 technical report, "on average, mining reserves have increased 2.5 times over the initial resource and reserves estimate." Trout Lake has had 10-fold increase in estimates over its mine life, but whether there is more potential to extend the mine life at this point is not clear. Their Flin Flon/Snow Lake area also has exploration potential.

Blue Note's current plan is a 5 year LOM plan. Their mining plan goes to depth of 300 meters and they have some drill results to indicate that they will be able to continue their mine to 900 meters giving their mine a life of up to 14 years. This is a significant exploration potential.

Mining Production from Concentrate

Blue Note does not have facilities to smelt or refine their concentrate.

Hudbay has more refining and smelting capacity from concentrate then they get from their own mines. They purchase additional concentrate to utilize their capacity. This part of the business gives them some income stability from declining mine production in that when a mine stops producing they can continue this income stream by switching to purchasing more concentrate.

Financial reports have to be evaluation to determine how this part of the business adds to revenues.

Looking at Financial Reports

Blue Note does not have an earning history to look at and evaluate. It is a speculative stock based on its new mine production. The pre-tax earning potential according to their reports for 2007 is $25 million and that is with zinc priced at $1.44, lead at $0.52, silver at $12.50 and copper at $2.80, and that is based on 2007 projected production of 68 million pounds of zinc, 35 million pounds of lead, 0.8 million pounds of copper and 0.85 million ounces of silver. Current commodity prices suggest they will exceed this projection if they meet their production goals.

Hudbay had a record year for earnings and revenues. Revenues were $1.13 billion. What is highly confusing, and perhaps misleading, is how they came up with earnings of $5.32/share for 2006.

On page 28 of the Management and Analysis is the following table for 2006 (my totals):

	Q4	Q3	Q2	Q1	Total
Revenue	313,110	346,203	261,727	207,963	1,129,003
Earnings before taxes	134,636	151,582	94,590	61,643	442,451
Net Earnings	165,788	169,381	152,836	75,986	563,991
Basic EPS	1.32	1.37	1.71	.89	5.29
Diluted EPS	1.29	1.33	1.30	0.70	4.62

Problems

1. A minor problem is that their Key Financial results on page 5 of the report say $5.32 and $4.69 whereas when I add the quarters I get $5.29 and $4.62.


2. A big problem that I see is when you look at the difference between the basic and diluted EPS you see that for Q3 and Q4 the difference between the two values is about 2-3%. However, if you look at Q2 the difference between the two is 51c, and .51/1.30*100% is 39%, and for Q1 the difference is 27%. Without looking further, this tells me there was dilution and the true earning potential is overstated in the financial reports because of the dilution.
   
   They are doing this calculation using the net earnings divided by the number of shares at the time. If you redo this calculation using the today's diluted share count you get 564/129 for $4.37 eps based on today's fully diluted market cap. This is 93% of their diluted eps of $4.69 that they reported, and 82% of the undiluted $5.32 eps being promoted.


3. An even larger problem that I see is that is that earnings before taxes is less than earnings after taxes. Once you pay taxes earnings are supposed to go down, but somehow their earnings go up, very significantly. I saw this problem as so significant when reviewing the financial reports, I immediately checked insider activity.
   
   Upon a closer look at the financial reports I found that they had put $125 million of future tax into earnings and it says that as this is "drawn down, ... it will be reflected as a mining tax expense."
   
   When I take their earnings before taxes and divide it by the 129 million fully diluted shares I get $3.43 eps, which is 64% of the $5.32 eps, or more than 1/3rd less. It is an earning rate of 16.5% of the current share price, without paying taxes.
   
   I am not an expert, but I read the "reflected as a mining expense," as not a good thing. I read this as meaning that not only will future years bear their tax burden, but they will have this extra expense of writing off this future tax asset.
   
   I do not profess to understand how this future tax thing works, but from what I've seen in other financial reports in other industries is that it seems to result in highly overstated earnings in earlier years at the expense of plummeting earnings in later years.
   
   And my look at insiders going back to July of last year, they appear to have significantly reduced their positions. Anderson has taken a gain of about $185,000 from options, Axworthy about $252,000 from options (he still has about 6,000 shares), Deitrich sold 3,300 of 10,000 shares at $23.37, Gordon took a gain of about $2.2 million from options, Hair took a gain of about $950,000 from options, Jones took about $4-5 million from options, Palmiere sold options for a gain of about $525,000, Rood took a gain of about $300,000 from options, Swinoga took about $970,000 from options. Lawler is the only director that is holding significantly in the company, with 193,000 shares.

The average prices received for product for 2006 for Hudbay was $1.53/lb for zinc, $3.15/lb for copper, $603 for gold and $11.13 for silver. They are most price sensitive to zinc and copper.

I haven't studied how the money flows through smelting and refining companies. As commodity prices go up, what they pay for concentrate goes up, and the same is true for when commodity prices decline. This means that earnings from this part of Hudbay's business should remain relatively constant and is not subjected to the speculative risk of starting new mines, doing exploration for new deposits, etc.

A quick look at this part of the business is that it looks like it made up for about $250-300 million of the overall revenue. Operating expenses increased by about $120 million from 2005 to 2006, or 25%. If you examine the individual cost of operations you see far smaller price increases of 2-10% in the operating expenses. The biggest hit for the operating costs is in the smelting and refining part of the business because of buying the concentrate. A 2004 report breaking down the employment numbers shows that 558 were directly employed at mines and concentrators and 485 at smelter and zinc plant. So the mining part of the business is bringing in 75-80% of the revenue with about 54% of the workers directly employed in those operations.

The financial reports state what they averaged for final product, but they do not actually say what the average cost was for the concentrate they purchased.

The bottom line to me is that the 70 million pounds of copper, 10 million pounds of zinc, 2,000 oz of gold and 380,000 oz of silver produced from concentrate simply does not contribute to earnings the way that production from mining operations do.

My look at the two companies suggests to me that Blue Note has significant potential to outperform Hudbay. The risk with Blue Note is how successful they are in getting their new mine started. I see the handling of taxes and the loss of production from Trout Lake as the risks with Hudbay. I personally do not see how Hudbay can increase earnings this year over last year despite increased production because of Balmat and potentially higher commodity prices because of the $125 million added to earnings last year from future tax benefits. But I don't profess to be an expert, that's just my take on it.

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What's Up with Zinc?

I like Blue Note. It is a near term producer starting up in the next month or two.

The production plan for the Cariboo Mine is:

(x'000)	2007	2008	2009	2010	2011	Total
Zinc	68,105	104,467	107,748	107,039	88,816	476,175
Lead	34,946	57,471	46,571	44,708	39,804	223,501
Copper	805	1,263	1,905	1,945	1,699	7,616
Silver	847	1,317	1,055	1,014	886	5,119

Blue Note is ready to cash in on high zinc prices now, and it looks like their timing couldn't be better.

What's up with Zinc?

The charts below are the 24 hour spot price, the 5-year LME zinc price and the 5-year warehouse stores.


What caught my interest was the large Chinese imports of Zinc in 2005 when zinc was very cheap and then when zinc was peaking in price in Dec 06-Jan 07 the Chinese exports take off, and their large increase in exports brought the price of zinc down from its peak.







Meanwhile, there was a Shanghai exchange opened to trade zinc in March.

What's happening with the Shanghai Exchange?
On March 25th the Shanghai price for zinc was 28,510 yuan, which works out to $1.6765 US, but the LME price was just under $1.45, or almost 16% higher.

An April 5th article in the Chinadaily reports that zinc prices are around 28-30,000 yuan and that China's demand will rise about 10%.

An April 9th Bloomberg article states "Shanghai zinc for July delivery rose for a fourth day, advancing 990 yuan, or 3.2 percent, to settle at 31,950 yuan a ton. It rose by the maximum 4 percent from the morning session." That's about $1.88/lb, and about 19% more than today's LME price.

An April 10th story on Etrade said Shanghai zinc ended at 32,745, which at today's exchange of 7.7257 works out to $1.93 US/lb zinc, or about 21% more than the current 1.59/lb.

Zinc is looking good to me.

http://www.chinadaily.com.cn/bizchina/2007-04/05/content_843935.htm
http://www.bloomberg.com/apps/news?pid=20670001&refer=china&sid=ab.xX6jx.AJc
https://uk.etrade.com/e/t/uk/NewsContent_Component?ArticleId=2876744&ORIGIN=news.UKHeadlines&TITLE=
http://www.xe.com/ucc/convert.cgi
http://www.metalsinsider.com/WIR/zn260307.html

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The Leverage of Earnings

"Around 2000 I left my job and cashed out my pension and put it into commodities," was what a colleague was saying. "I had $14,000 and it is now a quarter of a million."

The commodities bull run created an enormous leverage of earnings. Take Northern Orion, a junior start-up company around the beginning of the bull run and now it has $230 million in the bank. The big players have reported billions of dollars of earning.

Eastern Platinum has gone from a junior start-up to a company with a $1.5 billion dollar market cap. Its earnings are a little on the low side for the market right now, but with 700% expansion of mining production over 5 year planned, high grades of platinum resources and demand for platinum as both an industrial metal and a precious metal, they will have good growth in earning..

Roca is a new start-up that if moly prices remain where they are should make in the range of 25-30c/share in either Q3 or Q4 this year.

Blue Note is also building a new mine and should have earnings of 2-4c by Q3 or Q4 this year. Blue Note will perform nicely this year.

Aur Resources has gone from a $2 stock in 2000 to $23 today with 2006 earnings of $3.23 per share, and 60-70% growth in production planned over the next 2 or so years.

To have been there at the beginning of the bull run, at the period when earnings exploded.

There is one stock I've recently looked at that an unfortunate hedge decision reduced its earnings to about 20-25% of what they would have had without the hedge. The company's earnings were 87c/share for 2006, and with only 40 million shares, taking a $144 million dollar loss and still making money is amazing. $144 million is about $3.60/share of cash flow that they didn't have to put to earnings. There is a thing called taxes that they would have to pay on that, so it isn't quite that good, but it is very sweet overall.

The stock is Quadra and this stock is in a position to see a leverage of earnings much like the early bull run days, indeed, 2007 will be Quadra's bull run.

Quadra's hedge which limited them to an average of $1.72/lb of copper for 2006 hit them at both end, earnings and costs. There is a thing called "price participation" where as the price of a commodity increases, smelter companies get a cut of that increasing price. Quadra had hedged at $1.60 and copper went as high as $3.99/lb on the LME. So, not only did Quadra forfeit 60% of the potential income, they had to pay smelter costs as if they were getting $3.99/lb. So Quadra paid the full costs of the bull run, but had none of the benefits. The average LME price for copper for 2006 was $3.05/lb. Quadra didn't get an average of $1.32/lb of "free" money.

Quadra has even more leverage of earning to come. They ran into a few problems with production and produced 117 million pounds of copper. They believe they've worked out those issues, certainly towards the end of Q4 their recovery rates improved considerably, and they've given guidance of $125 million pounds, an small increase of 7%. But, they are in the process of building a second mine which is planned to start producing late 2008 and will add 75 million pounds of production per year, so a two year growth in production rate of 67%. There are a couple downsides, increased debt to pay for building the new mine, but that is highly preferable over dilution that would limit earning potential forever.

2007 is going to be Quadra's year for stellar performance.

QUA Toronto, QADMF.PK in the US.

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Blue Note (BN on Venture)

Blue Note is a little known near term producer. It is building a new mill to commence operations in June and will start mining the ore for the mill in April. The metals are zinc, lead, copper and silver.

Blue Note will be a commodity winner due to their choice to develop their mine and cash in on the commodity prices rather than to drill, and drill, and drill their property. An educated look at the property told them they have these metals at depth. An existing mine in the area has been mining for over 20 years and has mined to incredible depth. The geology of the area is similar.


A difference between Canadian and Australian philosophy in mining is that Canadian companies and investors have become more concerned with showing the resource is there rather than making money. Australian companies look at this policy of premature drilling when you have good reason to believed the resource is there as wasteful of capital. Spend $10 million today to establish a resource you won't use for another 20 years means you have spent $10 million that will gain no return for 20 years. Their mines work on a philosophy of having about 5 years of reserves always established. It maximizes the use of capital.

Blue Note has followed this type of philosophy in choosing to put the resource to work by building a mine and earning money sooner rather than later and also tying up capital to establish a reserve that won't be used for 20 years.

Their forecasted 2007 cash flow numbers look very good. At prices of $1.44 for zinc, $0.52 for lead, $2.80 for copper, and $12.50 for silver they expect $15.3 million cash flow. They also expect costs net of byproduct credits to be $0.76. Currently the price on lead means this cash flow estimate is low by about $10-$12 million. They are most price sensitive to zinc, then lead, then silver. Copper has little influence on their cash flow as it will only contribute perhaps 2% of the total.

The number get impressive for 2008. They have adjusted their prices way down, $1.17 for Zinc, $0.44 for lead, $2.29 for copper, and $11.65 for silver. The costs also decline, to $0.55 net of by product credit, and it gives them about $58 million in pre-tax cash flow. After taxes I calculate 2008 eps of about $0.14, exceptionally impressive for stock currently trading at $0.47-$0.48, and those earnings strongly take into consideration the price of commodities coming down. The IRR on the mine is 126.3%.

As a near term producer, Blue Note is one that will win big time for its investors.

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