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 PDAC 2009 Diamond Technical Session: a market pricing model for publicly traded diamond exploration companies
    Publisher: Kaiser Research Online
    Author: Copyright 2009 John A Kaiser


This slide show and talk was presented by John Kaiser on March 2, 2009 during the Diamond Technical Session at PDAC 2009. All comments refer to the above slide and all figures in this presentation are in Canadian dollars.

The announcement in 1991 by an obscure exploration junior called Dia Met Minerals that it had discovered diamonds in Canada's Northwest Territories sparked an unprecedented staking rush that broadened into a new sub-sector of publicly traded diamond exploration companies. Since then four Canadian diamond projects discovered by juniors have gone into production, pushing Canada into the upper ranks of rough diamond production. Canada has been scoured by several waves of diamond exploration that have resulted in a half dozen or so advanced diamond projects. While the number of juniors still actively involved in diamond exploration has shrunk from a hundred or so to about a dozen companies, and the investment community has grown weary of the long timeline associated with the diamond exploration cycle, the potential to make a multi-billion dollar diamond discovery through grassroots exploration continues to draw the attention of speculators.

During the early days the investment community had a poor understanding about the nature of diamond exploration, and the reporting standards for diamond projects were considerably less evolved than they are today. My efforts as an analyst to understand the market volatility and wide range of diamond company valuations led me to develop the "rational speculation model" which I use extensively in my capacity as an independent analyst to assess the speculative value of diamond projects.

The charts on this slide feature the familiar daily closing price as a red line and the daily "implied project value" plotted as blue bars corresponding to the billion dollar scale on the right side. The "implied project value" is defined as the fully diluted capitalization multiplied by the stock price and divided by the company's net interest in its flagship project. This equation normalizes the company's market value to a 100% basis. It is in effect the net present value a major is assigning. to a project when it buys out a junior.

When BHP bought out Dia Met at $21 per share in 2001 the value implied for the Ekati project was $2.3 billion. The value implied for Diavik during the first year of production in 2003 when Aber traded above $50 was about $7 billion. When De Beers bought out Winspear at $5 in 2000 the value implied for Snap Lake was $440 million. The peak value implied for Tahera's Jericho project in 1996 when the stock touched $4 was $871 million.

I use fully diluted capitalization and net interest to calculate the value being assigned to a diamond project by the market because if a project does turn out to be the next Ekati or Diavik, every warrant and stock option will be exercised. And every party will maximize the direct interest in the project to which it is legally entitled. In other words, back-in and step-up rights will be exercised.

Before I explain how I use the implied project value in my rational speculation model, I will briefly describe the diamond exploration cycle.

I have broken the diamond exploration and development cycle into nine stages. The arrival of each stage will be the subject of a company news release. Each stage fleshes out in greater detail the economic potential of the diamond project.

The grassroots stage involves land acquisition and target generation. The key information available at the land acquisition stage is the cratonic setting and its history in terms of known diamondiferous kimberlites. Target generation is done through till sampling and geophysical surveys. Canada's glaciated terrain lends itself well to regional indicator mineral sampling which reveals dispersal trains emanating from kimberlites exposed at surface. Because a kimberlite is an intrusive that disrupts the country rock, geophysical surveys are able to pinpoint drill targets by identifying a somewhat circular "anomaly" created by a pipe and a linear anomaly created by a dyke.

If the company has identified geophysical targets that correlate with indicator mineral trains whose chemistry is prospective for diamonds, it proceeds to the target drilling stage. At this stage investors will base their expectations on the familiar G10/G9 pyrope plots where these days garnets which plot above the Herman Gruter line are perceived as good.

If drilling intersects rock confirmed as kimberlite, the project moves to the micro diamond testing stage where samples up to 1,000 kg are subjected to caustic fusion to identify the micro diamond content. While the micro diamond results are awaited investors will want to see photos of the kimberlite to assess the texture and abundance of indicator minerals. Generally the coarser the texture and more abundant the indicator minerals, the better the diamond carrying capacity of the kimberlite. Investors will also want to see the size of the geophysical anomaly so that they can assess the tonnage potential of the pipe. The rough calculation typically used is the width times length times 300 metres assumed depth times 2.6 specific gravity times 75% to adjust for the carrot like tapering of a pipe.

Micro diamond results are reported as number of stones per sieve size. These numbers get normalized to a 1,000 kg sample and are plotted on a log scale against sieve size. The higher the resulting size distribution curve, the shallower its slope, and the farther it extends into the large sieve sizes, the better the macro grade potential.

If the micro diamond size distribution curve points at a macro grade that could be economic based on estimated pipe size, the project proceeds to the mini bulk sampling stage. A mini bulk sample can be up to 200 tonnes and is designed to establish the macro grade potential of a kimberlite. It is collected by excavating outcropping kimberlite or drilling core holes which also help delineate the geometry of the kimberlite and shed light on facies and phase variability within the kimberlite. The sample is processed by dense media separation which recovers diamonds down to a 0.85 mm cutoff sieve.

Based on the grade indicated by the diamond parcel recovered from the mini bulk sample, the quality mix of the diamond parcel, and the tonnage implications of the kimberlite, a decision will be made to conduct a bulk sample. At the bulk sampling stage the investor has a rough idea of the contained carat potential based on grade and tonnage estimates, but no real sense for the average carat value.

A bulk sample will be designed to recover a parcel large enough to be suitable for diamond valuation. It is collected through underground sampling or large diameter drilling.

If the grade holds up in the bulk sample, the carat value is good, and tonnage is at critical mass, the project will proceed to the prefeasibility stage. In the case of smaller kimberlites the project will not move to prefeasibility until enough pipes have been identified to establish the needed tonnage.

The prefeasibility stage involves more detailed sampling to firm up the resource, but most importantly it establishes the cost side of the equation.

If a positive prefeasibility study is delivered, the project proceeds to the permitting and feasibility stage during which the true cost of securing a mine permit is established and social licenses are secured.

Once a permit has been received a production decision will be made and the project proceeds to the construction stage during which the junior will establish a diamond marketing strategy if it is entitled to receive its share of production in kind.

Once at the production stage a diamond mine will be valued on the basis of expected and actual cash flow.

What should be apparent is the long timeline for the diamond exploration cycle which will take at least 8 years to complete, and longer if there are seasonal constraints.

This slide displays how long Dia Met's Ekati project spent at each stage of the diamond exploration cycle and the range of implied project values achieved during each stage. It also includes the project value implied by the closing stock price on the first trading day following the release of news which justified pushing the project to the next exploration stage. I will not dwell on this table and similar ones for the Diavik, Snap Lake and Jericho projects. They are included in this presentation for information purposes.

The table, however, is the basis for this chart which plots the implied project value in million dollars on a log scale against the exploration cycle stage. The width of the tick marks on the project stage axis have been adjusted to reflect the proportion of time Ekati spent at each stage relative to the 11 years between announcing its JV with BHP in 1990 and being bought out by BHP in late 2001. The green band represents the IPV range achieved during each stage, with the vertical line marking the high and low. The icons starting with the triangles and progressing through stars and diamonds indicate the IPV at the start of each stage. What is remarkable about Dia Met is the sharp valuation increase after the company reported the Point Lake micro diamond results on November 6, 1991. From September 18, 1991 when Dia Met first reported hitting kimberlite until November 5, 1991 when it reported micro diamond results, Dia Met's IPV had ranged from $27-$45 million. The market rewarded the news and decision to proceed with a mini bulk sample boosting the IPV overnight to $71 million, and during the next two years while Dia Met found other diamondiferous kimberlites and mini bulk sampled them, the market pushed the IPV to a high of $2.4 billion. This was in effect what BHP said Ekati was worth eight years later when it bought out Dia Met at $21, or $52.50 in pre-split terms.

Here we have the same table for the Diavik project in which Rio Tinto and Aber, now renamed Harry Winston, had a 60:40 partnership.

Here we now see the Diavik data converted into an IPV chart. Aber was the first junior to acquire a land position near Dia Met's Ekati discovery. It's IPV jumped from $8 million to $100 million while still at the target generation stage. Part of that increase was a result of farming out 60% to Rio Tinto for a $10 million exploration commitment, which reduced Aber's net interest to 40%. Aber was the first junior to encounter kimberlite and rapidly achieved an IPV in excess of $1 billion while testing various kimberlites for micro diamonds. But Aber had nothing until July 1994 when it reported micro diamond results for the A154 pipe and proceeded to the mini bulk sampling stage. The resulting Diavik cluster turned out to be among the richest kimberlites in the world and after a lengthy permitting period went into production in August 2003. Today the market is assigning an IPV of only $500 million to the partially depleted project.

Here is the table for the Snap Lake project of Winspear Diamonds which De Beers bought out in April 2000 at an implied project value of $440 million.

Winspear joined the diamond hunt in May 1992 and did not hit kimberlite until two years later in May 1994, and then did not get good enough micro diamond results to justify mini bulk sampling until July 1997 when it decided to excavate a 200 tonne sample from the outcropping portion of the Snap Lake dyke. But it was only when Winspear reported high carat values in June 1998 which prompted a decision to proceed to bulk sampling that the market started to assign much higher valuations. De Beers put Snap Lake into production as an underground diamond mine in 2008.

Here is the table for Tahera Diamond Corp, known as Lytton Minerals during the early years.

Tahera pursued a strategy of acquiring large land positions on the Slave craton and raised a lot of money. Tahera was able to achieve an IPV of $145 million in January 1993 when it announced it was drilling a large geophysical target associated with indicator minerals. Less than a month later when Tahera announced finding the Ranch Lake pipe the IPV jumped to $245 million. When Tahera reported micro diamond results a month later and indicated it was proceeding with a mini bulk sample, the IPV jumped to $486 million. The Ranch Lake pipe proved to be sub-economic, but by 1995 Tahera had discovered the Jericho cluster and in April 1996 made a decision to proceed with a large bulk sample. The $801 million IPV was the top during the bulk sampling stage. It had sunk to $299 million by March 1998 when Tahera reported the Jericho bulk sample results and initiated a prefeasibility study. During this period it became apparent that Jericho was a small diamond project and the IPV sank as low as $10 million. When Tahera decided in February 2003 to develop Jericho the IPV had climbed to $96 million. During the next 3 years the Jericho IPV climbed as high as $662 million, and was at $455 million when Jericho commenced production in May 2006. Much of this IPV increase, however, was due to massive equity dilution as Tahera financed the development of Jericho, rather than stock price increases as was the case with Dia met and Aber. The Jericho mine did not meet expectations, and operation was suspended on January 23, 2008. Tahera now trades at half a penny and is bankrupt.

The very different outcomes for Dia Met's Ekati project and Tahera's Jericho project reveal the risks and rewards associated with the diamond exploration cycle. But the wide range of valuations during the exploration cycles of both projects poses a serious problem for investors and analysts trying to decide whether to buy, hold or sell. Consider the current example of Peregrine Diamonds and its Chidliak project on south Baffin Island where the Ekati-Diavik history looks like it might repeat itself. Although Peregrine has not yet drilled the CH1 kimberlite, it is proceeding with a mini bulk sample and BHP has exercised its back-in option. Everything an investor wants to see at this stage of the diamond exploration cycle is present, but Chidliak could turn out to be a Jericho rather than an Ekati or Diavik. What price should the investor pay?

The first question, of course, is what value is the market assigning to Chidliak based on the current stock price? Based on 106 million shares fully diluted, a stock price of $0.56, and a net interest of 42% if BHP elects to go to 58% by producing a bankable feasibility study, the implied project value of Chidliak is $142 million. How does one decide if this is reasonable?

Peregrine's stock chart does not offer any guidance. Since early 2006 when the company completed an RTO of Dunsmuir the stock has been in a downtrend as Peregrine spent more than $50 million revisiting the DO27 pipe south of Ekati. Peregrine's work has demonstrated that DO27 is much better than Rio Tinto thought in 1994, but the pipe is still short of the critical mass needed for a standalone development. The stock bottomed in the $0.10-$0.20 range during the summer of 2008 as the market digested the implications of the DO27 prefeasibility study. But in late August Peregrine reported micro diamond results which signaled that Chidliak was a major new diamond project. As this chart demonstrates, I started to recommend Peregrine when the micro diamond results came out. And I have repeated the recommendation as Peregrine disclosed additional information about the project. The up arrows represent good speculative value, but the more recent up and down arrow represents fair speculative value. What do I mean?

First of all I need to remind everybody that the value of a deposit is the net present value of its future cash flow from production. Once a company has completed a prefeasibility study it is easy to estimate the net present value of a deposit. But what do you do when a project is still at an early exploration stage when tonnage, grade, value and costs are unknown or just partly understood?

The exploration cycle is essentially a process of reducing risk and visualizing with increasingly concrete detail an uncertain outcome. In this table I have assigned a probability ladder to the diamond exploration cycle. As a project moves from one stage to the next the failure risk declines. A grassroots diamond project has a less than 1% chance of becoming a diamond mine. By the time a project enters the prefeasibility stage the chance of becoming a mine is 25-50%.

One can debate about the precise probabilities associated with each stage, but a much more important question is, what sort of target outcome can we expect based on available information? Using the discounted cash flow model as the valuation basis for a mine that is entering production, one can work out what a project might be worth if completion of the exploration cycle delivers the numbers one is currently using. Exploration is an exercise in visualization of something that does not yet exist, or exists only with faint outlines. To make my work as an analyst simpler, I pigeon hole projects into three target outcome sizes: a small mine worth $100 million, a medium sized mine worth $500 million, and a world class mine in the style of Ekati or Diavik worth $2 billion. I also make the assumption that the probability ladder is constant regardless of the size of the target outcome.

Now before I pull all this together into the rational speculation model you have been patiently waiting for me to spell out, allow me to review a very basic gambling concept which I think everybody intuitively understands. That concept is that the probability of an anticipated outcome should match the payout delivered when the outcome is achieved. For example, anybody who has bet at the track knows that a fair bet would be one where a horse with 10:1 intrinsic odds will pay 10:1 if it wins the race. A poor bet would be one where that same horse with 10:1 odds will only pay 5:1. And, of course, the bet everybody wants to make is the ringer where the horse has 5:1 intrinsic odds of winning the race, but the payout will be 10:1.

What I have done here in this table is convert the diamond exploration cycle's probability ladder into a percentage of the target outcome. For example a diamond project which I have reason to consider as being in the game for a $2 billion target outcome should have an implied project value range of $10-$20 million based on its 0.5% to 1% probability of yielding a world class Ekati style mine. In contrast, a grassroots diamond project that is in the game for a small $100 million outcome should have an implied project value of less than $1 million. As we move from grassroots to target drilling, the probability improves to 1% to 2.5%, and the implied project value range for the $2 billion game jumps to $20-$50 million. According to my rational speculation model, as a project moves through the exploration cycle the market should price it within the range channel defined by the probability ladder and the target outcome. That is the definition of fair speculative.

In more abstract terms, speculative value is the degree that the return achieved through actualization of an anticipated but uncertain potential outcome matches or deviates from the intrinsic odds of achieving that outcome. Fair speculative value exists when the implied project value is within the range defined by the probability ladder at each exploration stage and associated with a target outcome. Poor speculative value exists when the implied project value is above this range, and good speculative value exists when the implied project value is below the range. When a project offers fair speculative value, the shareholder is at the mercy of the odds, meaning that risk and reward are in balance. In market terms this translates into a "hold". When the project offers poor speculative value, the risk outweighs the reward, which translates into a "sell". When the project offers good speculative value, the reward outweighs the risk, which translates into a "buy". That is the essence of the rational speculation model.

All of this sounds very complicated until you plot the fair speculative value range for each target outcome against the exploration cycle. The blue band is the fair value channel for a $2 billion Ekati style outcome. The yellow band is for a $500 million outcome. And the red band is for a modest $100 million outcome.

And now lets overlay the historical implied project value range for the Ekati project that you saw earlier. You can see how during the grassroots and target drilling stages Dia Met was largely within the fair value channel for a $2 billion outcome. When Dia Met announced the Point Lake kimberlite and proceeded with micro diamond testing, the resulting $29 million IPV represented good speculative value. When the Point Lake micro diamond results came out the IPV jumped to $71 million, which still represented good speculative value, but as the mini bulk sampling stage progressed from one pipe to another with promising micro diamond results, the IPV soared as high as $2.4 billion, which represented very poor speculative value. In fact, Dia Met shareholders were offered the full reward very early in the exploration cycle. The Ekati project did not return to fair speculative value until it got bogged down in the permitting stage, and from there it stayed within the fair value channel band until the BHP buyout. In effect all the big money was made by shareholders well before the results vindicated such valuations.

A similar situation applied to Aber and its Diavik project. In fact, the Diavik project offered poor speculative value from the moment it started target drilling until it too got bogged down in the permitting stage. By the time Diavik got into production the IPV jumped well above $2 billion, which suggests either that one should have constructed a fair value channel for a $4 billion outcome, or the market erred in pricing Aber as it did when production started. The current IPV of $493 million with only one third of the resource depleted suggests that the latter interpretation applies.

In the case of Winspear the implied project value was never good for a $500 million outcome, but it was at times good for a $2 billion outcome and fair for a $500 million outcome. As the nature of Snap Lake became apparent the $2 billion target outcome ceased to be appropriate. When De Beers bought out Snap Lake the $440 million IPV represented fair speculative value for a $500 million outcome. The question today as De Beers deals with complexity at Snap Lake is whether Snap Lake was really in any game at all.

It certainly turns out to be the case that Jericho was not in any game. As this chart shows, Tahera offered poor speculative value during the early stages of the exploration cycle, and when it became apparent at the prefeasibility stage that Jericho was not in the $2 billion game, or even in the $500 million game, the price crashed from a high of $299 million to a low of $10 million. When permitting started the IPV had climbed back to $98 million, which was poor speculative value for a $100 million outcome, but good speculative value for a $500 million outcome. By the time construction started the IPV had climbed to $455 million, which represented fair speculative value for a $500 million outcome. But as we know, the Jericho Mine never performed up to expectations and has since shut down, wiping out Tahera's shareholders.

In this version of the IPV chart I have standardized the time spent at each stage. This is the format that I use to track diamond projects in real time. The Chidliak project of Peregrine Diamonds is plotted as an IPV of $142 million at the mini bulk sampling stage. Based on the rational speculation model this represents fair speculative value for a $2 billion outcome, but poor speculative value for a more modest outcome. In contrast the Qilaq project has an IPV of $60 million, plotted at the grassroots stage. The lower $60 million IPV reflects Peregrine's 100% ownership. If Qilaq were Peregrine's only project, it would qualify as poor speculative value for all target outcomes.

This chart also includes the $1.7 billion IPV the market was assigning to Shore Gold's Star project in March 2007 while the Star project was at the bulk sampling stage. This represented poor speculative value even for a $2 billion dream target, and I made myself hugely unpopular by pointing that out. Two years later Star has shifted to the prefeasibility stage, but the IPV has plunged to $63 million where Star offers good speculative value with regard to a $500 million target outcome. The relevant question is now whether Star remains in the game for a $500 million outcome.

In this chart I have added the implied project values for the flagship projects of some of the other diamond juniors. Take note that most of these projects offer fair to good speculative value for a $500 million target outcome, and very good speculative value with regard to a $2 billion outcome. The relevant question is what game is each project in. It is interesting to see the market assigning an IPV of only $128 million to Mountain Province's Gahcho Kue project, which is at the permitting stage. Why is Gahcho Kue lower than Chidliak? One reason is that the limits of Gahcho Kue are pretty well known, and Gahcho Kue is comparable to Ekati or Diavik. In contrast, we do not yet know that Chidliak is not like Ekati, so Chidliak is still in the $2 billion game.

As an analyst who covers the diamond sector I use these IPV charts to monitor how the market is pricing projects. When a diamond junior issues a news release I first ask myself, what do these results imply for the scale and value of the dream target. Do they support a $2 billion target outcome, or do we need to drop down to a $500 million outcome? A diamond project that offered fair speculative value yesterday could represent poor speculative value today. The other question I ask is if the project is ready to move to the next exploration cycle stage. If this is the case the project moves up the probability ladder where it a higher range of implied project values represents fair speculative value. The results may also push a project back to the prior stage, as happens when mini bulk sample results are poor and the junior has to find new kimberlites.

The rational speculation model also works with the exploration cycles for other commodities as this table shows.

Here is an example of an IPV chart featuring gold companies with projects at different stages.

What are the limitations of the rational speculation model?

One limitation is that the model assumes only one project in a junior's property portfolio will ever be a success, which in my view is a reasonable assumption. However, this tends to penalize prospect-generator-farmout juniors because the implied project value will typically offer poor speculative value. These companies develop a premium because the failure of one project is immaterial.

The model does not work when the junior has multiple advanced projects at the infill drilling or later stage. At these more advanced stages enough is known about each project to allow discounted cash flow valuations. And because a company can simultaneously finance and develop such projects toward production, the probability ladder would have to be applied to a combined target outcome. But this cannot be done when advanced projects are at different stages.

The model also does not distinguish between working, partly carried and fully carried interests. A company such as Tahera which owned its projects 100% had to endure substantial dilution through equity financings, whereas Dia Met was carried by BHP through most of the development costs. However, this is only a problem when trying to estimate gain potential in terms of stock price. The rational speculation model tracks the probability ladder driven expansion of implied project value which is defined by the three variables of fully diluted capitalization, net interest, and stock price, all of which are subject to change during the exploration cycle.

The rational speculation model is not a decision-making blackbox. It is a decision making framework which still requires old fashioned fundamental analysis of the geological and economic nature of a project. Its importance is that once you have done the target outcome visualization, you have a basis to make a buy, hold or sell decision.

When a sector attains bubble characteristics, the model may signal poor speculative value for all projects. This can be helpful in identifying bubble conditions. But more importantly, the rational speculation model can help one identify those projects which are less over-valued than others.

For example, consider this IPV chart which featured the key juniors in the McFauld's Lake area play when it was just emerging in October 2007. Almost all the juniors offered poor speculative value, with Noront's Eagle One at an IPV of $683 million. The $4 billion IPV at the prefeasibility stage is the Voisey's Bay project when Inco bought out Diamond Fields. During the McFauld's Lake mania the hope was that Eagle One would evolve into another Voisey's Bay deposit or that additional major deposits would be found in this region which collectively added up to a Voisey's Bay.

Look at the IPV chart today. Eagle One proved to be small, and no other similar deposits have yet been found. Rational speculators should shun bubbles and manias, but that can be hard to do because once a bubble is underway, it is difficult to predict how big it will get before it bursts. The rational speculation model allows speculators to identify and pursue relative speculative value, but if such a strategy is adopted, the rational speculator must keep in mind that when the music stops, it is game over.

To summarize, the rational speculation model first requires one to analyze the potential outcome of a project, then it requires one to identify at what stage of the exploration cycle the project is currently at, and calculate the valuation the market is assigning to it, and finally one must apply a probability ladder to the exploration cycle and the potential target outcome to establish whether the current implied project value offers good, fair or poor speculative value.


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