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Can’t Stay Away: Arcan Resources and Second Wave Petroleum

PHH, Newcastle Investments and Mortgage Servicing Rights

Shadow Inventory and how an improving US Economy begets an Improving Housing Market begets and Improving US economy begets….

PHH and one way to bet on a turn in the US economy

Jumping on the Bandwagon

As I wrote about earlier, I am coming around to the view that the US economy will perform reasonably well over the next few quarters.

Now let us not confuse the short term with the long term here.  I don’t for a moment think that the longer term issues in the US have been solved.  The situations in Europe, in Japan, and in the US are very similar.  There are massive storm clouds on the horizon, and those coming storms are causing the winds to pick up and the boats of the economy to waver in the seas.  But the storms themselves have not yet reached us, and so while we may have bouts of turbulence brought on by rising winds, or even, as in the case of Europe in November, sudden gusts that threaten to capsize the rigs, the actual storms are still a little ways off in the distance, far enough  that we can pretend at times that they are not there.

Now appears to be one of those times.

The LTRO seeming to have stabilized the banks of Europe in the near term.

TED Spread:

Italian 10 year:

Spanish 5 Year:

The economies of the European periphery, while entering what has to be an inevitable and deep recesion, are still far enough away from the consequences of these (maybe 2-3 more quarters) that we can ignore that more bailouts or a mass exodus from the euro is close at hand.

Finally, there can be no doubt that the numbers in the US are picking up some steam of late.  How long will this continue?  Perhaps not too long, but who is to say.

More specifically, the housing sector has been beaten to such a pulp in the past few years, and the stocks involved have taken such a beating, that even a stabilization at these low levels (both prices and activity) may lead to a substantial uptick in the share prices.

Always on the look-out for a bull market

So while I don’t really believe it can last over the long term, that doesn’t mean I can’t take advantage of it.  In the absence of the arrival of a true storm (like what happened in 2008), there is always some bull market somewhere.  You just have to find it.

Where am I looking?

1. US Regional and Community Bank stocks
2. Mortgage Servicing companies
3. Oil stocks with large resources that can take advantage of Hz-multifrac technology to exploit those fields

I still don’t know what to think of gold. There is a bull market out there, but only for select stocks (see Atna and Argonaut Gold for a couple of examples).

Buying into Newcastle and buying more into PHH

As I wrote earlier, I believe that the mortgage servicing business provides a unique opportunity right now, and while I have started a position in Newcastle Investments in response to that, I expect to increase that position substantially over the coming weeks.  I have also turned PHH Corporation into one of my largest positions.

I’ve already talked about both of these investments ad nauseum in the last couple posts so I am not going to reiterate those theses here.  What I will say is that I am becoming more and more cozy with the mortgage market bottoming idea and I would expect that you will see more of my capital make its way over to this market in the coming weeks.  I am already looking for an opportunity to exit OceanaGold and reduce my position in Aurizon Gold.  The proceeds are likely to either go into PHH or NCT, or into another mortgage leveraged corporation that I find.

Sometimes selling a stock can make you think about it more clearly.  Such was the case with both Arcan and Second Wave.  In fact I spent last weekend working through their prospects.  I hope to post on this soon, but for now, let me just say that the work reiterated to me just how much potential these two companies have.

The main reason for not owning both of these Beaverhill Lake producers is because they are spending a lot more then they are taking in.

They really have been spending a lot more than they take in.  The original reason I reduced my position in both companies last fall was because with Europe appearing on the precipice, being invested in companies in need of capital seemed like a poor proposition.

However Europe seems to be back on the back burner.  For Arcan and Second Wave, spending a bit more then you make is not such a bad thing anymore.  It can actually be perceived as a good thing; growth and potential and all that jive.

The reality is that the prize at Swan Hills continues to prove itself up, and the NAV of both companies will likely continue to rise as they drill more wells.

Perhaps the kicker for me was the news release put out by Second Wave last Monday.  In the release SCS announced a number of new boomer wells in and around the existing boomer wells that they (with the JV with Crescent Point) and Coral Hills have been drilling.   But more importantly, SCS announced the success of a well drilled far to the south of this existing “sweet spot”:

[Second Wave] completed its 100% working interest 01-17-062-10W5 Beaverhill Lake light oil well in south Judy Creek with an initial two day flow test rate estimated at 800 bbl/d of light oil further delineating the Company’s south Judy Creek land base.

The 01-17 well (big red circle) is well to the south of the existing sweet spot and it opens up a whole mess of land in between.  A lot of those southern sections are 100% interest for SCS as well:

While we are somewhat away from proving up the sections in between, the 800boe/d success gives me a lot of confidence that they will be proved up over time.

I ran the cash flow numbers on 2012 based on their expected average production of 3,850 boe/d and $95 oil and I figure they can generate around the $85M mark of cash flow.  I will post that cash flow analyis more thoroughly in a later post.   For now, suffice to say that my estimate compares favorably to the $85M CAPEX estimate that the company had in their February presentation.  Perhaps the days of spending in excess of what you make are soon to be over for Second Wave?

Future Catalysts?

I see a couple of catalysts for Arcan and Second Wave that made me want to stay out of the stocks.

I think that the biggest catalyst to get me back into both stocks in short order was the spector of the upcoming reserve report of both companies.  I suspect that the reserves for both Arcan and Second Wave are going to show some excellent numbers, potentially with NPV10 estimates decently above the current share prices.

Arcan has the additional catalyst of the waterflood of Ethel.  I posted late last year how quickly Ethel production was declining without waterflood.  I wrote:

If you look at the average Ethel and DMU production curve, you can see the effect of the waterflood taking place at DMU versus Ethel.  Ethel wells do appear to stabilize at a lower level. The following chart looks strictly at horizontal Ethel and DMU wells drilled after Jan 1st 2010 (I didn’t want to confuse things by adding data from old completions) averaging out the monthly production for all wells at that point in their decline.  Producing day rates are used.

Now it has to be pointed out that the post 6 month data for Ethel is a single well (the 10-27).  So we are not dealing with a large dataset here.  Still, I think the conclusion can be made that Ethel wells drop off quicker and stabilieze at a lower rate without the waterflood.

Presumably with waterflood one would expect that Ethel type curve would shift up to where the DMU curve is.  One mitigating factor to this improvement might be reservoir quality.  The sands at Swan Hills have often been thought to thin to the south.  On the other hand, Arcan’s completion techniques have improved quite dramatically lately with the move to the larger acid fracs (another detail that was provided in the Q2 MD&A).  This is witnessed by the significantly higher IP30 and IP60 results produced by these presumably thinner sands at Ethel.  So this may help the Ethel wells outperform.

Its a bit of a guessing game until you get some data.

So what does it mean to production?  Two things.  First, with the waterflood implemented you would expect that the existing wells at Ethel would deliver a higher rate.  I’m going to speculate that, on average, this would be about 40bbl/d for the post 2009 drills.  This would add about 350bbl/d of production to Arcan.

Since that time Arcan has drilled a number of additional wells at Ethel.  I would estimate that once in full operation, if the 40 bbl/d per well increase number holds up one could expect around 500 bbl/d extra production from Ethel.  But it could be more, and at least in the short run, likely will be more.

While an uptick in new home building may still be some time away, mortgage origination should benefit over the next year from the refinancing associated with HARP II and from less competition due to the exodus of originators from the ranks brought on by the dismal market conditions.

Mortgage servicing, meanwhile, has been hurt by falling interest rates (remember that as a servicer you get paid as long as the loan is being paid, so refinancing can hurt your business if you can’t reoriginate the refinancing), by uncertainty in the regulatory environment, and by the regulatory capital concerns of banks.  But valuations on mortgage servicing rights are low and with loan quality standards currently high and with interest rates unlikely to go lower, new servicing rights should be a good investment.

I want to delve a little deeper into the  mortgage servicing rights (MSR) part of the business this week.

What is a mortgage servicing right?

A mortgage servicing right is a somewhat complicated little piece of paper of conditions, responsibilities and payments.  For the basic definition I will defer to investopedia:

An MSR is a contractual agreement where the right, or rights, to service an existing mortgage are sold by the original lender to another party who specializes in the various functions of servicing mortgages. Common rights included are the right to collect mortgage payments monthly, set aside taxes and insurance premiums in escrow, and forward interest and principle to the mortgage lender.

In return for these responsibilities, the servicer is entitled to a small piece of the recurring interest payments made by the borrower, usually around 25 basis points (0.25%).

A more investment oriented definition of an MSR comes from kamakuraco, who published an interesting paper on estimating the risk of an MSR, and who define the mortgage servicing right in the terms of a security:

One can approach the valuation of mortgage servicing rights as the valuation of a fixed income (broadly defined) security subject to default risk and prepayment risk.

There are two risks implicit to an MSR; either the mortgage is paid off, or the borrower defaults.  In both cases the payments to the holder of the MSR are no more.

The collapse of the MSR

There was a great discussion two weeks ago on the Lykken on Lending mortgage banking podcast.  Lykken had on Austin Tilghman and David Stephens, CEO & CFO respectfully, both with United Capital Markets.  These fellows are industry experts in the mortgage servicing market.  The discussion begins about a half hour into the podcast.

To take an aside for a second, I have to say that listening to the discussion brought about one of those exciting moments that make investing fun.  I was biking home from work, had my ipod on listening to the broadcast.  The roundtable discussion with the UCM execs came on and the second question, put forth by Alice Alvey, asked why are company’s beginning to retain their own servicing rights when traditionally most originators just sold those rights off for the cash up front?  Austin Tilghman (I think.  He didn’t identify himself) replied with the following:

Prior to the meltdown the price paid for an SRP [servicing release premium] was generally 5x or more of the [mortgage] service fee.  That multiple dropped to 4x a few years ago and we are hearing that its dropped to 0x in some cases today.

Andy Schell, Lykken’s partner, then went on to say that he had recently done an analysis of SRP’s and MSR’s and, in his words, “I couldn’t believe the numbers are so low.”  He reiterated that the SRP’s are in some cases approaching zero.

Wow.

When I hear that kind of disconnect I immediately think opportunity.  And then I think how can I capitalize on that opportunity.

Defining SRP’s  (there are too many acronyms in this industry)

But first of all, another definition. When a company originates a mortgage, along with that mortgage comes the right to service the mortgage.  That’s the mortgage servicing right.

As an originator you have the option to keep the MSR on your book and service the mortgage through its life in return for the 25 basis point (or thereabouts) premium.

Alternatively you can capitalize the MSR up front by selling it.  In return for selling the MSR you get cash.  The cash you get is referred to as the servicing release premium (SRP).

The acronyms MSR and SRP get used all the time in discussions without definition so its good up front to understand what these two concepts are.

Why SRP’s have collapsed

As David Stephens alluded to above, the value of an SRP has collapsed of late.  A few reasons why this is the case:

1. There is concern about a regulatory change to make MSR’s a fee for service as opposed to a tacked on percentage of the loan interest (this is preventing new participants from getting into the market but it appears that it is not going to happen)
2. There is a more nebulous concern about the regulatory environment in Washington in general and what the “unknown unknowns” of future legislation might be
3. You only get the cash flow stream of an MSR over time whereas you get cash right now by selling the SRP and has of course been a liquidity problem in the industry since 2007
4. Its a long term commitment to get into servicing.  You can’t just jump in overnight without  getting approvals as a servicer from the regulators and developing the infrastructure to do the servicing
5. The market for buying and selling servicing is thin at the best of times and especially thin now (because of all the folks getting out of the business)
6. And that is because… no bank wants to have anything to do with the mortgage industry

The opportunity

The basic investment premise here was well put on the broadcast by Joe Farr, who asked the following question:

With rates at 3.5% or 4% and quality never being better, why is it that that servicing values are close to zero in some cases?

To which Austin replied:

Its the aggregation of the aggregators.  In 2007 an originator might have 20 take outs for the loan they produced.  After the spectacular failures of 2008 and the combination of large companies into even larger ones there may have been 10 takeouts.  Recently we’ve seen BoA and Citi getting out of the market and you can count on one hand the number of people that account for 50% of the market.  And they have their own capacity limitations.  It just gets tougher and tougher to find a takeout and then those that are left are becoming more selective about what they buy.

And there you have it.  A simple supply and demand imbalance where demand for SRP’s has been decimated by the housing collapse have caused a disconnect in servicing valuations.

Who is going to benefit?

So I own a bunch of PHH now.  They are big time servicer and the MSR’s on their books are valued at about 2.7x.  Clearly from a book value perspective PHH has some upside  to that servicing valuation if interest rates begin to rise and they can value that servicing at something closer to 5x.   Servicing values have had to take major writedowns over the past 3 years as defaults have increased and more importantly, as interest rates have fallen, raising the possibility of refinancing.  I found that really interesting table of the writedowns taken by some of the major banks over the past 3 years in the Kamakura report that I mentioned earlier:

That is nearly $30B in writedowns over the past 3 years for the 8 major banks.  Wow.

Remember that the writedowns are being taken in part because the current MSRs are expected to refinance at a faster rate.   PHH has, in the past, managed to retain most of their servicing rights that get refinanced by being the originator on those refinancings.  So its perhaps a little misleading to value those servicing rights at 2.7x.

To get an idea of impact of a revaluation of those MSRs on teh PHH books to a 5x servicing fee multiple:

Ok, so that’s a pretty big impact on the accounting end.

As I already mentioned, PHH has proven that they can produce more MSR’s then they lose even during times where a large amount of the MSR’s are refinancing.  The new MSR’s replacing the old MSR’s are of a much higher quality.  By high quality I mean that these MSR’s are connected to mortgages that are being financed at extremely low rates (and therefore where the chance of early repayment is low) and within a market where credit quality is extremely restrictive (meaning the chance of default is low).  This doesn’t seem to be reflected anywhere in the books.

So PHH has some upside as MSR come back into favor.  That’s good.  But there are two problems with using PHH as the vehicle to play the MSR disconnect:

1. They don’t have the cash right now to take advantage of the disconnect in price and buy up MSR’s on the cheap.  What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.
2. They are an originator, so when the MSR’s begin to recover their value its going to be on the heels of rising interest rates which will hurt the PHH refinancing business.  In other words, PHH will never have all cylinders firing at once.

What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.

Enter Newcastle Investment

I have owned Newcastle investment in the past.  In fact, I owned them as recently as last summer, but I sold them in one of my “sell everything because who the hell knows what is happening in Europe” moments. At the time, I owned Newcastle because they, much like Gramercy Capital, had a large disconnect between the NAV of their managed CDO portfolio and the share price.

I’m not going to go through that CDO valuation right now because I want to talk about the MSR business that Newcastle is branching out into.  I probably will in the next few weeks, just to get a better idea of the value proposition here.  In the mean time the best places to find a comprehensive analysis of Newcastle’s CDO business are on the Gator Capital blog and the analysis by PlanMaestro on variantperceptions here and here.

The essence of these analyses is that if you add up the CDO business and cash at corporate, subtract out the preferred’s and other debts, you get a company with an NAV of about $5-$5.50 per share.  So your net asset value is something pretty close to the current share price.

Here’s the crux then.  Of that $5-$5.50 per share net asset value, about $205M (or a little less that $2 per share) was cash at the end of the third quarter.  The potential upside exists if Newcastle can turn that cash into a cash producing asset that has a value greater than the face value for which it is purchased.

NCT gets into the MSR business

On its third quarter conference call Newcastle made the announcement of the change in direction.  The company was getting into the mortgage servicing business.  The company said it would be making major investments into MSR’s over the next few quarters (one of which they have already since announced).  The reasons that they decided to make the switch in strategic direction was:

1. They felt the MSR business offered the best risk adjusted returns out there
2. The existing core business of CDO creation was basically dead

Interestingly, Derek Pilecki, who writes the Gator Capital blog, dumped NCT when the news was announced.  While I am of the mind that getting into the servicing business right now is a savvy move, I recommend reading his final analysis of (and reasons for selling) Newcastle here for a contrary point of view.

Newcastle believes that there are significant returns that could be realized from MSR investments.  From the SeekingAlpha Q3 conference call transcript:

We are still very optimistic that the returns on an unleveraged basis will be kind of mid-teens even mid-20, so very compelling in any environment but in particular with all the certainly in the world if we get something that is a big deal for us.

Newcastle went on to describe something that the fellows from UCM pointed out on the Lykken broadcast; how banks are basically dumping their servicing business on the cheap.  Again from the  transcript of the 3rd quarter conference call:

Banks in the U.S. are very focused on regulatory capital, on regulatory risk, on just the perception of headline risk, [and this has] made them more likely to be source [of MSR supply]

To get into the business Newcastle is partnering with an originator and servicer (Nationstar) and Nationstar will be performing the actual servicing.  I think that Newcastle can be thought of as a silent partner that is putting up the cash.   Again, the problem with MSR’s is that you have to have the cash to put up, and while most originators are running a tight cash flow, Newcastle has ample cash to take advantage of the investment.

Newcastle has also received approval from the IRS that MSR’s can receive the same favorable taxtreatment as other REIT assets.

That they had to clarify approval demonstrates the “first mover” status that Newcastle holds.  Newcastle is early on in the game, being one of the first REIT’s to take advantage of this opportunity.  As one of the analysts put it on the Q&A, Newcastle is “leading the way”.

What’s the upside?

The upside to Newcastle is a big increase in the free cash flow that the REIT can generate.  Before getting into the MSR business, Newcastle was generating around $80M of free cash flow (FCF).  At a 20% return on the $200M of unrestricted cash (using the assumption that the company puts all its free cash into the MSR business), you are looking at FCF of another $40M.  Given the current market capitalization of $600M that puts NCT at a 5x free cash flow multiple. The company paid about a $60M common share dividend in the third quarter, so clearly another dividend hike would be likely.

The company announced their first MSR deal with Nationstar in a December 13th news release.  In it the company reiterated the return metrics:

  “I am very pleased to announce our first investment in Excess Mortgage Servicing Rights. This is a watershed investment for us in this sector. We expect this investment will generate approximately a 20% unleveraged return and total cash flows of over 2 times our investment. I am excited to be investing alongside Nationstar, a premier mortgage servicer and originator. Residential mortgage servicing is a large market and we currently see a strong pipeline of similar investments at very attractive returns.”

The deal was for $44M.

In my opinion, apart from the basic cash flow expected there is unrealized value in these MSR assets.  For one, because Newcastle is partnering with an originator in Nationstar, there is a good chance that a decent percentage of the MSR’s that the company is investing in will be refinanced through Nationstar.  Newcastle was quick to point out that refinanced mortgages remain in the portfolio and continue to cash flow to Newcastle.  The refinanced value is not included in the value of the MSR.  Newcastle estimated the following refinancing rate on the Q3 call (from the SeekingAlpha transcript again):

So our experience at Nationstar on our agency pools that we service which is a material amount of loans is that we’ve had recapture rates in the kind of low-to-mid 30% (inaudible) over the past six months, and that’s obviously significant, we think and we’re hopeful that with a little bit of focus, we could increase that to 40%, 50% at the extreme end of it, not that I’m predicting this, because it wouldn’t be prudent, but at the extreme end of it, you can capture a 100% of the loans that prepays, then you would have really the perpetual money machine right, as the IO would stick around, the extra service will stick around forever, but even at recapture rates at 20%, 30%, 40%, 50%. It has a terrific impact in terms of the volatility of the MSR and that’s (inaudible) investment profile looks like.

Second, as I already pointed out, recent and new MSR’s are being collected from mortgages that have been financed at historically low rates and in an era of extremely strict lending criteria.  There is little chance that these mortgages are going to default and little chance that they will be refinanced any time soon.  In other words these are high quality assets.

Its kind of a weird perfect storm here; you have a situation where the asset quality has never been better at a time when nobody wants the asset.  While I suppose its not clear exactly what the quality of the MSR’s Newcastle is investing in are, if one presupposes a little faith in the management team (which has after all had the foresight to see an opportunity that many others have not yet seen), you might draw the conclusion that Newcastle is getting into high quality assets at a fraction of their underlying value.

Anyways if you add it all up I think NCT is on to something here.  I bought a position in the stock and plan to add to incrementally as the stock moves up and my thesis is proven right.

Two things about this graph.

1. Visible housing inventory is approaching a low not seen in 30 years.
2. You can’t take a shadow inventory number at face value.  You have to understand how it was estimated.

First a little bit about shadow inventory

I want to talk for a second about shadow inventory. I wrote this explanation about shadow inventory in Letter 23:

Laurie Goodman (who I first learned of from ftAlphaville fame) pegged shadow inventory at 11M (which is an amazing 20% of housing mortgages outstanding).  Mark Fleming pegs it at 2M.  Both analyts are using the same data…How is this possible?  Its all in the assumptions.  Shadow inventory is really just houses that are expected to go into default at some point.  There is nothing particularly nefarious about the concept, even though the name suggests it is some sort of inevitable flood of housing supply.  It may be, but it may not.  It depends on what happens.  Laurie, to come up with her 11M number, assumes a fairly large number of prime mortgage defaults, including some that are currently with LTV (loan to value) of less than 100%.   Laurie also looks at 60 day past due as her “bucket” from which to extrapolate current nonperforming loans.  Mark on the other hand, uses 90 day past due, and does not include currently performing prime mortgage defaults.

I did a bit of investigation and the number used in the above graph is the CoreLogic number, which is the lowball Mark Fleming estimate from the above quote.  According to CalculatedRisk that number is comprised as follows:

Of the 1.6 million properties currently in the shadow inventory, 770,000 units are seriously delinquent (2.5-months’ supply), 430,000 are in some stage of foreclosure (1.4-months’ supply) and 370,000 are already in REO (1.2-months’ supply).

The thing about the shadow inventory is that if what you see is what you get, then we are almost through the worst of it.  Looking at the above categories that comprise the shadow inventory estimate, they total about 1.6M homes.  If there was a little bit of confidence in the housing market, and you began to see sales returning to pre-crisis and pre-boom levels, you would run through those homes quite quickly.

As well, it must be kept in mind that the month-of-supply number is assuming a continuation of a level of sales that is a historically low level.  Rising sales would help eliminate shadow inventory and real inventory much more quickly than the monthsof-supply number might suggest.

The most basic point here is that shadow inventory is not an inevitable houses-on-the-market number like visible inventory is.  Shadow inventory is a “houses that are likely to go on the market” number where the definition of “likely” is a function of whether those home owners have jobs, how low interest rates are, whether the refinancing market is liquid enough to let home owners with high interest rate mortgages refinance to low interest rate mortgages, and probably most ambiguously, what homeowner think about the future prospects of the housing market.

Laurie Goodman and her firm Amherst Securities have some of the most pessimistic numbers on shadow inventory.  She does an excellent job describing the methodology they use at her firm on this conference call.  Amherst ends up with the following estimate of shadow inventory:

This is a huge number.  Much bigger than the 1.6M number that CoreLogic is using.  If Goodman is right then we are years and years away from a housing recovery.

But lets go through this.  Amherst uses 60 days past due to define nonperforming loans.  Reperforming loans are loans that were in default before but aren’t now.  MTM LTV means mark to market loan to value, so a 120 MTM LTV is basically saying that the loan is worth 120% what the house is worth.

I would say that you can make vastly different assumptions about how many loans in each of these categories will default depending on whether you assume the housing market is improving or not.

Somewhat paradoxically the true amount of shadow inventory is going to be determined by the perception of just how much overhang exists in the housing market.  To put that more bluntly, would you walk away from your house right now if you saw the housing market turning up?

You would be a lot less inclined to I think.

And all of this brings us to the US economy

I have two graphs here to prove my point.

When I started dumping stocks and raisigng cash in the late summer and earlier fall it was partially because of my uncertainty about Europe.  But it was also partly because of my concern that the US economy was slowing down again. The big reason for my concern was that the ECRI leading index was falling again.  I am reluctant to be too invested in stocks when this indicator is dropping.   Once it starts to drop, I’m not all that sure that anyone knows when its going to stop.  It could stop and turn around relatively quickly, suggesting a soft patch in  the economy, or it could fall precipitously, indicating a sustained move back into recession.

The move down ended at the end of the last year, and the last few weeks the uptrend has shown itself to be persistant.  Such persistance must be noted.

The second graph is simply jobless claims.  Jobless claims are the single best indicator of the health of the economy.  You simply can’t deny that claims are heading down, and that the trend down is accelerating.

Growth in an economy builds on itself.  Growth begets growth.  Taking it back to the housing market, I think that these early signs of true growth in jobs could begin to snowball into a housing market.  Jobs beget stabilizing housing prices which begets greater housing activity, which begets rising prices, which begets falling inventories (and non-materializing shadow inventories), which begets the need to build new homes which begets more jobs. And so on.

Economies as large as the US economy do not turn on a dime.  But when they turn a lot of the viscious cycles that had amplified the downturn become virtuous cycles that amplify the move up.   I am of the mind that we may be in the process of making such a turn right now.

I love to add to a rising stock.  I think its truly the best way to make money.  You buy a start position, the stock begins to move up, you add to that position, it moves up again, you add again.   The market is telling you that you are right and so you listen to the market, and to use a phrase of Dennis Gartman’s “do more  of what is working”.

In the last week I basically doubled my position in PHH:

I wrote my basic thesis on PHH 3 weeks ago.  I love that the company is involved in mortgage origination and servicing.  I think that mortgage servicing rights represent one of the best investments you can own right now (I’ll put out a post a little later where I’ll discuss the upside of the mortgage servicing business along with another new investment I just made; in Newcastle Investment).  I also love that the company trades at about half of tangible book and at around 4x a core earnings number that truly does represent the core earnings metric that should be used to evaluate the company.

What I had kind of ignored up until this this week was the company’s Fleet business.  It seemed like it was making money, it wasn’t really a core part of my reason for owning the company, so I just disregarded it as something that wouldn’t necessarily hurt the investment thesis but was not really something I wanted to focus on.

What is Fleet Management?

The best definition I could find as to what the business of fleet management is all about came from wikipedia:

Fleet management is the management of a company’s vehicle fleet. Fleet management includes commercial motor vehicles such as cars, vans and trucks. Fleet (vehicle) management can include a range of functions, such as vehicle financing, vehicle maintenance, vehicle telematics (tracking and diagnostics), driver management, speed management, fuel management and health and safety management. Fleet Management is a function which allows companies which rely on transportation in their business to remove or minimize the risks associated with vehicle investment, improving efficiency, productivity and reducing their overall transportation and staff costs, providing 100% compliance with government legislation (duty of care) and many more. These functions can be dealt with by either an in-house fleet-management department or an outsourced fleet-management provider.

So what’s so great about that?

This week I ran a quick set of earnings numbers on the PHH Fleet business:

If you average earnings over the last 6 years you get average earnings of $0.83 per share of PHH.

Think about that for a second.  Here you have a business that has shown the ability to earn money consistently, even through what was probably the worst recession of our generation.  What would you value such a business at?  10x earnings?  12x earnings? 15x earnings?

If you start running the numbers at those kind of multiples on the average and peak earnings numbers, you realize pretty quickly that the Fleet business could be worth something pretty close to the current stock price.  Or in other words, when you are buying PHH you are buying the mortgage business for very little.

Moreover, as one would expect, the fleet management business is going to improve along with the economy.  As per last year’s 10-K:

The fleet management industry continues to be impacted by the relative strength of the U.S. economy. As the U.S. economy improves, we expect to see continued improvement in the industry. We believe that improvement in the economic conditions will be reflected in continued growth in our service unit counts.

If I am right about my previous speculation that the US economy is improving, the Fleet business could turn out to be a cash generating machine for PHH.

One last point.  When you see the value that appears to be unrealized in Fleet you have to wonder whether there could be a spin-off of Fleet from the rest of the company at some point.  There was a question on the Q4 conference call that alluded to this possibility.  Management did not deny it, saying only that it wasn`t an appropriate topic for a public forum.  Meanwhile, what better way for a cash strapped company to raise cash then to spinoff a somewhat unrelated business that isn’t being realized at fair value anyways.  For those of you not familiar with spin-offs I would recommend Joel Greenblatts excellent and terribly titled book,  How to be a “Stock Market Genius”.  While there is no guarantee that a spinoff of Fleet will occur, the cards are all aligned.

 Portfolio Composition

Shaking it up

Things weren’t exactly peachy for me this week.  Rarely have I felt more confused about what sectors I should invest in then I do right now.

One of the best gauges of just how divided I am is the number of stocks I have in my portfolio.  This got up to 20 stocks on Thursday this week.

20 stocks is silly.  I’m not running a mutual fund.

Anyways, on Friday I sacrificed a number of these positions to the trading gods.

A sacrifice to the trading gods?

A sacrifice to the trading gods can be anything from selling a few shares of a single company to wiping out a number of positions in a sort of sacrificial blitzkrieg.

When things aren’t going my way and I am feeling confused and disordered, quite possibly the cause of such troubles is that I have upset one of the trading gods.  In such a case, it is necessary to appease these gods by “sacrificing” one or more positions as atonement.

On Friday, in the midst of another crummy looking day, I did just that.

In my actual account I also liquidated Second Wave Petroleum.  I came within a hairs breadth of selling OceanaGold, Golden Minerals and Canaco as well, but I decided to stick with them (for now) because it just feels to me like gold is on the verge of a move up.  There may be a second leg to this sacrifice yet.

So what is this superstition all about?

Well on the one hand the sacrifice is about gods and reconciliation and bowing to the higher power.  You don’t mess with the supernatural.

On the other hand, there is a method to this seeming madness.

Let me tell it like this.  I was listening to Radiolab this week.  Help!   That was the title of the program.  The episode had a story about a young man who had “lost his life to a coin toss”.

What, you say?   Well that was what the reporter that overheard the remark said, and so he set out to track down the poor, life-less man that uttered those words and to find it how it was that a life could be lost by such chance.

As it turned out the young man managed a massage parlor.  It had been his fathers business and he had taken it over.  A number of months (maybe years) before his father had come to him and his brother and told them that one of them had to take over the business.  The father didn’t care which boy took it over, but it had to be one of them, and the boys had to figure out which one would be it for themselves.

Neither of the two brothers was very excited about the prospect.  After sitting on it for a few days, hanging over their heads, finally the one son couldn’t take it any more.  He proposed to his brother that they make a bet on who had the most tea leaves float to the top of their next cup of tea.  The one with the most tea leaves would walk away clean.   The loser would take the business.

Well the bet was made and the tea leave floated.  The brother who lost the bet was despondent at first, but he begrudgingly took his place.  He had to be dragged to the massage parlor for work by his father, and he had to be forced to work on his own father’s feet until he became proficient enough to work on the clients.  At first he hated it, but over time his attitude changed.  Soon he began to like the interaction with people, the sense of performing a service, he felt good about having happy clients with happy feet.  He began to relish his job, coming in weekends and working late nights.  He no longer regretted his decision.

Now here’s the interesting part.   When he was asked about the bet by the report, he replied that it was luck of the draw.  But his brother said something enitrely different.  His brother said he would have never have let that bet decide for him whether he would take over the business or not.  The bet wasn’t going to make the decision for him.

But not so for his brother.  He believed that the bet was never about him anyways, it was always about his brother.  His brother, he says, deep down wanted to manage the massage parlour.  He couldn’t admit to himself, and definitely couldn’t bring himself to admit it to his father.  The tea leaves helped him along, gave him the reason to do what he should do but did not want to come to grips with.

The reporter went back and confronted the brother now running the massage parlor with this theory. He didn’t deny it.  On the one hand he wouldn’t say that he set up the whole gig with the tea leaves just to have an excuse.  Of course not; he couldn’t say that.  But he also wouldn’t deny that the tea leaves had led him to act as he really wanted to act.  “I probably couldn’t have done it without the tea leaves, he says, but once the tea leaves had spoken then I had no other choice.”  The tea leaves made him do what he knew needed to be done.

And that’s why you make sacrifices to the trading gods.

Weekly Trades

Well it remains to be seen how much it helps with my waffle (I was pretty darn close to dumping OGC, AUM and CAN on Friday morning), but I did the work and here are the results.  I used data from the World Gold Council for all the estimates.

Its all about Asia

So the first thing that I was a little surprised by was by just how much India and China mean to the market.  I mean for all practical purposes, India and China are the market.  Take a look:

Maybe this helps explain why when gold keeps getting hammered down intraday here in North America, those moves to the downside can’t gain any traction.  When you think about it, the big, sustainable moves down of late have all come overnight.  The main reason I didn’t include a number of my gold stocks in my sacrificial orgy on Friday was because it seems to me that someone is doing their best to bring gold down, and isn’t having much luck with it.  The outsized influence of China and India on the demand side show why.

The other point to make, just in passing, about the above chart is that Chinese demand is a lot more stable than Indian demand.  If I had to pick out who was at the margin here, I’d have to say it was the Indians.

The jewellery buffer

This second chart isn’t really telling a surprising story. Its just confirming the one we know, and that is that investment demand is driving demand increases.

A couple of more nuisanced comments about the chart.  First, the chart is in tonnes.  So what you say?  Well if jewellery demand is flat in tonnes it is “to the upper right” in dollars.

Look, when you go out and decide to buy a piece of jewellery you don’t say to yourself “well I think I will by a 0.1 oz gold ring.”  You say, “I think I will buy a $300 gold ring”.  The point is that the key metric for understanding jewellery demand is probably not mass.  Its dollars spent.  And if demand in tonnes is flat, then demand in dollars spent is going up pretty substantially.

If you put this together with the previous fact that much of the demand is coming from developing Asia, you are left with the conclusion that there is a rather firm underpinning of jewellery demand brought on by the rising wealth of the Chinese and Indians.  If the gold price ever stalls out for a year, or heaven forbid goes down, I would expect to see a substantial uptick in jewellery demand as those increasing “dollars spent” buy more gold.

I think you can look at jewellery demand as a big old damper.  If prices go up too fast than the dollars spent number isn’t increasing in concert and so you see a reduction in demand from jewellery.  If, on the other hand the price goes down the opposite happens, and jewellery demand puts a floor under price as the same dollars spent buys more tonnage.

Mine supply versus recycled supply

Last chart.  Mine supply.  First thing about mine supply is that all the data is in tonnes and no one I know thinks about the amount of gold a mine produces in tonnes, so this chart is in ounces.

Does anyone else think its kind of wild that there are only 25 million ounces of gold produced every year.  You could basically fit a whole years production of gold into one of those big 500 tonne mining trucks.

Second, supply is growing.  It is growing, but mine supply alone does not match demand.  Mine production was 746 tonnes in the third quarter.  Recycled production was 427 tonnes.  So recycling of gold makes up almost 50% of the total supply.

Again this is all about what is the drive at the margin.  Clearly its the recycled gold that is going to come when gold prices go up and go away when gold prices go back down.  Just as with jewellery demand, this is another great dampening factor.  Somewhat more intriguingly, one has to wonder if a point will be reached where the recycling has run its course, or at least all the easy recycling has been done.  No signs of a drop so far, but one could point out that even with vastly higher gold prices, recycling has been pretty flat for the last couple years.

The release of the Pinson resource produced one of those bizarre situations you happen on in the market from time to time whereby you had a company valued at a price that wasn’t really reflecting anything near the value of the assets in the first place, but on the other hand the value of the assets has disappointed on the downside so clearly the company must be worth less today than it was the day before the news was released.

So the stock goes down and the assets are even less reflected in the price of the stock.  C’est la vie.

Was it that bad?

Lets look at the details.  I don’t think numbers are that bad.  The underground number is still robust, and the open pit number is intriguing.

The reasons for the sell-off is that compared to the previous resource on Pinson (done ages ago in 2007), the numbers were a little disappointing.   Two ways they were disappointing.

The first disappointment

The underground ounces went down.

Now the lost underground ounces are compensated by the gained open pit ounces.  Kind of.  I mean the open pit is a whole other animal.  It needs its own permitting, it needs big yellow trucks, and while the grade is decent (a little over 1 g/t), its not the kind of knock your socks off grade that the underground is.  In fact, I think the open pit was maybe what Barrick was looking to make Pinson attractive to the larger miner.  Just to recap the history with Barrick, and perhaps shed some light on the open pit, here is a short timeline of those events, as presented by sequential Atna MD&A and press releases.

The history of Atna’s official comments about Pinson

Press Release August 8th 2008:  Initial results of PMC resource optimization studies indicate the potential for an open pit concept that could combine the underground resource with un-mined resources remaining in and around four of the historic Pinson mine pits, into a large pit concept… Simultaneous work is being conducted on optimizing underground mine design and economic trade-off studies on the benefits of mining the high grade resource zone by underground methods or proceeding with the project using a large scale open pit concept.

Q2 2008 MD&A:  However some of the remaining MAG pit material is believed to be refractory and may require autoclave or roasting preoxidation to be amenable to conventional cyanidation.

Q2 2009 MDA: PMC recently concluded the expenditure of US$30 million at Pinson to earn its 70 percent equity position. The results of that work are being evaluated to determine the feasibility of development and a future plan for the project. The property has been placed on care and maintenance while the technical study is completed and until a decision is made concerning the future of Pinson. Dewatering of the underground facilities will continue during this decision period to protect the partners’ investment and facilitate re-start, if warranted.

Q3 2009 MDA: Drilling reported by Barrick included a significant number of infill drill holes within the Ogee, the CX-West, the Range Front (and hanging wall splays), and Mag Pit mineral zones. This new information, along with the existing drilling data developed by Atna and prior operators, has been included in PMC’s evaluation of the project’s potential. On the basis of this evaluation, PMC has determined that the open pit potential is not viable. The joint venture is discussing alternatives for the project.   The joint venture has agreed to a property budget that allows for continued dewatering of the underground workings while the technical evaluation is being completed.

Q4 2009 MD&A:  The joint venture is discussing alternatives for the project. These alternatives include the development of high grade gold resources at the property by underground methods. Atna is in discussions to potentially acquire Barrick’s interest in the project and Barrick may be considering this offer, but they may also solicit other offers or they may continue to hold their interest. Atna holds a preemptive right to match any third party offer should Barrick decide to sell their interest. The joint venture has agreed to a property budget that allows for continued dewatering of the underground workings until a final development or divestiture decision has been reached.

Q1 2010 MD&A: In general, the drilling program did not extend any of the known resources significantly. Drilling was suspended in December of 2008. In 2008, underground exploration drifting was re-started with 2,010 feet, of drift excavation completed. The underground excavation contract was terminated in January of 2009. Over 4,000 feet of underground drift and workings have been completed at the site… PMC has completed an in-house review of the project for both underground and open pit mining potential. They are currently reviewing their strategic options in regards to the project, which may include sale of their interest.

Q3 2010 MD&A: PMC has completed an in-house, unpublished review of the Pinson project for both underground and open pit mining potential, but did not develop a project that was immediately attractive to Barrick for development. Atna believes that the underground development potential at Pinson is attractive. As a result, the MVA partners are engaged in an active dialogue concerning the future direction of this project.

It sounds to me like Barrick lost interest in the project when it looked like the open pit was a no go.  Now of course, the open pit was a no go when gold prices were under $1000 per ounce and Barrick was probably using $700-$900 per ounce as its target price for development.

Of course the Pinson open pit is undoubtably viable at these gold prices.  And Atna is anticipating bringing it into the mix.  So its good news that the resource is robust.  It just doesn’t necessarily compensate for the loss in underground ounces… or in grade.

The second disappointment

And that is the second disappointment.  The grade was lower.  What is not completely clear to me fromthe press release is whether the grade was lower because the more recent drilling just outlined lower grades, or because the new grade estimates are taking into account more realistic dilution of grade now that the company has a firmer grasp of the mining methods that will be used.  I have just emailed the company about this (I should have thought of it sooner). Atna vaguely alluded that this might be the case in the press release:

The Block model was divided into five statistically related zones to accommodate statistical search parameters appropriate for individual mineral styles.

But its hard to say what that sentence is saying.  I will update if I get one from the company.

Taking a look at Atna’s most recent presentation, the company has changed its costs at Pinson from (I think) the $700 to $750 per oz range to a wider $700 to $850 per oz range.    That increase in the upper end range is probably reflective of the lower grade, either because of a decrease in the ore grade itself, or an expectation of a higher dilution of that ore through the mining techniques expected to be employed.

When I did my estimates I assumed what I thought was a restrictive dilution of 30%. To refresh, the parameters I used in my analysis were:

• A 15 year mine life, beginning at 350t/d and ramping to 750t/d by year 4.
• Total produced ounces of 940,000 oz over LOM
• 0.4 oz/t resource over the mine life, diluted by 30% with 90% recoveries, resulting in gold production beginning at 50,000 oz and ramping to 75,000 oz.
• Mining costs of $110/t, milling costs of $50/t and G&A costs of $11/t
• Cash costs of $687/oz over LOM

I went back over that analysis and looked at the sensitivity to dilution.  Turns out that Pinson is quite sensitive to that dilutive factor.  You would need to see about 45% dilution at my original grade of 0.4 oz/t to get up to $850 per ounce costs (these are the $2100 per oz gold price estimates.  I used the high end number so that I could see just how big the differences in dilution could amount to in terms of NPV):

You could run the same sort of sensitivity with grade and you’d get about the same thing.  Dilution and grade are really two sides of the same coin; the outcome of the two combined is the actual grade of the rock being mined and processed.

Its all academic

So you can run the numbers and get an idea of the sensitivity to grade and dilution and of how the change in reserves affects the present value.  That’s nice.  But in the end what’s it come to?

Sometimes you have to step back and look at what you got instead of focusing on the details.  Pinson is probably worth at least double Atna’s current enterprise value (about $125M).  You add onto that the value of Briggs, of Reward, and of Columbia, and they are probably worth at least the enterprise value themselves.  Put that together and it seems rather stupid to be talking pennies about whether Pinson has gone up or down 10-15%.

Bottomline: Atna remains the best opportunity in the gold space over the next year, in my opinion.

I noted last week that Canaccord Capital has said that they expected the soon to be released NI 43-101 report to show 2.3 Moz at around 3 g/t.

I thought it would be an interesting project to come up with my own estimate.  So that’s what I did.  As you will read, I had some difficulties, was left with a big question mark, but learned a lot along the way that will help me evaluate Canaco and Magambazi going forward.

But first a bit about Canaco

While Canaco has fallen rather dramatically over the last year, the still stock commands a rather large enterprise value for an company exploration company.

Even after subtracting the current cash on hand of $115M, the stock still sports a valuation of $200M.  For $200M you need to be getting a lot of gold to make the upside worthwhile.

The gold is at Magambazi

Canaco is a one trick pony and that one trick is Magambazi.  Magambazi is in the eastern part of Tanzania.

There has been a lot of gold found in Tanzania but it is all in the northwest.  There has been almost no historical exploration in the eastern part of Tanzania.  That is because the geological intrepretation was that the Sukumaland Corridor, which is the belt that holds all of the gold on Tanzania, extended only to the western part of the country.  In 2007 this changed, and academic research began to reinterpret the geology as extending much further to the east.  It was around this time that Canaco stake claims around Handeni, and soon after that they returned their “discovery hole” at Magambazi of 53m of 4.32 g/t.

The deposit

The Magambazi deposit consists of a number of zones, or what the company calls lodes, that run any where from a few hundred metres to a kilometre along strike.

The most prominent of the lodes is the Main lode.  The Main lode hosts the original discovery and also a number of other impressive intercepts with rather eye-popping numbers.

When you look at these drill intercepts your first reaction is that there must be a massive amount of gold here. Numbers like 48 metres of almost 15 g/t are extremely high numbers.  The problem that I have found in the course of my evaluation, and perhaps this is why the stock has done so poorly over last year, is that the gold is erratic.  More often than not, that long high grade intercept will be right next to a much shorter or much lower grade intercept, suggesting a quick pinch off, or even to a barren hole entirely, suggesting a fault line that ended the mineralization.

The numerous faults present in and around the deposit make any evaluation complicated.  They create sudden start and stops to the mineralization that are difficult to pin-point exactly without dense drilling.  I have to wonder how this will affect the Ni 43-101 that is going to come out in a few months?  Will the evaluator be forced to make conservative assumptions with respect to where mineralization begins and ends?

The deposit also has a number of very quickly narrowing finger like strands.  These also make it difficult to evaluate without a lot of drill holes. Take for example the following section from the company’s presentation.  In particular, focus on hole 265.  Here is one of those fairly monster like holes, grading a little over 3 g/t over 56m.  But notice hole 6, only a few meters away.  The mineralization goes from robust to not even reported in the presentation very quickly.

Another example of the same sort of quick pinch out can be seen from hole 134. Taken alone, at 34m of 2g/t, you would think that it has discovered another lode comparable to the main lode.  But 225 quickly demonstrates that the lode pinches out quick to the east, and 220 shows that the lode ends abruptly due to a fault to the west.  The overall ounces present in such a lode are not as impressive as the single intercept would suggest.

The point here is that you simply can’t take a bunch of drill intercepts and extrapolate the robustness of the deposit.  You probably shouldn’t do that in general and you definitely can’t do that with Magambazi.  You really have to look at it in detail and make out what the actual orientation is.  So that is what I did.

The Power of Corebox

Corebox.net is a website that hosts a powerful and rather surprisingly free tool to help you evaluate mineral deposits.  The tool holds a database of drill results for more than 100 different deposits.  It displays those drill results in 3-d form, making it really quite simple to look at each cross section individually and evaluate continuity, overburden, etc.

The Magambazi project is on Corebox.  This greatly simplified my work.  Its a very empowering (dangerous?) tool because it lets you attempt evaluate a deposit to a degree that you would otherwise only be able to guess at.  I have tried to do this sort of work before on other projects where I didn’t have Corebox.  There isn’t a great way to graphically display the angles correctly, so in the past I ended up using a crude approach whereby I summed up lengths and multiplied by what the total width of the end holes were.  This isn’t very accurate.  Corebox eliminates the need for such simplifying assumptions.  It also gives you the great advantage of being able to visualize where the deposit is with respect to topography.

My Process

Evaluating a deposit is time consuming, getting the information is a struggle, but overall it is not a complicated process.  Basically I had to go through the following steps.

1. Determine a volume of the deposit.  You do this by simply figuring out the length x width x height of the ore bearing gold
2. Use the volume to determine a mass of the deposit.  Mass is simply volume multiplied by density (or specific gravity)
3. Make an estimate of the average grade of the deposit and multiply that by the mass to determine the amount of gold in-situ
4. Convert the grade from grams to ounces and you are done

Step 1: Determining the Volume

This is the step where corebox really helps out.  Canaco has drilled the Magambazi deposit at 40m spacing.  The birds-eye view of this drilling is shown below.

With corebox you can look at each of these cross sections and try to deliniate the deposit.

How did I do that?

First I used the Microsoft program Snipit to snip the screen shot of the section.  So I got something like this:

Next I had to find a program that would allow me to draw the deposit in free form around the drill holes but (and here is the tricky part) then tell me what the area of the resultant irregular polygon was.  This proved to be difficult to find.  The first program I used was a app on the web called SketchandCalc.  It worked fine, you can import the image, you draw your shape and it calculates the area and as long as you have a reference block on your image of known area you can scale that block to determine the actual area of your shape.  With a section like the above one, the reference block is the 130m x 130m grid block so you just sketch deposit, record the area and scale appropriately.

I probably would have stuck with SketchandCalc but I ran into some problems with my results not being quite what I expected (more on this later).  This led me to question the validity of the area being calculated by the program.  I went out searching for a second program to use as verificiation.  As it is, it turned out to be rather fortuitous because one thing SketchandCalc doesn’t let you do is save the sketches so you have no record of your work.  After much searching (there is truly a dearth of programs available on the web for calculating area) and many failed attempted to determine the area using Powerpoint (you can’t do it), I figured out that another Microsoft program, Visio, works extremely well for the task.  By the way, it turned out that there was nothing wrong with the calculations by SketchandCalc, my Visio results matched up well to my original SketchandCalc work.

My Visio sections

Its really easy to draw and get the area of a section in Visio.  You just have to do the following:

1. Import the screen capture of the cross section into Visio
2. Draw out the shape of the deposit to align with the intercepts
3. Under the tools add-ons there is a Visio Extra that allows you to calculate the area and perimeter of an irregular polygon.  Use this to get the area of the shape and of the reference block

What you end up with (for example with section 200 that I showed above) is something like this:

What a Orogenic deposit should look like

So clearly there is some interpretation going on here.  And I am not a geologist so you do have to take my personal interpretation of the deposit with a grain of salt.  With that said, before drawing out a bunch of squiggly envelopes I did do some research into the type of deposit at Magambazi to get a better idea of how one might expect the gold to be disseminated.

Of particular help was a fellow named D.I Groves.  Groves is referenced numerous times in the 43-101 and I think it is fair to call him an expert on deposits of the Magambazi type.  Magambazi is a Orogenic gold deposit.  An orogenic gold deposit is a type of mesothermal deposit, which means a deposit that was created by the influx of water from deep in the earth’s crust that has been heated and risen through cracks and fissures, taking some gold along with it.  Where this water find “traps”, meaning non-porous barriers that prevent it from rising further, it stops, and over time the water dissipates leaving behind the minerals it carries.

It used to be (and maybe still is in some circles) that all mesothermal deposits were called mesothermal deposits, but Groves wrote a few papers on the subject arguing that these deposits should be further categorized based on a bunch of technical geological attributes that aren’t really that important to what I am trying to accomplish.  One such deposit type was named an Orogenic deposit, and the term must have stuck because in the NI 43-101 filed on Sedar by Canaco, the deposit is referred to as being of the orogenic variety.

Most importantly to what I am trying to accomplish is that Groves provided some descriptions and a few useful pictures about the specific nature of an orogenic deposit, how it evolves and thus how one might expect the gold to be deposited.  One such picture is shown below.

What you would expect to see at Magambazi is a number of thick, organ like veins with small branches jutting up from the deeper sources.  This is exactly what you get in Canaco’s own interpretation as illustrated in a couple of the cross-sections they make available in their February presentation.   At Magambazi there is the added complexity of vertical faults along strike throughout the deposit, resulting in sudden terminations and offsetting of the mineralization.

For reference, the interpretation I used for these same two sections are below:

With Section 280 (on the left in both pictures) you can see a few spots where corebox wasn’t perfect; where the complete drill result wasn’t shown in the cross section.  I was careful about this, and whereever there was a discontinuity where it didn’t seem there should be one I checked the actual drill results against what corebox was showing to make sure corebox didn’t miss one of the shorter or lower grade intercepts (in a few cases it did).

Overall though it did a nice job.

There were 25 sections in the deposit spaced 40m apart.  I basically spent my lunch hours last week drawing funny looking shapes in Visio (and/or SketchandCalc) for each one of these sections.  I have a link to my visio sections here.

Because I am not trying to be excessively detailed, to compute a volume I made the simplifying assumption that each cross section was valid for a 20m strike in each direction, meaning that each cross section represented 40m of the deposit.  Volume was therefore calculated by multiplying each cross section by 40m.

Organizing the intercepts and getting an average grade

The other tedious task was taking the long list of drill intercepts and determining which cross section each belonged to.  Canaco provides a list of all the drill intercepts here.  Basically I took the PDF file and turn it into an excel file (something that turned out to be more complicated then it should have been), and then went to each of thecross sections, found all the intercepts that lay within that cross section and grouped those intercepts together.

Now if I had been doing the analysis with the detail of an actual report I probably would have broken up each cross sectional volume up into smaller blocks, determine the average grade in each block and then determined that amount of gold in each block discretely.  But that is too much work.  Instead I made the simplifying assumption that the average grade in each cross section is constant throughout the section.  I determined the average grade per section by summing up the length weighted grade of each intercept and then dividing by the total length.

I have a spreadsheet that I have tried to make available here with the data.

I calculated the overall average grade for the deposit as a whole as being 3.66 g/t.

Figuring out the density

As it turns out, determining the density is was BY FAR the hardest part of the process.

The density that we are interested in is the density of the rock that immediately hosts the gold mineralization.   The density is typically defined in terms of specific gravity, which is the ratio of the density of rock to the density of water.  I have exhaustively researched what to use as thespecific gravity (also sometimes referred to as bulk density) and to be honest, I’m just not sure.  This is a real sticking point and what it means is that I can’t report my results as a single estimate.  Instead I’lll have to give a range of ounces depending on the specific gravity assumed and we’ll just have to see how it turns out when the actual resource comes out.

My initial assumption was that the density was simply the density of quartz, or maybe a little bit more.  Quartz has a density of 2.6.  According to the initial NI 43-101 put out by Canaco (Page 8):

In situ gold is spatially associated with quartz vein zones within silica and garnet altered amphibolite gneiss. Mineralization is commonly associated with arsenopyrite (possibly also loellingite), pyrrhotite and graphite. Visible gold is commonly present in drillcore.

And then later on, talking specifically about the Magambazi zone (Page 9):

Gold is spatially related to quartz veins within silica and garnet altered amphibolite.

So its quartz.  Plug in 2.6 and its end of story right?

Wrong.  Or at least I think so.  The problem is that if I use 2.6 as my density I don’t get anywhere near as many ounces as I should.  A specific gravity of 2.6 gives me a little over 1,000,000 oz of gold.

This is where the real work began.  As I mentioned early, the first thing I thought was that there must be something wrong with my cross-sections.  Enter visio and a rigorous re-evaluation of each intercept (sometimes 3 times!).  Eventually I was satisfied that my original cross-sectional estimates were fine, and that this wasn’t the problem.  Next I thought I might be using the wrong spacing.  Was it 80m (my number was about 1/2 of what I would have expected).  But no, its not, the spacing is 40m.  I also checked all my units (intercepts are recorded in metric, gold is reported in grams per metric tonne, specific gravity is in tonnes/m3) so no that’s not it either.

The only parameter I am left with uncertainty about is the specific gravity.

My theory is that the gold is hosted in a quartz that has a lot of heavier pyrite (basically iron sulphide) in it.  Maybe its even all pyrite.  There is some evidence that leads me to this.

First of all from the NI 43-101:

Page 42: Mineralization is characterized as vein‐related structurally‐controlled orogenic gold associated with pyrrhotite, arsenopyrite, and locally graphite

Page 100: Mineralized zones at Magambazi and Magambazi North are distinctively mineralized with pyrrhotite and arsenopyrite, with graphite and chalcopyrite present locally. Additionally, graphite appears present in significant quantities related to major fault structures.

And second of all, from the original discovery press release:

The 293 metre drill hole (MGZD 001) has intersected a broad, intense alteration zone and sulphide mineralization (pyrrhotite, arsenopyrite, pyrite and chalcopyrite) with trace amounts of visible gold in eight separate metre intervals

Pyrrhotite, arsenopyrite and pyrite all have much higher specific gravities then quartz.

Therefore if the rock has a significant amount of pyrite in it, the specific gravity would be higher, which would help to raise the ounces to an amount more consistent with the Canaccord estimate.   I scoured the net looking at the NI 43-101 of other projects that appeared to have the gold hosted in pyrite.  Unfortunately I wasn’t able to find a single instance where the vein was not dominated by quartz and thus where the specific gravity was significantly higher than 2.6.

Finally I emailed the company and asked them if they would tell me what sort of specific gravity to expect.  Unfortunately they wouldn’t give me a number but they did say:

We don’t have an exact number yet for the specific gravity of the rock but it’s hard silicified material, so likely a higher density than your average mineralized system.

Exactly how much higher remains an open question.

Summing up the resource

I’ve already mentioned the spreadsheet that I built to sum up the resource.  Basically all I did was take the volume for each individual section and convert that volume into a mass using the specific gravity of the rock (in this case 3 scenarios with a range of specific gravity’s between 3 and 5).  Once I had the mass, I multiplied that mass by average grade of gold in that section (as determined by by weighted averaging) and then converted that gold from grams to ounces.

What I ended up was the following:

All 3 of these estimates are lower than I would have expected.  To be honest, I’m not sure what to make of that.  I don’t know how much I trust my own work given the uncertainty with specific gravity and obviously the low-tech tools I am using.  But before I draw any conclusions about the results, I want to talk for a second about some of the potential sources of error.

Sources of error

Even my high specific gravity estimate is on the low side of the estimate provided by Canaccord (they estimated 2.2Moz).  I suspect the actual specific gravity is closer to 4, which would mean that my estimate is really quite a bit on the low side.  I am of the opinion that Canaccord probably knows more than I do, so I am pretty sure there is something being under-estimated by mine.  With that in mind there are a few other potential sources of error in the calculationsthat could be responsible for the discrepancy.

First, as I mentioned already, there is a lot of interpretation involved here, and perhaps with Visio I was making the connections between drill holes too narrow or too short.   I do admit that I was consciously erring on the side of conservativeness when I drew out each section, though I didn’t think that doing so would have such an effect.  I played around with this a bit to see how sensitive the resource is to changing the cross sections.  Its actually not that much, not unless you start getting really creative and adding mineralization where there clearly isn’t any.  If you are just tweaking the known areas to make them a bit bigger, you might be able to add 200,000 oz but you would have trouble adding more.  My conclusion is that this can’t be the only issue.

A second potential source of error is that the high grade intercepts are surrounded by a low grade halo of gold.  Canaco didn’t report the low grade numbers in their press releases or in the 43-101 so its really difficult to get a handle on their significance.  The 43-101 did have this to say about the low grade:

What is apparent from sectional review is that significant gold is present outside of acknowledged ‘main zones’ of mineralization, or key intercepts as documented, and the mineralization system is in areas, seemingly pervasive. While separate internal gold intercepts exist that would be considered high‐grade in terms of underground mining assessment, the overall type of mineralization can be difficult to quantify, and requires assessment as a potential pitable target.

If you look at the cross sections Canaco provides you get an idea of how significant the low grade is.  The halo is the light red areas.

Based on what the 43-101 says, I think the halo likely has a grade of aroud 0.3g/t.  Perhaps if you add this up over the entire strike of the deposit you might get another 500,000 oz, which would put you more inline with what Canaccord is estimating.

A third source of potential error is that corebox isn’t scaling correctly.  I tried to verify this by taking a number of intercepts and measuring the depth of the intercept versus the length, and seeing whether the ratio was correct.  In all the cases that I tested it matched up.  But that does not preclude the possibility that some of the cross-sections I used to estimate area had error.

What other conclusions can you draw?

Aside from the resource number, I can draw some other qualitative conclusions about the Magambazi deposit.

1. This is not evenly disseminated gold.

The point here is that with an open pit project it is going to be difficult to maintain a consistent mill feed.  The project dips from north to south, with the north being the closest to surface.  Unfortunately the north has the lowest grades and the shortest intercepts.  If you look at the deposit section by section, the northern most third of the deposit has on average 16,000 oz of gold per 40m width.  This compares to 49,000 oz per 40m in the central part of the deposit and 70,000 oz per 40m in the southern part.  Its not a uniform deposit and the deepest part of the deposit is the most economical.

2. The strip ratio is going to be pretty high

I didn’t calculate the strip ratio but it is clear from looking at the cross sections such as the one’s I have highlighted above that much of the gold is deep and vertically oriented, which is going to mean that you have to move a lot of waste to get to it.  The ore at the northern end of the deposit is near the surface, but towards the central and especially southern portions that deposit deepens significantyl. To give just a couple of examples, taken from the company’s own cross sections:

You can see just how much waste lies above the gold.

3. The widths and grades of mineralization vary significantly

Perhaps one of the reasons that I struggled to match my estimate to Canaccord was because the mineralization changes so suddenly.  While stepping through the deposit I found again and again the situation where a long, high grade intercept was offset by a shorter or much lower grade intercept.  This has a consquence for the eventual mining operation of course but it also has a consequence for the upcoming Ni 43-101.  There is certainly some wiggle room for the evaluators to mark up or down the resource depending on the interpretation they use.  It’s not necessarily a good or bad so much as a risk.

What am I going to do?

At the end of the day I do this sort of analysis and it really comes down to a decision of whether I am still going  to hold the stock or whether I am going to sell it.  At the price level that Canaco is currently at I am inclined to hold.  I would be reluctant to buy much more though.

As Steve T pointed out in one of his comments the other day, you really are holding a stock like Canaco for the potential that they can grow the deposit beyond its current size.  At its current market capitalization I would say that the company is probably fairly valued for the resource it currently has, but there is certainly upside potential as the resource expands.  Management gave a good presentation on the potential of the land package around Magambazi at the Denver gold conference this year.  There are plenty other anomolies around Magambazi that are left to be explored, these anomalies are virtually untested historically, and because of the high levels of pyrite associated with the gold they are easy to detect through surveys.  I wouldn’t be surprised to see more success from Canaco as they expand the envelope that they explore.  So I will continue to hold my position on that speculation.