A Seasoned Explorer of Mongolia
We are initiating coverage of Erdene Resource Development Corporation with a speculative buy rating and a target price of 1.3 Canadian dollars. Our investment summary is as follows:
One of the largest molybdenum deposits in Asia (Zuun Mod) with a mining license, next to the world’s largest molybdenum market. Depending on the outlook for molybdenum prices, the deposit could be developed in 2014, and production could start in 2015.
A coking coal project in Nova Scotia (Donkin) with a completed pre-feasibility study. The feasibility study hasn’t been completed yet, but we believe that Erdene’s interest in the Donkin Coal Project could potentially be worth more than the current valuation of the company.
Upside potential at Altan Nar. Erdene initiated a 3,300-meter drilling program in November, 2011 at Altan Nar. The assay results of the program have confirmed anomalous gold and silver mineralization (some highly anomalous) in 15 of the 24 drill holes. Further exploration work is planned for the second quarter of 2012.
Construction aggregate and kaolin projects in the US. Erdene has royalty interest in a construction aggregate project, and majority interest in a specialty kaolin producer. The aggregate project commenced production this month.
Other prospective areas. Besides Altan Nar, there are a number of prospective areas for gold and base metals in the area surrounding Altan Nar, and for molybdenum and copper in the area north of Zuun Mod (Khuvyn Khar) where further exploration work will be conducted in 2012.
A seasoned explorer of Mongolia. Erdene’s management has been in Mongolia since 1997; they collectively have 30 years of experience in the country. We believe that such experience counts.
Industry Overview
Outlook for 2012
A lot has been written about the spectacular potential of Mongolia’s resource industry—the extraordinary demand from China, a government that is generally supportive of the industry, an industry that is transforming the economy, and a country that is the “last frontier of mineral exploration.” While much of this will remain true in 2012, the new year is likely to be a more challenging year for natural resources companies in Mongolia than 2010 or 2011. Equity market volatility will likely continue. The Eurozone debt crisis is far from resolved, and China is showing signs of a slowdown. With the risk of a global slowdown, we are certainly cautious about commodities prices. More close to home, the Parliamentary election, which usually brings out the radical elements of Mongolian politics, will dominate the headlines.
2012 will be an important year to the development of Mongolia’s resource industry. This year, Oyu Tolgoi is expected to start production, and complete the construction of its processing plants. Moreover, Tavan Tolgoi’s path of development will likely be decided this year. The current plan is to sign an investment agreement with a consortium of companies to develop the West Tsankhi part of the deposit, and to hire a mining contractor to develop the East Tsankhi part of the deposit with funds raised through an IPO. B. Enebish, the director of Erdene Mongolia has told Reuters that Erdenes Tavan Tolgoi will push for an IPO in May, 2012. However, the investment agreement, and therefore the IPO, could again be delayed due to the approaching election.
The Junior Exploration Business in Mongolia
Much like the resources industry of the rest of the world, there are generally two types of natural resources companies in Mongolia. First, there are the mining companies: the producers, or soon-to-be producers like Rio Tinto, and Mongolian Mining Corporation. Second, there are companies whose core competency is not in mining, but in exploration. These are called “junior exploration” companies, and they (and their investors) take on a completely different set of risks than the mining companies.
Orebodies, which are, by definition, economic to mine, are tiny relative to size of the exploration field. Thus finding economic deposits, even ones like Oyu Tolgoi, is not a straightforward matter. Luck plays a huge part. However, a lot also depends on the knowledge and the experience of the exploration geologist. A few geologists that we consulted have expressed that, for some junior exploration companies, their limited success has been partly due to (1) their lack of persistence, and (2) the fact that Mongolian geology might be different from the environment their geologists are familiar with.
Correctly interpreting the exploration survey and assay results— and thus knowing where to drill—is important. A junior exploration company must spend its limited exploration dollars wisely. A part of our valuation of Erdene is reflective of our confidence in Erdene’s geological team. The following is a list of exploration companies operating in Mongolia (note that this list isn’t exhaustive, and that it excludes oil & gas exploration companies):
We hardly need to mention that these exploration companies are either from Australia or Canada. In Canada alone, junior exploration companies number in the thousands.
A junior exploration company’s wish is to find the next Oyu Tolgoi
or Tavan Tolgoi. However, such deposits are rare, and very few companies will find them. In fact, most exploration projects usually turn out nothing—hence the “speculative” in almost any rating we would give to junior exploration companies.
Once a junior exploration company has made a significant discovery, the strategy often is to either bring in a mining company, which has capital and the technical expertise, in a joint venture, or to sell the project to the mining company. Sometimes, the mining company will acquire a controlling interest in the junior exploration company. Recent examples of this include Banpu’s acquisition of Hunnu Coal, Mongolian Mining Corporation’s acquisition of QGX, and Rio Tinto’s acquisition of a controlling interest in Ivanhoe Mines.
Company Overview
As the name of the company also suggests, Erdene first started in Mongolia. The company started acquiring exploration licenses in 2002, although some members of the management has been coming to Mongolia since 1997. Erdene completed its IPO in March of 2004, and subsequently listed on the Toronto Stock Exchange in 2005. In 2005, the company acquired Gallant Minerals Mongolia Limited, along with its license portfolio, which included Zuun Mod. In 2006, Erdene acquired Kaoclay Resources, which held interests in three North American projects.
The fact that Erdene has unrelated projects in two different parts of the world (North America and Mongolia) has, we believe, led to a situation where many Canadian investors value Erdene largely based on its properties in Canada (while undervaluing or not paying attention to its Mongolian properties), and vice-versa for Mongolian investors. We believe that Erdene is undervalued partly because of this reason.
Erdene operates in Mongolia through its wholly-owned local subsidiary, Erdene Mongol LLC.
Partnership with Xstrata
In 2006, Erdene and Xstrata signed a Strategic Alliance agreement to develop coal projects in Mongolia. Under the agreement, Xstrata fully funded Erdene’s coal exploration program, with the right to earn a 75% interest in any coal project by fully funding to completion a feasibility study. Moreover, in accordance with the agreement, Xstrata has the right to appoint a board member to Erdene’s Board of Directors whilst it holds more than 5% interest in Erdene, as it currently does.
Being one of the largest coal producers in the world, Xstrata’s interest is in operating a large coal project in Mongolia. Xstrata was one of the companies that bid to develop Tavan Tolgoi’s West Tsankhi. While officially-confirmed winning bids are yet to be announced (the National Security Council and the Parliament have to give their approvals), Xstrata was not on the list of investors that “won” the bid as announced by the Government in the summer of 2011.
As part of their Strategic Alliance agreement, Erdene explored a number of areas that had potential for large metallurgical coal deposits. However, no deposit of sufficient size and quality has been identified to date that meets Xstrata’s requirements.
Erdene and Xstrata co-own a coking and thermal coal deposit in Nova Scotia, Canada, where Xstrata is operator (see below). According to management, there is no expectation that Xstrata will acquire additional shares in Erdene at this time.
Major Shareholders
Key Projects
Zuun Mod (Mongolia): Molybdenum and Copper Zuun Mod is a large molybdenum and copper deposit located next to a Gobi oasis (hence the name Zuun Mod or “Hundred Trees”), 200 km north of the Chinese border point and railhead of Ceke. Zuun Mod was granted a mining license in May, 2011. Canadian National Instrument 43-101 compliant resource estimates were completed by Minarco MineConsult (an Australian independent third party), and announced in June, 2011:
These resources have been defined in an area known as the “South Corridor,” which is 3.6 km in length, and is made up of three deposits: Racetrack South, Racetrack North, and Stockwork. South Corridor itself is only a part of a larger system.
Pre-feasibility level studies—pit optimization, metallurgical testing, an environmental impact study, and hydrogeological studies—are currently being conducted for Zuun Mod. According to management, development of the project could take place in 2014, and production could start in 2015.
The value and the development of Zuun Mod will depend crucially on molybdenum prices. A pre-feasibility study will give us a better indication of at what range of prices the deposit is economic.
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