The Mining Report: How are the fundamental challenges facing the global base metals markets likely to play out in 2014?
Joseph Gallucci: There are several long-term issues that impacted copper and the other base metal spaces in 2013, and those long-term issues will persist for the foreseeable future. Allow me to explain the basics via a few examples:
Indonesia recently stopped the export of intermediary products, such as pig iron nickel. The country's leadership is increasingly practicing resource nationalism by restricting mining firms to in-house processing and to shipping only finished products. It is also unsettling that Intrepid Mines Ltd. (IAU:TSX; IAU:ASX) (not covered at Dundee) lost control of its project this year to an Indonesian partner!
In terms of supply chain disruptions in 2013, Grasberg and Bingham Canyon were two of the biggest issues, but we are still well below the annual average of a 5% supply disruption. This year has been an anomaly and quite low in that regard. Supply chain disruptions will definitely pick up going forward and they are impossible to predict.
For problems with mining infrastructure, Chile was the hot button. It has port access and infrastructure issues, and there are still no power agreements in place for many of Chile's mining development projects. These types of long-term issues will continue to impact the base metals sector into the future.
TMR: Were declining ore grades an issue in 2013?
JG: The decline of ore grade is a long-term problem. We are now seeing projects with only 0.3% and 0.4% copper being developed. Those are very low-grade ore bodies in massive open pits. The issue going forward is the grades will continue to fall unless there are stellar discoveries—which is certainly possible. Reservoir Minerals Inc. (RMC:TSX.V) (BUY rated at Dundee) has put out some very impressive drill holes in Serbia. And Ivanhoe Mines Ltd. (IVN:TSX) (BUY rated at Dundee) is developing the high-grade Kamoa project in the Democratic Republic of the Congo. But those projects are outliers—the trend is for grades to fall lower as the geography of mineable base metal deposits becomes increasingly remote and difficult to find.
TMR: Given declining grades, is there an exploitable synergy between mining for base metals alongside precious metals in terms of lowering overall costs of production?
JG: It depends upon the nature of the ore body. Unfortunately, the declining grades are not strictly limited to copper. There is a decline across all of the base metals and precious metals. The grades just keep sinking lower and lower. But if a firm is mining a polymetallic ore body and it can make a concentrate, the mining and the processing activities are very similar for polymetallic ore bodies. On the other hand, if a firm is purely focused on producing gold doré bars, there are no synergies with the base metals on the processing side.
Look at the experience of Nevsun Resources Ltd. (NSU:TSX; NSU:NYSE.MKT) (BUY rated at Dundee). I just returned from visiting its Bisha operation in Eritrea. Nevsun was mining a gold oxide cap there—putting it through a gold plant and making doré bars. It has changed gears: shutting down the pure gold plant to make a copper and gold concentrate. On the mining side, that process is fairly similar, but on the processing side, producing concentrate is quite different from making gold bars. That is an example of precious metal-base metals synergy. Nevsun has successfully transitioned from being a gold producer to being a base metals producer. The company has a solid balance sheet. It has $300 million ($300M) in cash and pays a 4.5% dividend. It is very rare in the base metals space to see a dividend of any kind, let alone one of that magnitude.
TMR: Let's look at zinc, which is a metal market that you have studied extensively. What are the commercial applications of zinc?
JG: About 50% of the zinc market is used for galvanizing steel as anti-rust protection for car manufacturing and construction. The biggest buyers are China at 45% and Europe at 20%.
TMR: What's the global supply situation?
"Even a small increase in the price of zinc will generate a big increase in revenue for producers."
JG: The market in the Western world has been in a supply deficit for quite some time, and now, for the first time, it is in a global deficit. And the deficit will only get bigger. The zinc market is quite different from the copper market because about 40% of its production comes from junior miners, whereas in the copper space, juniors only account for about 7% of production. As the big zinc ore bodies are tapped out and the large mines close, they will continue to be replaced by smaller zinc operations. Brunswick was the first to close, and Century, Skorpion and a whole host of other mines are following suit.
TMR: Are companies hoarding zinc in anticipation of higher prices?
JG: Hoarding is definitely an issue. For example, the zinc inventories on the London Metal Exchange (LME) are controlled by four big players. The bulk of their inventory is stored in several warehouse facilities in New Orleans. The metal stores are not readily available for distribution and it is in fact due to the multiple locations that warehousing companies can move product among themselves in an effort to keep queues long. Therefore, queuing issues can cause price increases—although it is hard to calculate the extent of the problem at present.
TMR: You have talked about the large zinc mines shutting down, which should drive up prices. Can you expand on that scenario?
JG: The big zinc ore bodies are near an end and there is no replacement on the horizon for two reasons: 1) There are no more big ore bodies available. 2) There is no serious exploration for zinc. The copper business faces the same dynamic of gradual diminishment of raw material. Interestingly, as Brunswick and Century and Skorpion shut down their zinc operations, the sector has been freed up to bring on smaller-capacity mines, which helps the supply situation. And there is undeveloped supply capacity in China. But none of these potential developments can replace the magnitude of what we are losing by way of the big ore bodies going extinct.
TMR: Does the downward trend in terms of supply mean that the zinc market is not cyclical?
JG: All commodity markets have long-term cycles. But right now we are dealing with a special zone of the long-term zinc cycle as the big ore bodies close one after the other and are not replaced. This is a first for the zinc market, even though it was not unforeseen.
TMR: So what features can make the changing zinc market attractive to investors?
JG: Zinc equities are leveraged to the commodity, and there are not many equities left to buy on the TSX. But it is important to look at the zinc cost curve, which is very flat compared to the copper cost curve. As the zinc mine shutdowns cause supply limitations, and warehouse inventories start to peter out, market prices will have to rise. And due to the cost curve, even a small increase in the price of zinc will generate a big increase in revenue for producers.
TMR: Which zinc mining firms do you view as the most promising?
"The stock price of zinc companies that are already in production, such as Trevali, will increase the fastest, but the others should quickly follow suit."
JG: My favorite is Trevali Mining Corp. (TV:TSX; TREVF:OTCQX; TV:BVL) (TOP PICK, BUY rated at Dundee). It is in production and it has access to a great partner in Glencore International Plc (GLEN:LSE) (not covered at Dundee). It is quite rare for a junior mining firm to have a strategic partnership with such a giant as Glencore. And because up to 40% of zinc production comes from the juniors, Glencore is interested in obtaining the zinc feed even though it does not have the time to directly manage small operations. In the Trevali-Glencore symbiosis, Trevali mines the ore and sells the zinc concentrate to Glencore at market terms. Trevali is well positioned on the Toronto Stock Exchange (TSX) to benefit from increases in zinc prices, or even by stability in the price.
TMR: Where are the Trevali mines located?
JG: Trevali has a zinc mine in Peru called Santander, which is operating at capacity of 2,000 tons per day (2 Ktpd). Its New Brunswick complex is composed of one mill and two mines, which are scheduled to go on-line by the end of 2014 at about 3 Ktpd. Trevali can rely on Glencore's expertise to get these mines and mills into production. And the New Brunswick jurisdiction is very safe.
TMR: Trevali's stock is down from last year. Why?
JG: Trevali was six months late in delivering on its Peruvian operation and the stock went into the penalty box. To secure financing for the New Brunswick operation, the firm announced a potential $60M debt facility arrangement with RMB Resources, but the deal did not close. Since then, Trevali has raised equity ~$45M at $0.83/share, and its stock has gone up. With the equity deal complete and the debt facility potentially resized to $35M, the financing overhang is gone. It is a good buy now that it has one asset in operation and the other asset is financed and can be put into production by the end of next year.
TMR: Who else do you like in the zinc space?
JG: There are not many players left in the zinc space! I like Canadian Zinc Corp. (CZN:TSX; CZICF:OTCQB) (BUY rated at Dundee). It has just finished a very long and rigorous permitting process that took six years to complete. Now, it is tasked with raising the funds to get the permitted asset into production. Its property is located in the Northwest Territories—a bit remote, but in a safe jurisdiction. The financing in 2014 will probably include a debt off-take deal and an equity portion. The project is undergoing some metallurgical work, but I expect news on the financing to start unfolding in H1/14.
There are also smaller zinc companies, such as Zazu Metals Corporation (ZAZ:TSX) (NEUTRAL rated at Dundee), Rathdowney Resources Ltd. (RTH:TSX.V) (NEUTRAL rated at Dundee) and TriAusMin Ltd. (TRO:ASX) (NEUTRAL rated at Dundee), which I follow. These three firms all have good potential, when and if we see higher zinc prices. Another company is Ivernia Inc. (IVW:TSX) (BUY rated at Dundee), which is a lead producer. Ivernia is the only pure-play lead producer on the TSX and is now in production after some environmental issues. The company operates the Paroo Station mine in Australia, which is the largest pure lead mine in the world, and has a strong partnership with Enirgi Group (a private company). Zinc and lead tend to move in the same direction. Lead is currently outperforming zinc, however.
TMR: Will we see higher zinc prices in the near term?
JG: The price of zinc should respond positively as more shutdowns are announced. The fundamentals are clearly in place for both the zinc price and the equity prices that are leveraged to zinc to increase. The stock price of companies that are already in production, such as Trevali, will increase the fastest, but the others should quickly follow suit.
TMR: Is there some kind of technology that can replace the industrial use of zinc?
JG: Not unless you figure out a way to eliminate rust! Galvanizing is always going to be needed, and there is no cost-effective replacement for it as far as I know. If cars and buildings were suddenly made out of plastic, the need for zinc would fall. But short of total plastification, zinc is here to stay.
TMR: Are there other base metals firms that investors should investigate?
JG: I am impressed with the performance of Capstone Mining Corp. (CS:TSX) (BUY rated at Dundee). It is on the cusp of becoming a midcap copper producer. It acquired Pinto Valley earlier this year. Analysts will get a chance to visit the asset in Q1/14. On a multiple basis, Capstone is one of the larger pure copper producers and it is less expensive than its competitors, Lundin Mining Corp. (LUN:TSX) (BUY rated at Dundee) and HudBay Minerals Inc. (HBM:TSX; HBM:NYSE) (NEUTRAL rated at Dundee). Capstone can really shine in 2014!
TMR: Any other companies in North America that have your eye?
JG: Nevada Copper Corp. (NCU:TSX) (BUY rated at Dundee) is one of my top picks. Its two-phase project is unique. Phase 1 is completely permitted and under construction. Phase 2 is undergoing permitting, which will likely be resolved in H1/14. Pending the passage of legislation to transfer federally owned lands to local authorities, it will be permitted quickly. It is rare to find an asset in the U.S. that does not have permitting issues. Nevada Copper is often compared to Augusta Resource Corp. (AZC:TSX; AZC:NYSE.MKT) (SELL rated at Dundee). Augusta is a great ore body, a great deposit, but is undergoing a lot of permitting problems. The next four months will be key for Augusta, whether or not it can complete its permitting process as promised. Nevada Copper offers investors an option in U.S. copper development with very little permitting risk attached.
TMR: One of the companies you cover— Quaterra Resources Inc. (QTA:TSX.V; QMM:NYSE.MKT) (NEUTRAL rated at Dundee)—is developing its Yerington project in Nevada on a former Anaconda Mining Inc. (ANX:TSX), open-pit copper mine. How is that dynamic playing out?
JG: Historically, Quaterra has been spread a bit thin as a mining company, analyzed by many as lacking a clear-cut focus. After Steve Dischler took over as CEO recently, he made it quite clear that the focus is to be on Yerington—and that is the correct focus for this company. Quaterra has a variety of developmental resources. It owns the MacArthur solvent extraction and electrowinning SX-EW project adjacent to the Anaconda mine. That is a low-capex, heap-leach, run-of-mine operation, so there is no crushing required. It will take a relatively low capex to go into production. Quaterra also has the Bear deposit, which has a non-NI-43-101-compliant resource at the moment, and holds about 5 billion pounds (5 Blb) at 0.4% copper. That will be drilled off this year and, hopefully, we can get some positive information then. The short story is that Quaterra will thrive under the new management regime with its primary focus on Yerington, and it will bring other projects along as tailwind.
TMR: Are there any other junior firms you'd like to call our attention to today?
JG: Taseko Mines Ltd. (TKO:TSX; TGB:NYSE.MKT) (BUY rated at Dundee) is a copper producer that is highly leveraged to the copper price but is high cost. However, it has a good cost protection program using low-cost copper hedging. If an investor believes that copper prices will rise, Taseko is the highest-moving stock related to that scenario. Its Gibraltar project is in production and moving along rather well. The project's third expansion has gone off great, but its growth project, Prosperity, is in the midst of a permitting battle. I do not have a current value for Prosperity. But in Q1/14, we expect an update on Prosperity, which could adversely impact the Taseko stock, or not.
Another stock for people's radar to track is Reservoir Minerals Inc. (RMC:TSX.V) (BUY rated at Dundee). It has generated fantastic drill results of late in its Serbia project. Similar to how Trevali has Glencore as a partner, Reservoir has Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) (not covered at Dundee).
TMR: Thank you, Joseph, for being with us today.
JG: Thank you, a pleasure.
Joseph Gallucci has approximately 10 years experience in equity research. He joined Dundee Capital Markets in June 2012 as a senior mining research analyst. Gallucci spent the previous five years at Canada's largest independent broker, in the mining research team where he was originally a research associate and then promoted to Mining Analyst. Gallucci's main focus is on base metals and bulk commodities on a global scale. Prior to this, he was a research associate in the forestry sector at a Canadian bank-owned broker. Gallucci holds a Bachelor of Commerce degree from Concordia University and an Master of Business Administration in investment management from the Goodman Institute of Investment Management.
DISCLOSURE:
1) Peter Byrne conducted this interview for The Mining Report and provides services to The Mining Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: none.
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3) Joseph Gallucci: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Trevali Mining Corp. Dundee Capital Markets has provided investment banking services to companies mentioned in this interview in the past 12 months: Trevali Mining Corp. All disclosures and disclaimers are available on the Internet at www.dundeecapitalmarkets.com. Please refer to formal published research reports for all disclosures and disclaimers pertaining to companies under coverage and Dundee Capital Markets. The policy of Dundee Capital Markets with respect to Research reports is available on the Internet at www.dundeecapitalmarkets.com. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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