Chesapeake Gold's Metates Project Needs A Much Higher Gold Price

| About: Chesapeake Gold (CHPGF)
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Introduction

In this article, I'll have a closer look at Chesapeake Gold (OTCQX:CHPGF) which aims to develop its Metates project in Mexico which is very likely one of the largest undeveloped gold-silver-zinc projects in the world. I'll start by providing a background of the project and will move over to play with some numbers to test how sensitive the net present value of the project is to changes in commodity prices.

Thereafter I will explain the risks involved with an investment in Chesapeake and I will provide some possibilities which might be used by Chesapeake to finance the initial capital expenditures of the project. This will result in my investment thesis at the end of this article.

As trading in Chesapeake Gold is quite limited on the US exchanges, I'd highly recommend to trade in Chesapeake through the facilities of the TSX Venture, where the company is listed with CKG as its ticker symbol.
Executive Summary

In this article, I'll explain why I think that even though Chesapeake Gold's Metates project is a very interesting project, it won't get built because of the recent volatility in the gold price. Despite containing almost twenty million (!) ounces of gold and in excess of half a billion (!) ounces of silver in the reserve category, I'm afraid the initial capex will be the main hurdle, as Chesapeake Gold will have to find $4.4B to develop the project.

I will also prove that the new Mexican tax on the EBITDA of precious metals miners has a huge impact on the Net Present Value of the project. According to my calculations, the new tax causes the after-tax NPV of the Metates project to fall by approximately $400M whilst keeping all other input parameters constant.

Even though the new tax has a negative impact on the NPV of the project, Metates might be a great project to own if you believe in an increasing gold price, as this thing will definitely be built when the gold price reaches $1500/oz again and when the financial markets open up again for mining companies.

The Metates Project - a background

Chesapeake's most important project is the Metates Gold-Silver-Zinc project, located in Mexico's Durango State. Metates is a huge project as it contains 18.5 million ounces of gold, in excess of 525 million ounces of silver and more than 4.1 billion pounds of zinc in the proven and probable reserve estimate, which results in an in situ value of in excess of $35B.

The Metates project is already in quite an advanced stage as Chesapeake Gold was able to announce a pre-feasibility study on the project in January of this year. This PFS aims to recover 16.5M ounces of gold, almost 400M ounces of silver and 3.3B pounds of zinc over a mine life of 25 years. Peak output should be reached in the fifth year of operations when in excess of 1 million ounces of gold will be produced, which makes this project an extremely interesting potential producer.

However, the initial capital expenditures were estimated at $4.4B which will be the main hurdle for this project. The capex is this high because the company envisages a conventional truck and shovel open pit mining operation with a throughput rate of approximately 120,000 tonnes per day. On top of that, The sulphide concentrate will be transported downhill via an 80 mile (!) long slurry pipeline to the Ranchito site located 2500 feet lower in elevation and southwest of Metates.

Playing with some numbers

As said, there is already a pre-feasibility study on the Metates project, but I would like to play with some more numbers and to incorporate the new Mexican precious metals mining tax in the NPV calculation. As most people know (or should know) Mexico plans to levy a tax of 8% on the EBITDA of mining companies which are producing precious metals.

As the tax is levied on the EBITDA, Chesapeake can't play around in the first few years of its operation and use a very aggressive depreciation rate on its assets in order to reduce the tax as the tax is levied on the revenue before applying a depreciation rate. Thus, in my calculations I will not use such an aggressive depreciation rate. I will use a tax rate of 8% in the first years of its operation until the initial capital expenditures have been paid back, where after I will use an average tax rate of 35% which would correspond to the normal corporate tax rate of 30% increased by an 8% tax on the EBITDA. Again, these are rough calculations but should give you a better idea about the influence of this tax on the after-tax NPV of the project.

I will use a gold price of $1200/oz and the expected cash cost of -$100/oz in years 2-7 of the operation, increasing to $350/oz over the remaining life of mine. The cash cost per ounce of gold will be negative in the first few years of operation thanks to the silver and zinc credits during those years. Please note the company has only revealed costs per gold-equivalent ounce, so the costs per ounce are my personal back-of-the-envelope calculations and estimates. The next table gives a summary about the production profile of the project.

So let's move over to a calculation with a base case scenario using a gold price of $1200/oz. I will also deduct $35M per year in sustaining capex and exploration expenditures. Again, there are huge fluctuations in the output of the Metates project, and this will have an impact on the cash cost per ounce. That's the main reason why the cash cost per ounce can be divided in two. As you can see, there will be a consistently higher output of gold and silver in the first seven years of its mine life where after the output decreases and causes the higher cash costs over the remaining life of mine.

Even though I think the initial capital expenditures will be a tad higher than the $4.36B described in the PFS, I will base my calculations on the official numbers because the new Mexican mining tax might actually be beneficial for the miners who continue to push ahead with new projects (mainly because of cheaper labor and construction works).

Cash Flow per year

Corporate tax rate

after tax

Discount rate (8% per annum)

NPV8%

-4360000000

0%

-4360000000

1,00

-4360000000

0

0%

0

1,08

0

15000000

8%

13800000

1,17

11831276

375000000

8%

345000000

1,26

273872123

860000000

8%

791200000

1,36

581555620

990000000

8%

910800000

1,47

619875176

1175000000

8%

1081000000

1,59

681213367

955000000

8%

878600000

1,71

512654661

937500000

25%

703125000

1,85

379876559

875000000

35%

568750000

2,00

284516600

675000000

35%

438750000

2,16

203226143

635000000

35%

412750000

2,33

177021400

640000000

35%

416000000

2,52

165199324

640000000

35%

416000000

2,72

152962337

640000000

35%

416000000

2,94

141631793

640000000

35%

416000000

3,17

131140549

640000000

35%

416000000

3,43

121426435

640000000

35%

416000000

3,70

112431884

640000000

35%

416000000

4,00

104103596

315000000

35%

204750000

4,32

47443045

315000000

35%

204750000

4,66

43928745

275000000

35%

178750000

5,03

35509715

290000000

35%

188500000

5,44

34672786

295000000

35%

191750000

5,87

32657956

270000000

35%

175500000

6,34

27676234

265000000

35%

172250000

6,85

25151584

85000000

35%

55250000

7,40

7469897

549,048,804

Based on my assumptions, the after-tax NPV8% of the project is approximately $550M. This is obviously a huge difference compared to the after-tax NPV of approximately $2.4B in the company's Pre-Feasibility Study's base case scenario. This discrepancy is caused by 1. Using a different gold price ($1200/oz vs. $1350/oz in the PFS), 2. Using the updated tax regime in Mexico, which has a huge impact on the profits of any precious metals miner, as the average tax rate increases by 8% in the first few years of its operation and by 5% in the subsequent years. I actually calculated the effect of this additional tax, and the difference is huge (see the next table), and 3. Rounding errors because of imprecise information.

Cash Flow per year

Corporate tax rate

after tax

Discount rate (8% per annum)

NPV8%

-4360000000

0%

-4360000000

1,00

-4360000000

0

0%

0

1,08

0

15000000

0%

15000000

1,17

12860082

375000000

0%

375000000

1,26

297687090

860000000

0%

860000000

1,36

632125673

990000000

0%

990000000

1,47

673777365

1175000000

0%

1175000000

1,59

740449312

955000000

0%

955000000

1,71

557233327

937500000

21%

740625000

1,85

400136643

875000000

30%

612500000

2,00

306402492

675000000

30%

472500000

2,16

218858923

635000000

30%

444500000

2,33

190638431

640000000

30%

448000000

2,52

177906964

640000000

30%

448000000

2,72

164728670

640000000

30%

448000000

2,94

152526547

640000000

30%

448000000

3,17

141228284

640000000

30%

448000000

3,43

130766929

640000000

30%

448000000

3,70

121080490

640000000

30%

448000000

4,00

112111565

315000000

30%

220500000

4,32

51092510

315000000

30%

220500000

4,66

47307880

275000000

30%

192500000

5,03

38241231

290000000

30%

203000000

5,44

37339923

295000000

30%

206500000

5,87

35170106

270000000

30%

189000000

6,34

29805175

265000000

30%

185500000

6,85

27086321

85000000

30%

59500000

7,40

8044505

944,606,440

If Mexico would NOT have instated the 8% EBIT tax, Chesapeake Gold's after-tax NPV would have been $945M, which is almost $400M higher than the first result. This gives you an excellent indication of the impact of the new mining tax in Mexico, and I'm afraid Mexico will just shoot in its own foot with this tax.

What are the main risks involved?

The first obvious risk is the gold price risk. Even though the project still has a positive after-tax NPV using the current gold price of $1200/oz, a substantial decrease in the price of gold might force Chesapeake to put the project back on the shelf and wait for a better day. The Metates project is highly depending on the gold price, as the NPV using a gold price of $1350/oz would end up in excess of $1B.

A second risk is the geopolitical risk in Mexico. Whereas Mexico was seen as a very safe destination until a few years ago, things might change rapidly. On top of that, the new tax of 8% on the EBITDA of a company will increase the tax pressure and will very likely scare potential new investors away. This obviously doesn't mean that Chesapeake Gold will walk away from Metates as it's one of the largest undeveloped gold projects in the world, but it could mean that Chesapeake might reconsider advancing its other Mexican projects.

A third important risk is the financing risk. It won't be easy (and even outright impossible in the current climate) to find $4.4B to fund the initial capital expenditures. In the next paragraph I will explain how Chesapeake Gold might be able to find the necessary financing to get started. However, I think we should be realistic and assume the project won't be built at the current gold price, as nobody will be willing to provide financing. On the other hand, should the gold price increase again towards $1400-1500/oz, the Metates project should be one of the most exciting development-ready assets in the world.

How will this project be financed?

As said, the initial capital expenditures to move the Metates project into production are estimated at $4.4B and will very likely increase to $4.5B due to inflation. So if we use a normal assumption under the rule of thumb of 1/3 equity and 2/3 debt, Chesapeake Gold will have to find roughly $1.5B in equity to fund its part of the initial capex.

The easiest thing to do might be to raise the funds by issuing new shares. However, even at $5/share, approximately 300M new shares would have to be issued which would result in a dilution of 666% and would very likely not be the preferred way of the management team to move forward.

Fortunately the Metates project also contains a lot of silver, so it might actually be possible to sign a deal with a silver streaming company such as Silver Wheaton (SLW) whereby Silver Wheaton would make an up-front payment to purchase the right to buy silver at $4/oz over the life of mine. If Chesapeake Gold would sell 40% of its silver output of the first 15 years up-front, I think this might fetch an upfront payment of approximately $1B which would lower the needed share dilution.

However, selling a silver stream also has a negative effect. Because the company would sell the silver at a discount to the spot price, the total by-product revenue will be much lower and this would increase the cash cost per ounce of gold.

That being said, I do think that a sale of a part of the silver production will very likely be the way to raise the needed funds, as I don't think the management team would prefer to raise all the finds by issuing new shares, which would be horrible.

Investment Thesis

Chesapeake's Metates project is humongous in terms of contained gold and silver ounces and pounds of zinc. However, I have serious doubts about Chesapeake finding the necessary financing to develop the project, as the initial capital expenditures carry a total price tag of $4.4B.

However, Chesapeake Gold's business case improves a lot if a higher price of gold is being used, despite the increasing greediness of the Mexican government which has recently introduced a windfall tax of 8% on the EBITDA of precious metals miners.

Long story short, Metates is the right asset in the wrong time, and it will need a substantially higher gold price in order to be developed, as I'm afraid not a single lender will lend the company $3B to start the development of the Metates project. That being said, Chesapeake Gold is actually the perfect bet for gold bulls who see the gold price trading over $1500/oz again within the next few years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.