Exploration Risks and Decisions - Part 1:
The sources of risk and odds of success in exploration
This is part 1 of 6 in the series of articles that I will be publishing throughout the next little while focusing on the subject of exploration risk. The topics that will be covered are:
- Part 1: The sources of risk and odds of success in exploration
- Part 2: The optionality of exploration
- Part 3: Quantifying reserve volatility
- Part 4: Valuing exploration optionality with risk neutral probabilities
- Part 5: A statistically based Monte Carlo Model for exploration
- Part 6: Conclusions and implications for exploration participants
I recently attended the Sprott Stansberry Natural Resources Symposium in Vancouver and was fortunate enough to hear many great speakers that touched on the subject of exploration risk. A common feature of these talks is the assertion of the 1:1,000 or even 1:10,000 chances of an initial prospect becoming a mine. While the statistics may stand true, it may be worthwhile to think what the data actually means in the context of an exploration company or projects overall risk.
Admittedly exploration is very high risk but do 99.9% of junior exploration companies really crash and burn? In my role as a Director at Plutus Strategies and in previous positions within exploration I’ve spent a lot of time thinking about exploration risk:
- It’s implications for exploration companies
- How understanding it guides management to make better decisions
- How understanding it can let investors deploy capital optimally
- How quantifying can lead to greater accuracy in the valuation of exploration projects at all stages, particularly early stage projects
We will explore the subject of exploration risk through a series of articles, diving into more statistically based approaches to model exploration risk.
Odds of Exploration Success
At a grass roots stage a typical exploration project consists of a large licence area within which many ‘mineral occurrences’ may be known from historical work, desk based studies or reconnaissance stage exploration work such as mapping and grab sampling. There are strong rationales that these mineral occurrences which make up the 1,000 or 10,000 in the odds stated in the paragraph above.
If we assume the 1:1,000 statistic to be correct, the project may contain 10 occurrences, and the company may have 4 projects, which would mean the chances of an economic deposit being found is closer to 1:25. This is perhaps closer to most market participant’s experience of exploration risk as they may endure in investing in various junior exploration companies.
Sources of Exploration Risk
After touching on the inherent risk of exploration, we will now break down the sources of risk in exploration to gain a better understanding. This requires a review of the exploration process as it currently exists, which is typically undertaken by Juniors with limited budgets and small technical teams. Below is a simplified breakdown of the exploration process with each factors inherent source of risk:
- Licence Acquisition: Political risk in the form of refusal or delays to the granting of licences by governmental bodies, demand for illicit payments and possibly first objections by NGO’s. Financial risk also arises in the form of overpayment.
- Target Definition: Geological risk due to a possible paucity of geological targets and technical risk arising from inadequate or incorrect exploration as a result of management failure, financing constraints and/or current limitations of exploration techniques.
- Scout Drilling: Geological risk arising from targets bearing no or inconsequential mineralisation. Some technical risk from poor exploration management.
- Resource Definition: Geological risk due to insufficient mineralisation and/or complicated geology.
- Feasibility: Geological risk from metallurgy and geotechnics. Technical risk from inadequate technical work. Political risk as explorers try to acquire mining licences and increased government involvement.
- Production: Largely technical risk from underperforming mining units (e.g. poorly functioning plant, badly designed mine) or poor assessment of geology/resources.
The above is far from exhaustive, one risk that probably plays on a lot on the minds of exploration management being financing risk to support ongoing exploration! Also many exploration companies openly admit to being explorers with no desire to mine, therefore they need to also assess the risk of finding a suitable takeover partner, this and financing risk depend on wider market sentiment, an important risk factor. Periods of exuberant market sentiment can see projects with extremely poor geological and technical risk factors make substantial capital gains for investors. Market sentiment depends on a number of factors, which further than the short term are notoriously difficult to predict.
As we are hoping to create statistical based model that surpasses often irrational market sentiment and that would lead to truly optimally deployed capital, sentiment will be omitted from these posts. Therefore it is clear that aside from political risk which is beyond the scope of these posts but can be accommodated somewhat by the selection of discount rate, the main risks arise from geological/technical factors.
All participants in the exploration industry have various decision points in the exploration process during which the risks need to be assessed. Exploration management should weigh up risks before progressing to the next stage of exploration (it should be noted that these are cumulative so that management deciding whether or not to proceed with licence acquisition should consider at least in part all of the above factors) and investors need to weigh risks to arrive at realistic valuations ahead of acquisition of stock. In my next post I shall investigate models we may use to arrive at a quantitative approach to exploration risk.
Modified 27th August 2015