Description

Like the Comstock Lode in Nevada, which I wrote about a few weeks ago, the Drumlummon district in western Montana was a rich producer of gold and silver in the late 1800s whose production all but ceased over a century ago due to a combination of legal battles and the limitations of the technologies and economics of that time.  There is good reason to believe that a vast amount of gold and silver is still there and can be mined very profitably.  RX Exploration (RXE CN Canadian trading symbol on Bloomberg, RXEXF in the US) has acquired most of the area, is doing drilling that confirms increasing amounts of very high grade ore, and has begun test mining that has already brought in substantial cash. Before I say any more about RXEXF in particular, I want to make a case why this sort of company is worth considering.

Why I think the time is right for development stage gold mining companies: 

Gold and silver have had a strong run for more than ten years.  I believe that will continue, as the central banks of the world continue to mass produce their paper currencies.  As an alternative currency in nearly every culture for thousands of years, the fact that more gold cannot be conjured into existence at the whim of a central banker will make it increasingly more valuable relative to the growing mountain of fiat paper. 

The path upward won't be a straight line.  So many momentum trend followers and other weak hands are in precious metals now that there will be shakeouts from time to time.  And in times of financial stress, such as during much of the year 2008, people desperately needing cash to pay debts will sell gold as quickly as any other assets if that is what it takes to avoid bankruptcy. 

Gold mining stocks are viewed as a leveraged way of playing gold prices.  If it costs $650/oz. for a mine to produce gold which sells for $1300/oz., then a 50% rise in gold prices with no change in costs will produce a 100% increase in the mine's profits.  Accordingly, the stock prices of mining companies that have substantial production, such as the ones in the GDX or GDXJ exchange traded funds, tend to react almost instantaneously to fluctuations in gold prices (and silver prices, for outfits where that output predominates.)  They are in effect a way for an account that isn't permitted to buy GLD or SLV on margin to get the same effect from the mining companies' operating leverage. 

The smaller companies who are developing their resource base and have done limited or no mining as yet typically do not find their stocks reacting very strongly to moves in gold prices.  Yes, investor sentiment will move them up and down somewhat with gold prices, but since these companies may not be selling much gold for a year or two or three, any jump or drop in gold prices today may be reversed back and forth dozens of times before they have any effect on the company's income.  It isn't logical to care about shorter term price moves in precious metals for these kind of companies, so most investors don't.  The lack of immediate stock price response to changes in gold prices keeps traders away, and the lower trading volume keeps larger investors from investigating them further, resulting, I think, in a relatively inefficient market for these kinds of companies, which provides opportunities for investors hoping to do a lot better than get just the change in the price of gold times 1.3, or whatever. 

In addition, I don't see any great analytical interest to date in individual gold mining companies.  The bigger ones are viewed as an adjunct to the precious metals asset class and are primarily traded as class members.  If any reader was investing during the heyday of small oil and gas companies in 1978-80, you may recall how each stock would react swiftly to arcane details of exploratory drilling reports, since each company was so well followed that details normally opaque to non-professionals were broadly understood. That is not the case with smaller gold companies as it stands now.  Two weeks ago, for example, RXEXF released a drilling report that showed a significant extension of a very high grade gold and silver vein on its property, and there was only a minor upward blip in trading volume and price level that was reversed over the next two days.  RXEXF is not alone in this, which is one reason why I think we are a long distance in time and price from any speculative top in these issues. 

The main edge these development stage mining companies have is that, assuming they have the financing and their properties are actually as good as they believe them to be, they should show a strong growth in the two things that mining stock investors value - resources and cash flow - over the next few years.  Yes, rising gold prices will make them move up sooner and ultimately further, but flat to even moderately declining gold prices shouldn't stand in their way.  RXEXF is one such company. 

Why RX Exploration? 

Although based in Canada and trading more actively there, RXE's main asset is in Marysville, Montana, where it controls the Drumlummon mine and considerable property around it.  The Drumlummon was once one of the biggest precious metals mines in the US, producing over 1 MM ounces of gold and 12 MM ounces of silver, mostly between 1880 and 1900.  That came mainly from six extremely rich veins of ore that started at or near the surface and then angled down to below 1600 feet underground, where expensive pumps were needed to keep the natural groundwater in the area from flooding the mine.  The mine owner at the time, The Montana Company, which was financed and controlled by the Rothschild family, lost a lawsuit brought by a neighboring claimant.  The court required the Montana Co. to pay large damages for all the gold and silver it mined underground from property that really belonged to the St. Louis Company. After extensive appeals it ultimately complied with the ruling by turning over the mine to the plaintiff in lieu of cash, but first it removed its pumps, causing the shafts to flood from 1600 feet underground all the way up to 400 feet underground.  The St. Louis Co. lacked the financing to reinstall the necessary pumps and gave up on mining the deeper levels.  For the next century only modest and underfinanced attempts were made to mine there, with all action ceasing after the mill that processed the ore burned down in 1950. 

Starting in 2007 RXEXF bought enough land and claims, totaling 2280 acres, to have control over both the old Montana and St. Louis companies' properties and claims, and additional land nearby.  It began test mining last year, has temporarily halted that to construct much wider and deeper access ramps, and expects to start mining again in a few months.  There are three reasons to think that RXEXF has access to gold and silver enough to justify a substantially higher stock price: 

1.  Changes in mining technology in the last 100+years:  Until diamond drilling technology evolved in the 20^th century, there were only two ways to find rich veins of gold.  The most common would be if there was an outcropping on the land surface.  Prospectors who started panning for gold in a river would look upstream and find where the gold was coming from.  They would start digging the vein and follow it however far or deep it would go.  The second way was blind luck: mining one vein, miners might come across another one and go after that as well. 

Only after the development of diamond drills that could go thousands of feet through hard rock, bringing up core samples which could be analyzed in a lab, was it possible to find veins that neither rose to the surface nor were chanced upon while aiming for something else.  There is no evidence that this was ever used in the Drumlummon area until RXEXF came along. 

Due to the geology of the area, with the gold and silver in quartz veins inside granite and other dense rocks, mining was so expensive and difficult in the 1800s that one didn't dig too many shafts just for exploration purposes.  Without diamond drilling or modern computer technology to use drill results to model underground structures in 3-D, there were large areas ignored then that now seem to have ripe potential for rich veins of ore. 

In 2008 RX found one such, named the Charly vein, which in the initial NI43-101 report was said to contain over $100 MM worth of gold and silver at today's prices.  Drilling since then has uncovered a considerable extension of the Charly vein, and possibly another new vein (or expansion of the Charly) near that.  Charly may turn out to be as rich as any other large vein in the area, and the geology suggests that there may be many more like that, undiscovered as yet because they don't pop out on the land surface anywhere and, lacking diamond drilling, the miners could have come very close and never known that they were there. 

During the heyday of the Drumlummon not only were the miners incapable of finding ore bodies that can be found today, but their technology for extracting gold and silver from the ore caused them to ignore as uneconomic a lot of ore that with today's technology would be very profitable.  In particular, they had considerable technical difficulty extracting gold when, as is the case in much of the Drumlummon, the gold was mixed with large quantities of silver.  After peaking toward the end of the Civil War, silver prices dropped steadily for the next few decades due to new silver mines opening up across the western US, and then fell in half again between 1890 and 1902.  Ore with high grades of both gold and silver was less attractive to mine than ore with less gold but little silver contaminating it. Today, of course, silver is a plus, not a minus. 

2. What is under the water?  In 1901, when the Montana Co. had lost the jury trial and its first appeal, it removed its expensive, powerful pumps, and the mine flooded from 1600 feet underground up to the 400 foot level. The company continued to mine the area from 400 feet up to the surface.  It claimed that it stopped pumping because there was nothing worth mining down there, but that was viewed skeptically at the time, and should be even more so today when we can make money on much lower grade and more mixed silver/gold ores than they could then. 

Most likely the Montana Co. figured that its legal defense was weak.  If it lost all its appeals, as eventually happened in 1910, instead of paying the massive damages it would turn over the Drumlummon to the plaintiff St. Louis Co., which is exactly what happened.  The latter would be financially weakened by its years of legal battles, would presumably be unable to afford to pump out the mine, since the required equipment was extraordinarily expensive in those days, and it wouldn't find much worth mining above 400 feet down because the Montana Co. kept mining there during the nine years between flooding the lower levels and losing its final appeal at the US Supreme Court.  Then, presumably, the St. Louis company would go bankrupt and the Montana Co., with its Rothschild financing, could come back and buy the property, pump out the mine again, and be back in business where it left off. 

That is my guess as to the Montana Co.'s thinking, and when the St. Louis Co. finally gained possession of the mine in 1910 it was indeed too weak financially to do much with the property. The low gold and silver prices at the time didn't help.  But it didn't go bankrupt for another twenty years, it just leased out the property from time to time to others who wanted to give it a go.  Other than a short lived attempt in the late 1940s, until RXEXF showed up four years ago, no one bothered to try to pump out the lower levels. 

Pumping has brought the water down to the 600 foot level, but pumping is proceeding slowly.  Testing showed a high level of arsenic in the mine water.  That may have come naturally, or it may have leached out over the last 100 years from the treated wood beams that were used in the flooded mine shafts.  Whatever the cause, the company has to treat the water to remove the arsenic before releasing it into the local creek, and that is a limiting factor in the speed with which the existing shafts can be dewatered. 

In any event, there is good reason to think that there will be significant amounts of gold and silver found in those lower stopes when they are pumped out. Given how expensive underground mining has always been, why would the Montana Co. have dug so far underground unless they were following a very rich vein?  It may be that removing and treating the water is all RXEXF has to do to rediscover a huge quantity of gold and silver, intentionally hidden for over a century. 

Even if the deep shafts were purely exploratory at the time and there are no obvious resources to be found once they are pumped out and examined, they still may provide a more efficient way to access other veins that are discovered to descend to those levels nearby. 

3. Extremely high grade ore found so far: RXEXF's last NI43-101 report came out in September 2009.  Since then the company has done a lot of drilling, and some of the results are spectacular, with multiple small segments recording an ounce or more of gold per ton, and one extreme and astounding sample showing 7.8 ounces of gold and 202 ounces of gold per ton.  Of course it is not all like that, or even close, but given the history of the Drumlummon as one with bonanza type finds and vast amount of territory unexplored by modern technology, it is plausible that there may still be millions of ounces of gold and equivalents for RXEXF to mine over the next decade or two.  The next NI43-101 report should be out in early summer, and it would be shocking if it didn't show a large increase in measured and indicated resources. 

Initial mining results and plans: 

In May 2010 RXEXF began what is called test mining, to determine the nature of the ore actually mined, and to learn how best to process it to extract the precious metals most efficiently.  Even though the amounts involved are not trivial, with revenues from the sale of gold and silver mined at Drumlummon in excess of $4MM in the September quarter (December quarter numbers should be out around March1), the mine is still considered non-commercial, so instead of sales proceeds showing up on the revenue line, they are used to reduce development expense. 

With high grade ore one wants to maximize the percentage of gold and silver that is recovered, which requires milling, which can extract 90%+ of the precious metals in the ore, as opposed to the much cheaper heap leach processing, which might remove for sale only 65%.  The mill that used to be on the property burned down in 1950, and would obsolete by now anyway.  RXEXF was able to lease a mill in Philipsburg MT, 114 miles away from the mine.  In addition to high hauling costs, the mill isn't ideal for processing Drumlummon ore, but isn't awful either. At this point the company is mainly interested in better understanding the metallurgy of its ore and figuring out what processing equipment would best maximize efficiency. 

After December 2010 RXEXF temporarily stopped mining in order to allow major construction on the site.  The ore removed so far has come from narrow stopes in which antique small rail cars are used to remove the ore.  The company is building a large decline down into the heart of the mine at the 610 foot level which will, in addition to allowing an extra escape for safety purposes and help with ventilation, permit large trucks to drive close to the actual mining and drive out with the ore.  That will triple throughput from roughly 500 tons/day and cut costs.  The decline should be complete by the end of March or so, and mining will resume then, although the delays in accumulating the ore, having it milled, and getting paid are such that cash won't start flowing in again until the summer.  There is a possibility that the decline might be extended to the 800 level to allow easy access to even more ore when mined; that is good in the long run but obviously costs money and disrupts mining while it is being constructed. 

In the long run, trucking ore 114 miles to a mill doesn't make a lot of sense.  The company is considering putting up a mill on its property, but it is cognizant of costs.  A new mill can cost $10MM or more.  There is some used mill machinery around that they might buy to keep costs down, and there are some mills run by other companies closer than the Philipsburg mill that have excess capacity.  So it isn't clear yet how the ore will be processed over the next year or so and beyond.  That said, if the exploration program finds the gold and silver resources that the company believes is there, that will dictate an aggressive mining expansion which tilts the economics toward owning its own mill, whether new or to some extent used. 

Finances: 

Like many early stage mining companies, RXEXF has had to scramble for cash and put up with some fairly funky financing.  Things seem to be in better shape now, especially since last spring when the company took in $2.5MM in a private placement from Sprott Asset Management.  Interest in the stock grew in 2010 as its drilling results showed more evidence of rich resources, and test mining started to bring in some cash.  

Last fall the company was able to call 44MM warrants with a C$0.40 strike price, forcing exercise and bringing in C$17.7MM.  There are now 156MM shares outstanding, but I am using 197MM to reflect some higher priced warrants and options that are not in the money yet, but are close enough.  I think a reverse split would make sense for the company to be taken more seriously. 

With the construction of the new ramp to be completed soon, test production should start up again in the second quarter.  By early in the summer, based upon expected production and the estimated grades, that should have the company operating at a 150 ounce/day of gold equivalents, which equals about 50,000 ounces/year or over $60MM per year rate.  With costs expected to be in the $500/ounce area, the company should be cash flow positive starting in the September quarter.  By the December quarter, assuming current gold prices, cash flow should exceed $10MM/quarter before administrative, exploration, and capital costs.  At some point the company should get its permit to change the production categorization from test to commercial, after which the cash from gold sales will flow into revenues rather than count as a reduction in expenses. 

With the capital from the option exercises and cash flow from the test mining, RXEXF finished 2010 with cash of $18.3MM and no debt.  Since production has been halted this year to allow construction of the large ramp, and the aggressive drilling program continues, cash is being burned at the rate of about $2MM/month, until production resumes in the June quarter and the cash comes in again from the resulting gold sales.  The company has indicated that cash should bottom out at about $10MM before heading back up again, which allows for various delays without there being any financial threat. 

Risks: 

With any natural resources company, there is always an issue of the political environment.  Montana has had a reputation of being very anti-mining, but that seems to have changed quite a bit, especially as economic weakness makes the high paying mining jobs (RXEXF's miners make at least $65/hour) attractive.  The governor has visited the mine (video on the company's website) and in a recent speech has specifically cited the company as the kind of outfit that Montana needs more of.  But obviously, politics is always a crap shoot.  Some of the few people who live in the near ghost town of Marysville, that sprung up in connection with the Drumlummon, would prefer that things stay quiet.  In addition, the company will continue to be monitored to make sure that the water pumped out of the mine is clean.  There has been no major objection to the company trucking its ore over 100 miles to its leased mill, but that is not efficient in the long run.  Constructing its own mill will require various permits, and other legal bottlenecks can occur. 

The biggest risk for a company like this is, is the gold really there?  There is excellent reason to think so, as discussed above, but until it is found and verified in a NI43-101 report one doesn't know for sure.  The second biggest risk is, even if it is there, can it be mined cost effectively?  RXEXF believes that its costs shouldn't exceed $500/ounce, and the high grade nature of what has been found so far suggests that is reasonable, but until we see the actual results for more than just a few months of test mining, one can't be certain. 

Accordingly, RXEXF should be just one of a portfolio of development stage gold mines.  The ones that work out will be ten baggers, and the ones that don't will be zeros, but unless gold and silver prices completely collapse, the portfolio should do well over the next few years. 

Company's website:  http://www.rxexploration.com 

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