Global exploration in changing market conditions

Excerpts from a presentation given by Eric Finlayson, Rio Tinto’s head of exploration, at the Mines and Money 2008 Conference, held in the United Kingdom in December 2008.

Sustainable development is a powerful economic concept that acknowledges our fundamental human right to potable water, adequate food, shelter, personal safety and access to medical care. It recognises that supply of these basic entitlements is the foundation of the economy, that an expanding population requires that the economy grows and that ongoing improvement in the quality of life should be an aspiration of society. It also clearly recognises that for an economy to be sustainable, it must cause no degradation in the Earth systems providing the supply.
While most minerals are non-renewable on a human timescale, the sustainability of mining is – paradoxically – far less problematic than that of industries exploiting renewables such as water, marine fisheries and forests. That this is the case is a fortunate consequence of combining Earth’s enormous geological endowment with rapid improvements in mining technology and mineral processing.
So, what demands does a growing global economy place upon the mining industry?

Mineral consumption and GDP
Rio Tinto has assessed that the demand for our products will roughly double over the next fifteen years.
The impact of China on mineral consumption has obviously been profound. China is now the world’s largest consumer of iron ore, steel, coal, aluminium, copper and nickel. And it is both industrialisation of the economy and urbanisation of the rural population that is underpinning this demand.
While there has been a deceleration in Chinese GDP growth… we expect strong Chinese growth to continue despite the challenges in the global economy.

Role of exploration in the mining industry
How can the mining industry grow the supply? Exploration is clearly part of the answer.
While exploration and mining are inter-dependent - one does not exist without the other - each activity in itself can create or destroy value for a company. Exploration for the majority of mining companies is likely a value-destroying pursuit.
Given the economic risk attached to exploration, a perennial debate in the mining industry is whether it is better for a company to discover its own resources or to acquire resources discovered by others. The position taken on this issue by Rio Tinto is that both discovery and acquisition can add value. However, discipline is required in both areas to ensure that value is actually delivered.
So why not just acquire? Why bother with exploration? Well, to use a soccer analogy, a player who can kick with both feet has more options for scoring goals. Exploration and acquisition - for those who have the skills - are complementary avenues for growth.

Geological context for exploration
While there is a common public perception that global mineral resources are finite, this argument only applies to the shallower and higher-grade mineral deposits that are currently economic. There are of course deeper high-grade resources that await future exploitation. There is also a near-infinite volume of low-grade material that grades ultimately into common rock.
Recognising that the world is actually not resource constrained, exploration is not so much about simply finding more mineralisation as it is about identifying higher-quality mineral deposits that deliver real economic value. And it is the failure to recognise this distinction - particularly in the irrational exuberance of a bull market - that leads some unsophisticated investors to invest in worthless companies and some reckless acquirers to purchase worthless deposits.
Now while all boats float on a rising tide, it is at difficult times like these that quality of assets really starts to count. Highcost producers start hitting rough seas and their investors take to the lifeboats. Closure of capacity is the inevitable outcome of this industrial natural selection.

Impact of the financial crisis
The financial crisis has also exposed fundamental differences between the majors and juniors. They occupy different investment niches and are valued in quite different ways. And we can illustrate the difference using the indices charted here.
When the economic going gets really tough, the market's time horizon shrinks to the here-and-now. Future potential becomes an irrelevance and its value is discounted to zero.
This of course has particular significance for the junior exploration sector - which, in the absence of operational cash flows or committed mine developments - is valued through the speculative future potential of earlier-stage opportunities.
The TSX Venture Exchange Composite Index - perhaps the single most important indicator of the state of the junior community - has been returned to 2001 levels. And in the absence of optimism about the future, the carnage has been unselective - with credible companies owning attractive exploration projects falling as hard as the market miners.
The majors and mid-tiers - represented by the HSBC Global Mining Index - provide an interesting comparison. While stocks have been hit hard by the financial crisis, the Index still shows a 100 per cent gain over the seven year period. This reflects discounted cash flow methodology applied to expanded or committed production. While exploration is currently worth zero in the eyes of the market as it has no immediate cash flow potential, under more normal economic circumstances exploration is valued differently between the major and junior sectors.
An exploration portfolio within a junior company is directly accessible to the market. The same portfolio within a major company is a much less visible and less tradeable asset. This isolation from speculative activity means that the value of the major’s portfolio - relative to the equivalent junior portfolio - is deeply discounted by the market.

Global exploration expenditures
What impact will the financial crisis have on global exploration activity?
While record expenditures are projected for 2008, we have now crossed the peak of the cycle. Cash conservation for both majors and juniors will mean a decline in 2009 spend. And the slowdown is already apparent. For the first time in almost five years, we are now seeing drill rigs, geologists and engineering firms becoming readily available for hire. And this demand slump will end the cost inflation that has heavily impacted the exploration sector.

Reduced appetite for sovereign risk
There is another inevitable impact of any financial downturn. Without the unbridled optimism of a commodity bull market, the appetite of investors for the more challenging jurisdictions tends to rapidly diminish. And we hear talk of “OECD premiums” for companies with First World assets. And while resource nationalism, corruption and unstable investment frameworks are real issues in certain countries, exploring in these environments requires a longer-term view on the likelihood for significant improvement.

RTX discoveries
So what is the attraction of the developing world?
More than 60 per cent of our Tier 1 discoveries have come from emerging countries. Yet our exploration spend until the mid-nineties was heavily weighted towards the OECD.
What this observation tells us is that prospectivity varies with political geography. And the biggest bang for our buck is in the developing world.
Mineral deposit discovery rates are diminishing in the OECD – due to the exploration maturity of outcrop areas and the ineffectiveness of covered area exploration.
Yet new greenfield discoveries are absolutely critical for the long-term sustainability of the global mining industry. And where better to look – from a prospectivity perspective – than politically improving countries where early-mover advantage still counts.

Local sustainable development
And this brings us back to sustainable development – this time at a local operational level. Much has been made of government-to-government investment agreements particularly on the African continent.
This is a new competitive dimension where resources are traded for government loans or for development of new infrastructure.
Yet companies like Rio Tinto have our own compelling value proposition. Not only do we bring the technical capability to make new resource discoveries, our mining investments are framed in the context of local sustainable development.
And close engagement with local communities starts at the commencement of exploration. It involves prior full informed consent for all of our activities. It involves hiring local employees, using local services and building local capacity. And this partnership with local constituencies continues for the life-of-mine.
And through world-class environmental stewardship and biodiversity management, companies such as Rio Tinto can have a net positive impact on conservation of the natural environment. And this is particularly important in areas that are threatened by deforestation.

Exploration success – value and growth
To return to the subject of exploration success and why performance is so variable in the industry - shareholders do need to know if they are supporting worthwhile exploration or simply the lifestyles of geologists and promoters.
At the end of the day, you can only judge an exploration group by the value it is delivering. And we are open about our discovery performance unlike many of our major competitors.
Based on what we know from publicly available information, we believe that Rio Tinto has an exploration track record second to none among major companies. Our sustained commitment to exploration since 1946 – funding the programme through both good times and bad – means that it is a core competency of the company.
Since the year 2000, exploration has acquired for the Rio Tinto Product Groups two of the largest copper opportunities in the world – at Resolution in Arizona and at La Granja in Peru. It has handed over the world’s largest-known undeveloped high-grade iron ore province in the world – at Simandou in Guinea – and the Caliwingina channel iron deposits in the Pilbara. It has handed over the Potasio Rio Colorado potash deposit in Argentina – the largest potash discovery in South America. And this year the Sulawesi nickel deposit in Indonesia and the Mutamba ilmenite deposit in Mozambique joined the list of Tier 1 discoveries.

Exploration strategy
So, what do we in Rio Tinto believe is required for exploration success?
First, there has to be complete alignment of the exploration programme with our corporate objectives. And a fundamental element of Rio Tinto’s business strategy is a very clear focus on finding and mining only the best – resources that are profitable at all parts of the natural price cycle and that deliver sustainable competitive advantage. This sets size and quality benchmarks for our exploration team against which our performance is measured.
Second, Rio Tinto has never embraced the business model that involves the outsourcing of exploration to junior companies – for the very simple reason that there is no evidence that this model works. Despite some well-worn industry myths, there is no evidence to suggest that major companies and junior companies systematically differ in their exploration abilities.
Moreover, by operating its own exploration programmes whenever possible, Rio Tinto avoids the problem of exploration proxies being side-tracked by smaller targets – targets that may be material to the proxy but not to Rio Tinto.
And both HSEC performance and corporate governance remain within Rio Tinto control. However, we do partner with juniors when required – to gain access to attractive prospects, to prospective land holdings and to experience that does not reside in the company. And with the juniors currently distressed, there are some good acquisition opportunities out there which we fully intend to pursue.
Third is our organisational structure. Any exploration group charged with finding the world’s best mineral deposits – wherever they are located – obviously needs global reach. To achieve this – and unlike some of our major competitors – our exploration group is organised geographically into regional multi-commodity teams. This gives us local presence, an in-depth understanding of the operating environment and an early warning of opportunities. At the same time, programmes are prioritised on a global basis so that only the best opportunities are pursued.
Fourth is a well-tried and cost-effective boots-on-the-ground approach rather than a misplaced reliance on high-technology silver bullets. While we do have a tradition of exploration innovation, technology is just another weapon in the exploration armoury – it cannot be the tail that wags the exploration dog.
And perhaps the most important factor for exploration success is managing the risk of failure.
Exploration involves the prioritisation and testing of opportunities – however it is they are generated. And as less than 0.1 per cent of targets will actually deliver a discovery, a continuous flow of opportunities is required.
Success in exploration – the creation of value – demands early recognition and culling of opportunities that are unlikely to deliver. Ongoing prioritisation – the ranking of projects based on probability of discovery – is absolutely critical. And the success of the ranking process comes down to the quality and the experience of the exploration leadership team.
The final part of the value story lies with minimising our discovery costs.
A significant proportion of our exploration spend is returned through the sale of our Tier 2 discoveries – deposits such as Sepon in Laos, Penasquito in Mexico, Corani in Peru and Kintyre in Western Australia.
So over the eight-year period 2000 to 2007, our net exploration spend of ~ $547M returned six Tier 1 discoveries. This equates to an average discovery cost of $91M per deposit.

Summary
Given the commodity requirements of the growing global economy, mineral exploration has an important role in global sustainable development. The global financial crisis has highlighted the importance of asset quality within the mining sector. It has also exposed the critical role of market optimism and financial speculation for the well-being of the junior companies.
Sustainable competitive advantage in mining comes through finding or acquiring the world’s best mineral deposits wherever they are located. And while the developing world is particularly attractive from a prospectivity perspective, investments in these countries require a favourable long-term outlook on political and commercial stability.
Finally, for exploration to add value to a company, it needs a rigorous economic focus, effective risk management and close alignment with corporate objectives. The majority of mining companies however are unsuccessful explorers.