Two junior mining stocks with high hopes

published 14 July 2010

The financial models of junior mining companies are very straightforward. That's one of the reasons I like them!

You start with the amount of ore that is mined. Next you calculate how much metal can be extracted, which is a factor of the recovery rate and the grade. Then you multiply this by the price of the metal, and deduct three things:

1. Running costs.

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2. Initial capital investment amortised over the life of the mine.

3. Whatever must be paid to the government.

After that, the only thing you are left to worry about is the discount rate that you apply to future earnings.

So if it's that simple, why are the share prices of junior miners so volatile? There are three reasons.

Three reasons junior mining companies offer the ultimate in penny shareexcitement

The first is that many junior mining companies are not yet at the stage of actually producing anything. Indeed, many never get there.

The second reason is that, although there are few moving parts in the equation determining the value of a mine, these can move about quite a lot. In particular, of course, the world price of metals can make wide swings in just a few weeks. Let's think about that.

Say it's costing you $3 per lb to produce copper. Suddenly the copper price moves from $3.30 per lb to $2.70 per lb. That's not an uncommon scale of move for copper. But for the miner it's the difference between comfortable profitability... and a terrible financial squeeze.

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Finally, plenty of problems can come out of left field and totally whack your plans. For example, a new hostile government, some expensive equipment that does not work, power shortages or bad weather. There are all sorts of things that can hijack the best of mining ideas.

But once a miner gets into production the risks are considerably reduced. As a dodgy explorer progresses to being a bona fide producer, its shares can make a nice upwards move. In fact, if they get it right and really hit the big time, miners can be the ultimate penny shares...

And here's what's really exciting. There are a number of junior miners I've seen that were set up with little more than a blank sheet of paper a few years back. Now, though, they are at or close to the production stage. Just last week my ear was bent by two of them.

Two small time miners with high hopes

The first is Hambledon Mining (LSE: HMB). Hambledon's Sekisovskoye gold mine in Kazakhstan is already producing, but to nowhere near its full potential. And it's had a catalogue of those glitches I mentioned earlier hamper itsprogress...

A Hitachi excavator suffered from engine failure; the machine used to crush the rock did not work; and snow storms, blizzards and winter temperatures of -30 not only made the task of open-pit mining extremely challenging but froze the piles of crushed ore.

So Sekisovskoye has fallen some way short of its potential production. But news last week suggests that things are back on track. The mine achieved its highest ever production in the second quarter, averaging 2,900 oz of gold per month as well as close to 5,000 oz of silver.

The plan is now to add underground mining to today's open pit operation, and raise annual production to 100,000 oz of gold by 2013.

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Broker Fairfax expects 'cash costs' (day to day running costs) to fall from $560 per oz to $380 per oz. Even on the assumption that the gold and silver prices fall back slightly from today's levels, the shares trade on under four times Fairfax's projection of 2012 earnings. That certainly makes Hambledon worth a closer look.

The small cap that could be sitting on a 'new copperprovince'

Cold weather is hardly a concern of Discovery Metals (LSE: DME), which is close to producing its first copper from the Boseto project in Botswana.

The world copper price dropped 20% in the last quarter. But chief executive Brad Sampson did not seem too concerned. That's despite the challenge of raising the $150m or so necessary to purchase a concentrator and sundry other equipment.

Sampson seemed very relaxed about this when I met him last week, and a few calculations reveal the reason why. The mine should be able to produce 38,000 tons of high grade copper annually. That's worth some $250m at today's price. Meanwhile, the cash costs of production will be about half this.

That margin of profitability will soon pay off the initial capital investment, leaving a healthy profit for shareholders.

What is more, Discovery has several other likely prospects on its licence area in the Kalahari copper belt of western Botswana. It reckons that it could ultimately develop not just a single copper mine, but a whole new copper producing province.

Sampson knows he can sell the product. "In the next twenty-five years,' he told me, 'the world will consume more copper than in the whole of its history to date. We need to find an extra million tons per year. So our 38,000 tons is just a drop in the ocean."

So while the shares of junior miners have recently suffered from one of their regular blips, neither Sampson nor any other mining executive doubt that the long-term prospects remain extremely bright.

Despite the hazards this is still very much a sector to follow.

This article was first published in Tom Bulford's twice-weekly small-cap investment email The Penny Sleuth.

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.