I recently had an opportunity to go through an early stage exploration project with the CEO of a promising Canadian junior. The company controls a nice land package in a friendly jurisdiction and has been adding resources at a stable, though leisurely pace. I was a little surprised when the CEO confided that the company, in response to market expectations, had decided to raise the resource base rather than increase the level of confidence regarding the density, shape and other physical characteristics of the deposit. In other words, the company banks on the market’s infatuation with the growing number of “inferred” resources, and postpones project development stage which would hopefully lead to an estimate of indicated resources. Technically, this means that the drill rigs will step out of the currently known mineralization, rather than “fill-in” the most promising zones with narrower and narrower spacing. But it also makes the economics of the project somewhat difficult to “infer”.

One of the reasons for this ‘either/or’ dilemma lies in the fickle nature of junior exploration financing. The junior exploration budgets were halved in 2009. In fact, the junior equity market had been an early leading indicator of the troubles that eventually befell the mining space in 2008. Interestingly, the equity market impact also appears to be strongly correlated with drill results, which, according to Metals Economics Group, also peaked in May 2008 – around the time mining equities turned downwards in London.

The sector is only slowly recovering from the subsequent damage. North American small cap gold companies raised $6.4bn throughout last year, but the majority of the transactions were concentrated in small amounts (up to $25m, with average transaction for exploration purposes at around $18m). According to RBC, as much as 76 of the transactions were closed for exploration purposes (by comparison only 48 transactions were closed to finance feasibility study and construction). The fragmentation of the junior universe means that this relatively high number of transactions yielded mere $1.2bn for actual exploration (or less than 20% of the total capital increase). Indeed, the actual number of what goes “into the ground” could be even smaller. Earlier this month at PDAC in Toronto, Renaissance Resource Partners estimated that only 30% of the money raised by the juniors goes into actual “exploration activity”, as opposed to other exploration expenses. Such estimates are often contradicted by mining companies’ pie-charts purporting that the budgets are invariably drilling-heavy. Indeed, the seasonality of the drilling season in some severe climates shows that a “drilling” month could be 5-6 times more costly than a month without drill rigs on.

Mining companies conveniently divide exploration into two categories – greenfields exploration on new land and brownfields exploration seeking to prove up orebody extensions near the existing operations. The heuristic proves useful to detect long-term trends in the industry. Globally, early stage greenfields exploration pipeline has dwindled in significance, from 40% of overall exploration effort in 2005 to 32% in 2009. It has been largely replaced by the less onerous – and much less risky – brownfields exploration, whose part, as a percentage of overall exploration effort, has grown from 20% five years ago to 27% last year (the remainder falling into “advanced” exploration category). This shift is understandable in uncertain economic conditions; in terms of the total dollar per recovered ounce, successful brownfields exploration is about three times less costly than greenfields exploration. However, from the industry-wide perspective, there is a fallacy of composition here. The known orebodies – like all mines – are finite resources and no mining sector can survive without new discoveries.

How is, therefore, the new year shaping for the junior market? Overall, both the gold equity market, and the financing rate have stabilized since December. However, there are encouraging signs concerning flow-through financing, which allows Canadian investors to lower their taxes by directing funds to exploration ventures. This system provides a buffer for investors when their equity investments depreciate less than the amount of the tax break. Understandably, the interest in flow-through peaks towards the end of the year, but this time, encouragingly, it has continued after the December season.

Following the financing rounds of 2009, there is now expectation that mid-cap and large companies will engage aggressively in equity deals with juniors (as opposed to simple joint ventures or option agreements). This could be particularly true in Latin America and in Canada, where majors frequently neighbor on prospective ground explored by juniors. Other areas of “relative” concentration can be found on Ghana’s three prominent gold belts. But it would be premature to bank your money on a rush to take out early stage gold explorers. Most large gold producers tend to favor acquisitions of companies closer to feasibility study and thus add to production in the near term, rather than swivel the “growth pyramid” with a thin pipeline of intermediate projects. And although there are exceptions to this dominant strategy (Agnico-Eagle comes to mind), investors who bank on majors’ private placements in early stage companies are bound to be locked in a low-delta option game. The gold equity market, and the gold exploration universe, are bound to remain fragmented and in slow recovery mode, for some time.

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Tags: Agnico-Eagle, brownfields exploration, exploration costs, exploration pipeline, gold juniors, greenfields exploration, junior financing, M&A, measured resources