DIAMOND SPECIAL — Assessing the value of an exploration

Attempts to value exploration properties prior to the actual discovery of a mineral deposit are highly subjective exercises. The foremost problem is to assess the probability that a particular area does offer the potential for diamond deposits to occur.

There is no better measure of the prospectivity of an area than the existence of known discoveries in the region. The announcement of the Dia Met/BHP discovery in September, 1991, at Point Lake suddenly turned the surrounding area from proverbial “moose pasture” into highly attractive real estate.

To illustrate the risk/reward profile of a diamond exploration venture as it progresses through its various phases, it is useful to first estimate the dollar amounts of expenditure that may be required to reach each critical stage and what the ultimate value of a successful discovery may be. To give an example, it could be assumed that a party holds a particular 100,000-acre claim block of notionally prospective land in the Northwest Territories. This land is subject to the first phase of “grass-roots” exploration. Taking account of the minimum work commitment required to retain the property and a work program that may yield targets representing mineralized kimberlites, a minimum expenditure of US$1 million could be contemplated.

For the argument developed here, the probability of taking a “grassroots” property through to the confirmation of a kimberlite is estimated at around 1,000 to 1.

From the point of discovery of a kimberlite, the probability that an economic ore deposit exists on the claim block obviously increases significantly, but the level of expenditure required to determine if the body is potentially economic (remembering that only a small proportion of kimberlites contain economic concentrations of diamonds) will require substantially higher levels of expenditure, in the range US$10-25 million per pipe. This phase would require work to determine the size, shape and the grade of the body and a preliminary estimate of the value of the diamonds.

Assuming successful progress, proving of the ore reserves and feasibility studies would then be required to determine the economics of developing the property and to allow the decision to proceed with mine development to be made. These are critical decision points.

To reach the decision to mine may involve total expenditure in the order of US$50 million. In addition, exploration will continue in the area of interest. Actual construction costs for the mine, processing plant and associated infrastructure for a large diamond mine may involve expenditure of US$500 million-US$1 billion. The timeframe for the development of a property, assuming successful exploration and a fast-tracked evaluation and development, could be five years.

The ultimate objective for any large mining house participating in the Northwest Territories is to prove the existence of a “world-class” diamond deposit, which supports a “bankable” feasibility study and could have a net present value in excess of US$1 billion.

Participants in an exploration joint venture, when structuring a deal, should recognize these critical decision points. There are increasing magnitudes of expenditure required to reach each stage together with the “step-wise” increase in probability that a mine will be developed as the exploration and evaluation work successfully progresses.

When these factors are put into the context of a typical joint farm-in, the original stake holder or the party farming-out, if not contributing, could have its equity rapidly diluted. Similarly, if the company farming-in offers a too generous “carry” to those farming-out, they may find themselves with an interest in a project that has potentially unsatisfactory economic returns. High gross overriding royalties could also render a project uneconomic. When dealing with the increasing levels of expenditure (or increases in property valuation) as exploration achieves each new threshold of success, the changes that occur do so by orders of magnitude.

To model this risk/reward relationship graphically therefore requires logarithmic scales to describe the changes in both the dollar variable and the probability factor. There is a straight-line relationship between the two variables when plotted on a log-log graph.

This direct correlation between cumulative exploration/

evaluation/development expenditure and the probability that a property will develop into a mine would have discontinuities (or steps or plateaux) at the various decision points.

Taking a simplistic example, it requires about US$1,000 to collect, process and interpret an indicator mineral sample from one site. If the geologist was extremely fortuitous (perhaps by throwing a dart at the Slave province) and his one sample resulted in the discovery of a diamond mine with a net present value of US$1 billion, his leverage would of course be a million to one. More realistically, taking a hypothetical grass-roots exploration program with a budget of US$1 million (1,000 samples at US$1,000 per sample) investigating an area of 100,000 acres, our estimate of leverage, which could be equated with the probability of success, is 1,000 to 1.

The underlying assumption in the probability estimate is that somewhere on the 100,000-acre block there is an economic kimberlite to be found. However, a purely random search (with no geological optimization) would require an expenditure of US$1 billion to be certain of locating the deposit. It can be seen that the success of scientifically based, systematic exploration is measured and rewarded by how quickly the probability of discovery is increased. The sunk cost of exploration can be repaid many times when the positive cash flows come from turning a discovery into a successful mine.

— From notes prepared by Ashton Mining of Melbourne, Australia.