I was inspired to write this article in the aftermath of the rather spirited arguments ignited on the forum of one of my previous articles, which I wrote earlier this month on shale oil (link). The main point of contention was the fact that I used Society of Petroleum Engineers (SPE) data from a study made in 2012, to give an approximate picture of per-well ultimate production for Eagle Ford and variation in ultimate recovery from county to county. The result was a spirited attack on my credibility as a writer on the subject, with fracking enthusiasts arguing that industry information on this topic, which is obviously the most recent, is the only information we should go by.
There were of course no shortages of references to "gusher wells", which companies like to showcase to show just how wrong I was. I tried to argue that perhaps industry numbers should be consumed more cautiously, because the numbers are not impartial, but to no avail. Thus, I decided to write this article explaining in more detail through a reference to a slightly different situation, which already came to pass, the obvious benefits of over-reporting future potential, versus the comparatively few downsides to doing so in many cases. I believe it is important for potential investors to be aware of these dynamics when making an investment decision.
The example I decided to use is one I am familiar with, because I was a past shareholder in the company named Uranium One (OTC:SXRZF) (my very first investment). I bought shares in early 2007 believing the statements made by the company, which were very exciting, based on core samples they collected from one of the mines they were in the process of commissioning. It was supposed to become a huge project, with much potential benefit to shareholders. They had literally no uranium production to speak of in 2006 despite what their name suggests.
In fact, their only mining revenue for that year came from selling some mined gold, totaling $3.3 million. Their operating loss was $50.7 million. Yet early in the following year they managed to take over a uranium mining company called UrAsia, which in the last five months of 2006, had total revenue from uranium production and sales of $50.4 million and net income of $19.7 million. Uranium One managed a takeover, based solely on their much stronger company valuation.
Uranium One's valuation in 2006-07 was mainly the result of high expectations from one very large project they had in the pipeline in South Africa. The Dominion mine as the company presented it was a very sexy prospect. At a time when uranium spot prices were spiking over the $120 per pound range, Uranium One claimed to be able to produce at Dominion at an average price of $14.50 per pound. Furthermore, in 2006 they were claiming a resource base of 65 million pounds in indicated resources, with an additional 184 million pounds in inferred resources. In the end, Uranium One never produced anything but a huge loss on that particular venture.
By the time news came out that the project would be put in idle mode due to the nonviable economics of the project, they already acquired UrAsia and its profit generating production facilities, as well as its future prospects, which turned out to be real, unlike theirs. In retrospect, Uranium One was not a viable company as it stood in 2006 yet it swallowed up another company, which on its own was a neatly run, good generator of net profit, based on viable projects. In the process, Uranium One became the second largest Uranium mining company in the world by market cap in 2007. Not bad for a company, which only produced $3 million worth of gold in the previous year, at a loss.
I do not mean to suggest by any means that Uranium One's reporting was purposely "sexed up" in order to hide what we now know to be the facts about the company. That is something no one can ever know in the absence of an investigation in the matter. Nor is it important to try to lay blame for the purpose of making the point of this article. The point of this article is to simply point out that overly positive expectations about future resource extraction potential saved a nonviable company from what would have been certain extinction. It did that by facilitating the takeover of a viable company, the resources of which were later used to cover the losses at the Dominion project, as well as giving the company a much-needed source of significant revenue, which as I pointed out was sorely missing from the company's portfolio prior to the takeover.
On the other hand, a well-run company ended up being part of the portfolio of an nonviable company, effectively ruining its value earned through their good work. The conclusion that we can draw from this is that not only nonviable companies, but also viable companies may have an interest in over-reporting resources and production potential, while under-reporting production costs, which go beyond the desire of attracting capital through share issues. It may in fact be a strategy for survival, especially for smaller companies.
After producing relatively small amounts of Uranium at a loss at their Dominion project, they decided to put the project on idle in 2008, costing $32 million for the shutdown and $12 million per year afterwards for the mine's upkeep. They eventually sold the mine in 2010 for $37 million. All the while, they survived mainly on revenue from former UrAsia assets they acquired. Neil Froneman, the former CEO of Uranium One, resigned once the troubles with the Dominion project became clear. Murmurs of a Bre-x-like scandal started to surface, but Uranium One officials were quick to dismiss any such comparisons. There was after all uranium at the site, except it was not as economical to extract as initial samples suggested. They pledged to re-examine the mine by collecting more core samples to figure out the true nature of the uranium deposit.
The reputation of Uranium One as a company suffered, but to this day the company is still kicking around and is now in the process of going private. For 2012 they reported revenue of $563 million, which is not bad from its original $3 million in revenue produced at a loss from gold production in 2006. The majority of this current revenue stems from acquisitions made during their stock price surge in 2006-07 when their existing assets were what we now know to have been nonviable. In 2012 they recorded a loss, but made $88 million in profits in 2011. Currently, they produce over 12 million pounds of uranium per year. As for their former CEO Neil Froneman, he is still around. He is currently the president and CEO of Gold One International.
The only people we can identify a definite downside for are the shareholders of Uranium One, as well as the shareholders of the companies they took over during their high-flying stock days. The stock went to over $18 per share in early 2007 and then cratered to under $1 per share, after it became clear where things stood at the Dominion mine. For some investors it was a total wipeout, especially for those who held on and kept hoping that things will turn around so they can re-coupe some of their losses.
As I stated already, the purpose of this article is not to paint the mineral extraction industry in a bad light, thus discouraging investment in the sector. We have to remember that aside from some companies like Uranium One, there are also companies such as UrAsia, which as I mentioned in the article was a solid company that performed well, right up to point of its takeover in 2007. I also recommended two weeks ago for the readers to look at a company called Gabriel Resources (OTCPK:GBRRF) as a great (but slightly risky) way to invest in precious metals miners for the longer run. I hope that a few people took notice, because since I wrote that article, the stock has done rather well (up about 20%).
Early indications are that I did not make a mistake to point out that particular company. By no means am I trying to discourage people from investing, but especially in the minerals extraction sector, people have to be cautious and avoid falling into the trap of following a potential hype trend. It is also important to understand the decision process at firm level, based on strategic considerations. Lastly, putting all potentially strategic decisions aside, we have to understand the one thing that all investors in resource plays should already know, which is that sometimes things simply do not turn out as initially hoped when it comes to mining and drilling.
In my past article, which inspired me to write this one, I mentioned the Shell (NYSE:RDS.A) decision to write down $2.1 billion in their shale oil play. It is important in my view to realize the difference between Shell deciding to take the loss and move on, versus the potential decision to do so for a firm for which one project may be the core of the company's very existence. For instance, that is exactly the case with the company I recommended people take a look at two weeks ago. Gabriel Resources, which currently only exists to facilitate the extraction of gold & silver from the Rosia Montana site in Romania is 100% dependent on the success of that project. If upon further study in the field it were to turn out that the project is not feasible despite initial estimates, Gabriel Resources' market cap would disappear into thin air in no time, with little chance of making up all the lost revenue incurred in the run-up to the production stage.
On the other hand, if they were to use the current market cap based on expectations of great profit at Rosia Montana to acquire already producing assets, the company would live to see another day. It would be in the interest of major stakeholders at Gabriel Resources to maintain for as long as possible the perception that it is sitting on a great potential future project for strategic reasons and as the example of Uranium One teaches us, there is only upside for companies to do so. The only exception, as I said, is if we are talking about large, diversified companies, which can take a loss on any particular project without danger of being wiped out, or even affected in a very significant way as is the case with Shell.
In conclusion, I do not think that it is such a radical thing to suggest to people looking to invest in oil & gas, or other mineral extraction industries, to be aware of the decision making process that may go into any annual or quarterly report prepared for the public and potential investors. Many companies may seem great based on the picture that the company wants to paint of itself through its statements, but that picture may or may not turn out to be accurate. Therefore, as is the case with the example of companies operating in the Eagle Ford shale oil extraction plays, one should not shy away from reading some independent studies, even if they may be slightly outdated, as was the case with the SPE papers over which fracking enthusiasts decided to declare me incompetent.
One should not make the decision to invest solely based on those independent studies either, for as many of my critics of my previous article pointed out, it may indeed be part of an outdated picture. At the same time however, it may serve to give a bigger more impartial picture of reference, which may be helpful in figuring out the comparative similarities and differences from one project to another. I think a little bit of healthy skepticism, which may lead to further investigation, cannot but benefit any potential investor.