Junior Mining Companies To Benefit From LME Rule Change

| About: Inca Pacific (IPRFF)
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An important change is coming to the London Metal Exchange [LME] in September. As from September 29th, the biggest and by far the most important copper trading ring in the world is extending future contracts on the red metal to 123 months out, i.e. 10 years into the future. Presently, copper futures contracts at the LME are available up to 63 months into the future. The LME is also extending contracts on Aluminium to 10 years, and Zinc, Lead and Nickel to 5 years. Therefore what follows can equally be applied to the Alu sector, and also in part to Zn, Pb and Ni, but for the sake of simplicity (I ballpark quite a lot through this post out of necessity, as you'll see), I'm going to stick with copper as my example.

Here's the current 27 month futures price chart for copper:

.... and we can see that the price of copper goes down as the contract date is extended. This is so for a variety of reasons, but we can sum it all up (for our purposes) by saying it's "opportunity cost". As outlined in this previous post linked here, the price of copper on this curve is pretty logical if you imagine yourself as an end user buyer of the metal. You can either buy your copper at today's spot price whenever you need it, or you can pay less for the same copper to be delivered in the future but at the same time tie up money in a contract that could otherwise be used for investment. In that previous post linked, I used an idea of putting the cash in a 5% interest rate time deposit, and in fact that 5% level explains very closely the current pricing curve.

So, if we stay with my admittedly very general, very ballpark concept of using 5% per annum opportunity cost to explain the current pricing curve for copper futures, we can extend that same hypothesis to the forthcoming 10 year future contracts. Here's the chart:

.....and we see that the far end of the 123 month contract would price up at U$2.34/lb under this theory.

THIS IS VERY IMPORTANT NEWS FOR JUNIOR MINING COMPANIES WITH COPPER PROJECTS (did the capital letters get your attention? I hope so...that was the idea)

Why is this so important? Well, it's going to change the way copper mining juniors can value their future production, and substantially so. This is because nearly all copper juniors are based on long term copper prices of between U$1.50 and $2 per Lb (with $1.50/lb being the norm).

Let's take one of my toppy top favourite junior copper companies as my example. Inca Pacific (IPR.v) currently uses U$1.50/lb for its long term pricing model. This, according to its own figures, makes it profitable. Recently (as mentioned in this post), a respected third party consultant put a net project value [NPV] on the company of U$206m by assuming a long term base case of U$2/lb copper. But if suddenly these junior companies can go to the LME and secure much higher prices for their longer-term production, it makes the projects as stand today worth that much more. This weekend I've been playing with my IPR.v database, and by using the 5% LME futures op-cost discount model outlined above and assuming 2008 as year one, of the curve the NPV of Inca Pacific rises by a conservative 50% to around U$310m (working out at $4.99 per share.....PR trades at $1.53 right now.....wanna know why I call it a "strong buy again?). Other routes to crunch the numbers bring about a much higher NPV but I'll stick with the lowball, conservative numbers for the moment, thanks.

Of course it's not such a simple calculation, and this blog just outlines the thought process rather than the nitty-gritty calculations I've been playing with this weekend. But the point is that the LME futures pit is about to open up a whole new way to show how much a mining project is really worth. The long term modelling done by Inca Pacific and all the other copper juniors is always with the banking people in mind; they still use U$1.50/lb for long term copper because they need to convince the people who fund the expensive construction phase of a project that they will get their money back, and they will get their interest payments, the miner won't go belly up and the guys with the money can be as sure as sure can be that they won't be left holding a rather expensive bag. But now, with the LME actually pricing up copper 10 years out, the junior miner has every right and reason to go to Mister Banker and say "no worries dude...we're using $2.30 base case now, cos that's what the copper world says it's worth."

The bottom line here is is that in this world where mining costs have been rising, the projects now in the pipeline can price themselves more accurately to the future and in that way justify and attract the funds they need. Or in other words, junior copper projects are about to get a dose of added value. You have until the end of September to get on board, and don't say I didn't warn you.

In due course, expect the concepts in this post to be repeated and elaborated upon by people who should have told you about this already (a.k.a. professional analysts at retail brokerages).

Disclosure: Author is long IPRFF.PK