Thursday, November 29, 2007

Who Will Own the Most Profitable Heavy Oil Production Technology?

Heavy oil accounts for more than double the resources of conventional oil, according to Schlumberger. Most of the current and historical oil production has come from conventional reservoirs, which contain oil that is sufficiently viscous to be pumped utilizing well pressure and non-specialized pumps. Heavy oil is more viscous (thicker, like molasses) than conventional oil so is much more difficult to extract from the ground. Currently, the volume of heavy oil production is currently only a fraction of the production from conventional oil. However, going forward, it is almost certain that the world's dependence on heavy oil production will increase due to the massive resource base of heavy oil and projected increased demand from Asian and developing countries.

Source: Schlumberger

There are several methods of heavy oil extraction currently, but, as the heavy oil industry is still in its beginning stages, there is not a de facto "standard" of heavy oil extraction for the industry -- one that is low cost and efficient, that can be applied across most heavy oil deposits. The question that is most relevant for investors is: will there be a dominant, patented technology for the development of heavy oil reserves? And secondly, if so, which firm will capture and patent this technology? These questions will be explored in this article.

Relevance of Heavy Oil Production Technologies to the Historical Success of Howard Hughes, Sr
There is (in the author's mind) a relevant comparison of the new technologies for the development of heavy oil to the historical example of Howard Hughes, Sr, who made his fortune mainly by inventing and patenting a drill bit that could drill through hard rock, which was, in turn, utilized by the majority of the oil industry to develop conventional oil reserves. Hughes Sr's drill bit became the foundation for Hughes Tool company which later merged to become the oil services firm Baker Hughes. Hughes Sr. patented drill bit design was so profitable and necessary for the development of conventional oil reserves that Daniel Yergin, writing in his epic book "The Prize" described Hughes' pricing leverage as "highway robbery." This article will explore if there is a similar technology, such as Howard Hughes Sr's patented drill bit, that is applicable to heavy oil extraction.

Background on the Heavy Oil Industry:

The interested reader is encouraged to read the heavy oil sections of Rigzone and wikipedia, as well as Schlumberger's excellent heavy oil website for a background to this very important topic of heavy oil. A brief discussion and summary of heavy oil is presented as follows. The majority of heavy oil deposits are found in two countries, Canada -- in its Albertan oil sands, and Venezuela -- in its Orinoco belt -- both of which contain reserves of recoverable oil comparable to those of Saudi Arabia. Approximately 90% of heavy oil is found in the Western Hemisphere -- mainly in Canada and Venezuela, although significant deposits exist in California, Alaska, Mexico and Brazil, as well as in Russia -- while 90% of conventional oil is found in the Eastern Hemisphere -- mainly in the Middle East. Most of both heavy oil deposits in Canada and Venezuela are underground, below where they can be mined by mining methods -- although approximately 10% of the surface area of the Albertan oil sands can be mined (and this area is already nearly 100% leased by firms, as I discussed in my earlier Canadian oil sands article). The Venezuelan heavy oil deposits are a bit less viscous -- able to flow more easily -- than the majority of the Canadian oil sands -- and therefore, so far, different and methods have been used to extract Venezuelan heavy oil deposits than the Canadian oil sands deposits.

Oil Sands Carbonates:

Note that approximately 50% of the Albertan Oil sands by area are in the form of carbonates, which means the oil sands are trapped in rocks, in a similar way to oil shale. The carbonate formation forms a "triangle" in geographic terms across the Canadian heavy oil deposits. The carbonates require different technologies for extraction than traditional heavy oil, as will be discussed below.

Source: Geological Survey of Canada

Heavy Oil Extraction Technologies in Usage Currently:

There are 5 main technologies currently in operation in the heavy oil industry for the development of traditional heavy oil (not heavy oil carbonates), with varying cost efficiencies and recoverability factors: Cold Heavy Oil Production with Sand, Steam Assisted Gravity Drainage, Mining, Cyclic Steam Stimulation, and Vapor Extraction. Note that most of the techniques were pioneered in Canada due to Canada's relatively early development of its Albertan Oil Sands. These technologies are described briefly as follows.

1. Cold Heavy Oil Production with Sand (CHOPs) -- this technique utilizes a submersible pump that can pump thick fluids, down to the heavy oil and pumps from there, allowing sand and other rocks up the wellbore -- as it is difficult to separate out the sand from the heavy oil. CHOPs is usually utilized without additional heating or chemical treatment. As such, it can be considered the most simple extraction method for heavy oil that is deep below the surface. It is believed the majority of Venezuela's heavy oil is produced using CHOPs. (Venezuela produced an estimated 625,000 barrels per day of heavy oil in 2006 through its national oil company, PDVSA.)

- CHOPs Advantages: Straightforward, relatively simple production method, continuous production, cost effective if heavy oil is viscous enough (as in Venezuela)

- CHOPs Disadvantages: Inefficient if the heavy oil is too thick (as in many areas of Canada), expensive to maintain and/or replace specialized submersible pumps, estimated only 5-10% of total heavy in place can be recovered with CHOPs, "technology stretched to the limits" according to Schlumberger so low future productivity improvements likely possible

2. Steam Assisted Gravity Drainage (SAGD) -- this method of heavy oil extraction involves melting the heavy oil with steam, then collecting the melted heavy oil by vents. A video demonstration of SAGD can be found at Rigzone. Imperial Oil of Canada (majority owned by Exxon Mobile) has done much of the pioneering work on SAGD in its Canadian Oil Sands properties, and is the largest producer of heavy oil by SAGD methods currently. According to Imperial, SAGD works well when the heavy oil is able to move vertically with relative ease (in petroleum geology terms, "good vertical permeability") -- therefore the usage of SAGD depends on the underground geological conditions of the heavy oil resource.

- SAGD Advantages: Continuous production, technology able to cost effectively access less viscous heavy oil (bitumen), room for efficiency improvement in process

- SAGD Disadvantages: Concerns over CO2 emissions and water usage [although water can and is recycled], uses natural gas (to heat the water into steam), relatively low recovery rate of oil in place of less than 50% [but future improvements of recovery rate are possible according to Imperial Oil], mainly only applicable to heavy oil reservoirs of at least 40 meters thick

3. Mining Methods -- this technique involves digging the oil sands which are available near the surface and transporting the heavy oil to processing facilities. The majority of the Canadian oil sands currently (12.07) are produced in using this method, although heavy oil produced in Canada by in situ methods is increasing. Suncor and Syncrude are by far the largest producers of oil sands in Alberta by mining methods, although Imperial Oil has new mining projects coming on line.

- Mining Method Advantages: Proven, cost effective with efficient use of equipment, straightforward to increase production, recovery rate 80-90% of heavy oil in place

- Mining Method Disadvantages: concerns over CO2 usages, heavy equipment and labor intensive, only a small amount of heavy oil sands can be produced by mining methods, possible concerns over environmental damage

4. Cyclic Steam Stimulation (CCS) -- this technology involves a multi-step process of first, steam injection, then a period of up to several weeks of steam "soaking" (heavy oil mixing with the steam), then a period of recovery of the melted heavy oil. This technology is demonstrated in video format at Rigzone. Imperial Oil was the pioneer of this technology, and holds patients with regards to usage of CCS. CCS is an older technology than SAGD, but still produces a majority of its "Cold Lake" operations using CCS due to geological considerations at Cold Lake (Cold Lake is Imperial Oil's largest in situ producing region). In theory, SAGD is the more efficient technology due to the fact that heavy oil recovery is continuous and, further, SAGD is newer, but CCS is more efficient than SAGD in geological formations in which the oil can move relatively easily horizontally (good "horizontal permeability"), according to Imperial. Imperial Oil also announced an improvement to CCS in 2007, which involves adding a hydrocarbon solvent to the bitumen to improve efficiency and recoverability, and is now using this solvent in its operations.

- CSS Advantages: Cost effective, applicable to heaviest grades of bitumen

- CSS Disadvantages: CO2 and water intensive [although water can be recycled], heavy oil is only collected periodically, not continuously, recovery rate is somewhat low at 15-20% [but possible to improve according to Imperial Oil], mainly only appilcable to heavy oil reservoirs of 40 meters thick and above

5. Vapor Extraction (VAPEX) -- VAPEX involves injecting the in situ heavy oil with chemicals, CO2 and/or hydrocarbons, in order to make the heavy oil more viscous -- and cut down on water, energy usage and pollution -- which can then be extracted efficiently, and possibly also improve total oil recovery rates. A video demonstration of VAPEX can be found at Rigzone. According to the technology editor of, VAPEX is the most promising of the new in situ heavy oil production technologies, although it has not been utilized on a large scale yet. In theory, VAPEX can be combined with SAGD and/or CCS above, and, in fact, Imperial Oil has started utilizing a hydrocarbon solvent to improve efficiency in its Cold Lake operations in 2007.

- VAPEX Advantages: Possible higher recovery rates, efficiency and less pollution than other above methods, applicable to all grades of heavy oil

- VAPEX Disadvantages: compared to other methods, relatively untested, some combinations of solvents will probably not work so possibly expensive to carry out trials of method technology

Future Heavy Oil Technologies Proposed:

These technologies for the extraction of heavy oil have been proposed but have not undergone significant field testing, on the scale of the five technologies listed above, as of late 2007:

1. In situ combustion: proposed by both India's Oil and Gas Corp and the independent firm PetroBank, this technology involves "burning" the heavy oil underground and using the heat and the force of the combustion to move oil and gas through collection vents. Petrobank provides an overview and video demonstration of its in situ combustion "THAI" technology on its website. A few years ago, in situ combustion was viewed with skepticism by heavy oil insiders such as Schlumberger, who considered in situ to be undesirable due to the fact that it does not leave oil for future recovery (combustion rates of the total oil resource were thought at first to be high), and, further, in situ combustion did not have a large number of successful demonstrated successes (the oil industry tends to be conservative and new technologies face an uphill battle). Further, many industry insiders scoffed at the notion that the oil could be "upgraded" underground -- upgraded meaning shortening the hydrocarbon chains -- which is what the in situ production proponents were proposing that combustion could do.

However, in situ combustion has fared well on several small scale trials as reported by Schlumberger's Recovery rates have been shown at 80%, with less than 10% of the total resource consumed in the combustion flood, while some upgrading of heavy oil resource as been shown. Start up costs are about half that of SAGD according to Petrobank. Petrobank stated that it expects its THAI to be economical up to $30 per barrel of oil. Perhaps most impressively, the in situ combustion proposes to make the production of heavy oil resources with less than 40 meters thickness economic -- Imperial Oil's SAGD and CCS are only economic at 40 meters and greater resource thickness levels. There are many areas in which the heavy oil resource is only 20 or 10 meters thick, which means in situ combustion could have a large number of applicable areas. So far, the trials have not produced more than 1,000 bpd per well
and the temperatures for larger production may be difficult to control, as temperatures at the 1,000 bpd well ranged between 400 degrees C and a very high 1,000 degrees C. Further, it is critical in in situ combustion to understand in detail the geological characteristics of the resource through seismic and survey data, before the beginning of the procedure. Operators also have a negative memory associated with in situ combustion stemming from failures in California in the 1970's (Petrobank insists that these failures have been fixed with the new method). With SAGD, It is likely many more trials will be needed before in situ combustion becomes a major new producing technology, but the possibilities are certainly intriguing.

- In Situ Combustion Advantages: Relatively low start up costs, higher recovery rates than SAGD in trials, less water and natural gas used than SAGD, partial upgrading of heavy oil resource, utilization of under 40 meters thick heavy oil resource

- In Situ Combustion Disadvantages: "one time through only" -- resource will be produced fully and no further extraction by other methods is possible after utilization, unproven application to large deposits, unproven scalability, possible difficulty in controlling fire flood across larger reservoirs

2. Electricity and Microwave Heating -- Two smaller firms (to the author's knowledge) have proposed electromagnetic radiation and electric heating of the bitumen for improved recovery -- Global Resource Corporation (microwave technology) and E-T Energy Ltd (electric heating of the oil sands). Only E-T Energy has initiated a trial of its technology -- with moderately successful results, as recounted on its homepage. E-T Energy estimates that 500 MW would be necessary to successfully produce 120,000 bpd of oil in the Albertan oil sands. Depending on the excess supply of power in the area, E-T Energy's technology likely has applications. Global Resource Corporation -- whose propriety technology consists of altering the frequency of the microwave in order to optimally heat certain substances -- is focusing mainly currently on microwaving used tires to produce carbon black, gas and synthetic oil -- so thus has been somewhat distracted in the near to medium term on a trial for microwaving oil sands. (note that Global Resource Corporation is currently a very small company, with less than $1M of assets on its balance sheet according to its latest 10-Q). A trial is likely a few years away for Global on microwaving oil sands. In theory, however, the microwave technology appears more efficient than passing simple electric current through the oil sands, so perhaps E-T Energy, or another heavy oil firm who wants to heat the oil sands would be interested in Global's microwave technology -- but at this point both technologies are in the theoretical stage.

Will there be a dominant oil sands production technology?

Taking in the lessons learned from the above survey, perhaps a more appropriate question than the above is: which technology will be the most profitable for underground deposits going forward? That is, when one asks, "Will there be a Howard Hughes of the heavy oil industry," one is mainly referring to technologies to develop underground heavy oil deposits, due to the fact that mining methods are firmly entrenched as the technology of choice for extraction of heavy oil deposits near the surface.

Much of the choice for the extraction technology depends on the characteristics of the underground heavy oil resource. For large (over 40 meter in thickness) non-carbonate deposits, it is the author's opinion that some combination of VAPEX and SAGD or CSS will be the most effective method, which would benefit Imperial Oil, which has patents on all three processes. Note also SAGD and CSS need capping shale, but preliminary geological data show that only 10% of Albertan non-carbonate oil sands lack capping shale. It is tentatively concluded that the majority of underground heavy oil is appropriately produced using Imperial Oil's technology. As noted above, Imperial Oil is the oldest producer of heavy oil and the largest currently, and therefore it makes sense that Imperial should have the most proven expertise with heavy oil extraction technologies. Imperial oil is not expensive currently at 15x earnings and a $45Bn market capitalization, which makes IMO an intriguing long term buy based on its heavy oil potential. Winner: Imperial Oil.

Heavy Oil Service Firms:

Schlumberger (SLB), and to a lessor extent, Halliburton (HAL), stand to benefit greatly from the coming heavy oil boom. All the in situ technologies are optimized by extensive 3-D mapping, resource characterization and understanding of the resource, in which both Schlumberger and Halliburton have world leading technologies. Further, most in-situ technologies require submersible pumps, which Schlumberger is the world leader in terms of technology (the submersible pump industry is a good subject for another post, but in summary, Schlumberger makes world-class, technologically advanced oil pumps). However, Schlumberger is already slightly pricey currently at 23x earnings -- but is a buy candidate based on its heavy oil potential if the stock drops further.

Notes on Firms with In Situ Combustion Technology:

Petrobank is a higher risk, high return play -- the stock has already increased 250% this year, and now boasts a 100x p/e ratio and a market capitalization closing in on $4.0Bn. If the author was forced to predict the future viability of the in-situ combustion process, the author would say that it will find short term success in heavy oil resources that are not viable by other means -- so this would include heavy oil seams of under 40 meters. Most likely the customers of the Petrobank's process will be smaller companies -- and of course Petrobank itself, as it has its own oil sands territory -- with more less attractive lease areas of the Albertan oil sands. It is unclear if Petrobank will be successful in Venezuela, because Venezuela is negotiating heavy oil in situ combustion agreements with India's Oil and Natural Gas Corp -- which boasts an in situ combustion technology similar to Petrobank's technology. Further, Petrobank's technology is likely not applicable to heavy oil deposits which exist in permafrost, in the far North, due to the fact that the high heat generated will destabilize the permafrost and the heavy oil deposit. In situ combustion is also most likely not applicable to oil sands carbonates, due to the high concentration of rock with the heavy oil (so a fire flood would not likely be able to be generated). But there are still many areas around the world that would be interested in a relatively low set-up cost production method with high recoverability factors.

Oil Sands Carbonates Production:

One firm (that the author is aware of) has proposed and is in the process of implementing a production technology for heavy oil from oil sands carbonates -- OSUM Oil Sands Corporation. The 100% privately held OSUM is proposing an underground collection method that would heat the oil sands carbonates (carbonates are, as described above, heavy oil trapped in rocks) above a long tunnel, then collect the melted bitumen below in the tunnel and pump the heavy oil to the surface. Most of the work force would be underground leaving a low environmental footprint on the surface. OSUM is proposing to use steam to heat the bitumen, although it is possible they could be interested in other heating methods (microwaves, electricity) in the future. The first production trials are set for 2008, with full production of up to 100,000 bpd thereafter. This underground method looks quite promising for the production of oil sands carbonates, but unfortunately most investors cannot participate as OSUM is 100% privately owned.

Political Issues Concerning Heavy Oil in Venezuela:

Note that it is difficult to see foreign firms making tremendous profits in Venezuela under the current (Hugo Chavez) administration. Schlumberger is working on Venezuelan heavy oil, but Total -- which had developed Venezuelan oil sands -- was kicked out of the country in 2002 and replaced with PDSVA without significant compensation. The heavy oil resource is huge but it is the author's opinion that firms with appropriate technology catered to the specific geological characteristics of the Orinco belt face very significant political obstacles. The same rule also applies to firms operating in Russia. This also limits the overall profit potential for a firm such as Imperial Oil, which may have the best technology -- its market is Canada first and other areas a distant second.


This article has discussed the current and emergent technologies for the production of heavy oil. It is concluded that, due to the wide range of heavy oil deposits, several technologies will be very useful in the future, and allow for high profitability to the designers and executers of these technologies -- including VAPEX, SAGD and CSS, as well as in situ combustion. These technologies point to future profitability for Imperial Oil and, for a higher risk, higher return play, Petrobank. Also noted was the fact that Schlumberger should see its share of profits from its expertise in servicing the heavy oil industry. However, it should be noted that it is possible that a certain up and coming technology has been missed by the author which could revolutionize the heavy oil industry. Further, axillary technologies, such as steam production equipment, carbon trapping and water recycling equipment, which are necessary for the production of heavy oil but not directly addressed by the main heavy oil production technologies, was not addressed in this article and is an important subject for a future article.

Monday, November 26, 2007

Boliden AB: Significant Upside if Copper and Zinc Prices Stabilize

Within the industrial metal mining (zinc, copper, nickel and lead) universe, the Swedish Boliden AB (Swedish OMX ticker: BOL) share price is down over 50% from its highs this year during the latest credit crunch, from a peak of SEK178 to a current SEK80-odd per share. This unusually rapid decline in the share price compares to relatively flat share price movement during the latest credit crunch for Xstrata, BHP and Rio Tinto, which are all not down more than -10% from their highs. Note however other copper miners such as Teck Cominco and Lundin Mining are down between 20-30% during the last month, but not nearly as severely as Boliden. As long as there is not a firm specific reason for this decline -- and there likely is not, as will be analyzed in this article -- then if there is a sector recovery in industrial metals mining, Boliden, from a value standpoint, has the farthest of the major industrial metal miners to appreciate.

Boliden Introduction:

is one of Europe's largest mining and smelting companies of copper and zinc, with operations in Sweden, Ireland and Finland. Boliden is currently the cheapest of the major zinc and copper producers, which are selling currently (at 11.07) at single digit p/e's, as shown in the chart below.

* Note that KGHM's proven reserves in the table above are total mineral resources and not proven reserves, as KGHM only publishes mineral resources and does not separate out proven and probable reserves.

Boliden has several strengths that make it an appealing long term buy, as long as copper and zinc prices remain at moderate levels (which in turn is mainly driven by new supply from Chile and the economic growth of Asia, which will be discussed below)(however note that of course if copper and zinc prices return to 2001 levels Boliden will be negatively affected).

probable and proven reserves of copper and zinc tripled during the first quarter of 2007, due to capital expenditures to expand proven reserves, ensuring long lasting mine lives for existing mines. Further, Boliden plans to double its volume of recycled electronic waste processed by 2010. Boliden owns and operates Europe's largest mine by volume of material mined -- Attik, which produces low grade copper -- and is the world's largest recycler of electronic waste (mobile phones and computers). By volume, Boliden is also the world's 4th largest producer of zinc metal.

Boliden Recent (3Q 07) Financial Results:

Boliden reported 3Q 07 results, with revenues down 12% to SEK8.2Bn from SEK9.3Bn for 3Q 06, and operating profit down 36% to SEK1.3Bn from SEK2.1Bn in 3Q 06. The largest contributor to lower operating earnings was lower prices for metals (zinc and copper) and temporary lower y/y output from their mines and smelters due to capacity upgrades, which combined to knock off an estimated SEK385M from EBIT, from the 3Q 06. Boliden plans to double the output of its largest mine, Attik, by 2010 and completed most of the expansion in the 3Q 07, so lower output should not (as long as Boliden executes in a timely fashion) be an issue going forward. Lower copper and zinc prices will, of course, be a risk to operating results in future time periods.

The second largest negative contributor to operating earnings was adverse currency movements -- the Swedish Kroner strengthened while the dollar (metals are priced in dollars) declined in the 3Q 07. Currency decreased EBIT by approximately SEK316M. Note that in the future, if the dollar continues to depreciate without a corresponding rise in the price of zinc and copper, Boliden's results will continue to be negatively affected.

The third contributor to lower earnings for the 3Q 07 was cost increases, mainly energy and labor, which increased costs by SEK147M. Energy cost increases, without a corresponding increase in the price of copper and zinc, will negative impact earnings going forward.

Overall, the recent financial results shows that Boliden should be able to post stronger financial results in 2008, as expansionary projects come online, as long as there is not a collapse in metal prices and/or a collapse in the dollar.

Question: Why Haven't BHP and Rio declined with the rest of the industrial metals industry?

As shown in the chart above, BHP and Rio sell at a significant premium in terms of price to earnings and price to revenue than the rest of the industrial metals industry -- note however, that larger mining firms should sell at a premium to smaller firms, but the premium that BHP and Rio command is thought (by the author) to be excessive. The premium that these two massive mining co's have is due to a combination of 1) Very large diversified operations across commodity groups -- note that larger mining firms should command a premium due to more predictable operating performance -- although there does appear to be a lack of awareness by the investing public that both BHP and Rio Tinto obtain a large percentage of their total revenues and profits from copper mining (BHP derives approximately 37% of its operating profit from copper , and Rio Tinto derived 45% of its EBIT for copper for the first 9 months of 2007). 2) a positive sentiment towards mining in Australia, due to an opinion that Asian growth (particularly Chinese growth) will continue. Note, that Zinifex -- the world's largest zinc producer, based in Australia, is also not down significantly from its highs over the last month.

The fact that BHP and Rio Tinto haven't declined significantly, while the North American and European (note, the author has not looked at Asian industrial metal miners) have declined is a legitimate contradiction, because miners receive a world price for metal -- namely, the price listed on the London Metals Exchange (which has declined over the last month, but has always been volitile so could recover quickly). The fact that the Australian group is steady while the rest of the mining universe has declined means that one of two possibilities exists: either 1) the valuations on BHP and Rio are correct, in that Asian growth will continue and metal prices will stay high or 2) the valuations on American and European miners is correct, and metal prices will decline. The author is more likely to agree with 1) -- that BHP and Rinto Tinto are valued appropriately and the rest of the large and mid-tier industrial metal mining group is undervalued.

Some Thoughts on Zinc and Copper Prices:

Zinc and Copper have been quite volatile over the last month -- although perhaps not as volatile as, for example, Palladium, which has gone (historically) from a peak of slightly over $1,000 per ounce in 2002 to a low of $80 per ounce in 2004 (currently at approximately $350). Copper has moved from approximately $7,500 to $6,500 per tonne currently (11.27.07), while Zinc has moved from over $3,000 to $2,400 per tonne. BHP and Rio Tinto both have very interesting commentary on zinc and copper prices -- it serves them well to keep a close eye on metal prices as much of their business is dependent on them. Both firms believe (see commentary here (large PDF warning) for BHP and here for Rio Tinto) that, due to exceptionally low inventories of metals and expected future growth in Asian demand, that prices will be volatile but at relatively high historical levels. The market appears to be assuming currently (at late 07) that industrial metal demand will fall off a cliff due to credit concerns in the US -- and also that there will be vast surpluses of copper and zinc next year (08) as new projects come on line -- and therefore zinc and copper prices are currently moving lower. In addition, Zinifex had very interesting commentary in its last quarter financial results, that the inventories of zinc in particular, is so low that some expected surplus is needed to keep the market functioning -- as continued shortages could cause extreme (even higher than current) volatility and therefore demand destruction. Note that inventory of zinc and copper divided by daily usages is less than 4 days, from historical days to use of over 30 days. The charts of inventories of zinc and copper prices are shown below: (note that each year, world copper consumption has increased by between 3-5%, meaning that inventories should increase as well by 3-5% in order to keep the days inventory constant, but clearly this has not been the case):

Zinc Prices and Inventory:

Copper Prices and Inventory:

Source of above charts: Boliden AB presentations

Proponents of the "Super Cycle" of industrial metals -- such as Goldman Sachs -- argue that a small expected surplus on top of unprecedented low levels of metals will not result in prices returning to pre-2005 levels. As Zinifex would argue, the small surplus would be necessary to keep the metal markets functioning normal and would not therefore represent a "glut" of metal -- supply vastly out striping demand and therefore causing the price to crash. This argument appears reasonable to the author, as long as China and India continue to grow, which is most likely (in the author's opinion) but not 100% certain.

Notes on Chilean Production of Copper:

The future copper price on the supply side is highly dependent on Chilean production, due to the fact that Chile accounts for approximately 35% of world copper production in 2006, according to the US Geological Survey -- the second largest copper producer was the US, at 8% of total world production. Chile is therefore the world's dominant producer of copper. Chile also has by far the largest reserves of copper of any country -- accounting for 38% of world total resources of copper, also according to the USGS.

The largest copper mine within Chile -- and the largest copper mine in the world, majority owner BHP's and minority owner Rio Tinto's Escondida Mine, is set to start declining in 2011, due to exhaustion of recoverable ore (pdf warning). Escondida produced 30% of Chilean copper in 2006. Escibdida originally opened in 1990 with an expected mine life of 37 years, and therefore is becoming more mature with 18 years and counting of cumulative production. Codelco -- Chile's state-owned copper mining firm, which controls 20% of the world's resources of copper -- plans to increase production from its own mines in order to offset the flatlining production from Escondida, but significant uncertainties exist as to whether this goal will be achieved due to the large size of Escondida, and/or the motivation of Codelco, as Codelco benefits from a higher copper price which could be driven by lower supply. (further, it is noted that BHP and Rio Tinto have appeared much more eager to acquire other mining firms in recent years, possibly due to concerns over lower copper production from their Escondida mine). Additionally, the exhaustion of Escondida gives Codelco a significantly larger share of overall Chilean copper production forecast for 2011-2012 -- from a share of 24% of total Chilean Copper production in 2004 to an estimated 43% in 2012 for Codelco (see page 25 of this presentation for reference) -- which means Codelco will have more influence over the world's supply and therefore price. Note that in the past, from 2001 to 2003, Codelco has stockpiled copper in order to support copper prices.

The upshot of this discussion on, particularly, copper prices is that the market is set to become more dependent on one producer in the future -- Codelco, which has a strong self-interest in keeping copper prices high, and this fact is bullish for copper prices on the supply side.

Smelting Verses Mining:

Currently, the market prefers firms with larger mining operations verses smelting operations, due to a squeeze on smelting operating profits -- energy prices are going up (smelting is highly energy intensive) and Asia, particularly China, has invested in Smelting capacity without domestic sources of metal concentrates. Boliden has a large Smelting division -- note that most larger metal miners will have smelting divisions in addition to mining divisions -- although Boliden's smelting divisions are large enough that Boliden only supplies about 60% of the concentrate for the Smelters from its own mines. As the argument that metal mining is more attractive than smelting is reasonable, then how will Boliden's smelting operations fare going forward?

It is reasonable to project that the margin on mining operations will increase going forward verses Smelting for Boliden -- and most other miners for that matter -- but Boliden's smelters have advantages in three respects over typcial smelters: 1) Energy costs: one of Boliden's smelters (of a total of 5) uses hydroelectric power, and two are in Sweden and 2 in Finland which have lower electricity costs that most of Europe, due to investments in the past in nuclear power. 2) Recycling capacity: as mentioned above, Boliden is the world's largest recycler of electric waste and is also one of the largest recyclers of lead batteries, which promises tremendous growth potential by volume -- so revenue growth can be reasonably predicted, if not margin growth (due to mainly to metal price volatility). 3) Boliden's smelters are world class in terms of efficiency and utilization of material -- Boliden is one of the few firms with the expertise to profitably recycle certain electronic wastes, which should help Boliden effectively compete against new smelting capacity from Asia.


Overall, the copper and zinc mining universe has taken a significant hit during this current credit crisis -- with the exception of BHP and Rio Tinto -- and is well positioned with single digit p/e's to rebound if economic growth, particularly in Asia, continues. It is assessed in this article that Boliden has fallen the farthest of the miners/smelters, and has not suffered significant, long term operating deterioration, and therefore could show the strongest upside if there is a recovery in the industrial mining universe.

Sunday, November 18, 2007

Anglo Platinum: The World's Largest Platinum Producer

Anglo Platinum (ticker: AGPPY) is the world's largest producer of platinum group metals (PGM), producing on an annual basis approximately 40% of the world's production primary platinum from its South African operations. Anglo Platinum is unusual among the (limited) platinum group metals universe (note that only two countries and produce platinum group metals on a large scale, South Africa and Russia) in that it has large reserves of proven platinum reserves -- verses probable and measured and indicated reserves -- translating to a future capability to maintain and increase production without corresponding large capital expenditures to start up new mines.


Anglo Platinum is the largest operator by production and ore reserves of of the Bushveld Complex in South Africa, a freakish geological deposit which contains an estimated 75-90% of the world's known reserves of platinum group metals (see link here for further information on this deposit). Anglo produces currently from two major mines, Ruthenburg and Amandelbelt, and two medium sized but important mines, Union and Potgietersrust, (in addition to 4 smaller mines) which will be discussed in detail below. Anglo's overall reserve life of platinum group metals -- including proven and probable reserves but excluding undeveloped (measured and indicated) reserves --at current production rates is approximately 60 years, which is a very high number in comparison to most other mining firms in other resource extraction industries (oil and gas producers typically have reserve lives of 10-20 years, while gold producers typically have 20 or less year reserve lives based on proven reserves).

Platinum Metals Market Overview:

The value of Platinum metal has increased in value over the past 5 years as strong growth in mainly autocatalyst demand has outpaced production. A good overview of the Platinum metal market for 2007 can be found here by the South African firm Johnson Matthey. In summary, according to Matthey, Platinum is projected to be in a small deficit for all of 2007 (supply of 6.660M ou and demand of 6.925 M ou) after several previous years of deficit but relative equilibrium in 2006 (supply = demand). The deficit in platinum production is expected to support or increase prices for the near term. In the Palladium market, Palladium is expected to continue to be in production surplus (production outpacing demand) leading to near term downward price pressure for the metal. The more rare PGM metals -- Rhodium and Ruthenium, which are used in speciality ceramics and electronics -- are expected to continue to be at deficit levels over the near term.

Production increases of Platinum and rarer platinum group metals outside of South Africa has been essentially non-existent in 2007 according to Matthey, illustrating South Africa's dominant market position in these metals. On the demand side, demand continues to go up due to autocatalyst demand and, to a lessor extent investment demand. Note further that investment demand is still only expected to be approximately 1% of total demand of platinum production in 2007 according to Matthey, which means (in the author's opinion) investment demand for platinum can go significantly higher in future years, putting further upward pressure on the price.

Brief Overview of the PGM Mining Universe:

One can say that there are two groups of PGM miners, those which mine from the Bushveld Complex in South Africa and those which do not. Of the firms outside of Buchwald, only Russia's Norilsk Nickel is a major producer, and this is due to Norilsk's production of mainly Palladium as a by-product of its massive nickel operations in Norilsk, Russia (in the far north of Russia, in mines that account for approximately 30% of the world's nickel reserves). As a percentage of revenues, palladium is estimated by Norilsk at 9% and Platinum at 7% of total 6 month 2007 revenues.

The other relatively high profile miner of PGMs outside of South Africa is Stillwater Mining, which produces palladium and platinum in a 3 to 1 ratio (3 units of palladium per unit of platinum) from its mines in Montana. Stillwater states that it is the only significant producer of PGM metals in the Western Hemisphere, according to its homepage. A review of Stillwater shows that it is more dependent on Palladium verses Platinum, and that it will be expecting high capital expenditures over the next 40 months as it moves from its proved reserves (at total of approximately 2 million ou) to probable reserves (total of approximately 20 Million ou).

Within the Bushveld complex, there are two major producers of PGM metals -- Anglo and Impala Platinum, and one minor producer, Lonmin, and several smaller producers. Impala is generally, by the investment community in South Africa, considered to be better run than Anglo in terms of planning, execution and presentation of financial results, but holds significantly lower reserves of platinum and sells at a higher premium to reserves than Anglo, as seen in the chart below. Impala (ticker: IMPUY and Anglo Platinum (ticker AGPPY) are compared as follows:

* Information concerning reserves are from the reserves and resources sections from the Company's respective websites and annual reports.

As indicated in the comparison chart above, Anglo Platinum and Impala sell at similar multiples to earnings and cash flow currently (11.07) -- although Anglo is a bit cheaper. The most striking difference between the two firms is that Anglo has far larger reserves overall of PGM metals and much larger Proven reserves, although, to date, Impala has been more somewhat more successful in developing its reserve base (higher interim 2007 net income growth for Impala of 67% verses 47% for Anglo, mainly due to larger production increases at Impala for this time period) . Note that the significantly larger proven reserve base for Anglo (103M ou proven of PGM metals for Anglo verses 10.6 M ou reserves for Impala) means that Impala is expected to have to spend significant capital to develop probable and measured resources in a closer time frame. Anglo's reserve life based on proven reserves is 36.7 years verses 5.4 years for Impala.

Anglo Platinum Mine Analysis:

Anglo produces currently from two major mines, Ruthenburg and Amandelbelt, and two mid-sized mines, Union and Potgietersrust, in addition to smaller mines. Anglo's 4 largest mines will be discussed below. As shown in the chart below, Anglo's major mines have a high proven reserves -- and therefore represent "cash cows" for Anglo over a very long period of time.

* Note that in the comparison chart, the future Sum of Operating Profits is crudely taken, by adding up the proven cash flows over future years and not using a discount factor, and assuming a constant operating profit for the life of the proven reserve mine life.

The 4 major producing mines of Anglo Platinum have at current production rates, and assuming constant prices of PGM metals, very high expected operating profits over the next several years without large expected costs and capital expenditures to access probable and measured reserves. Note that the above values for the mines does not take into account probable and measured resources -- resources that could be available with additional mine infrastructure and development. As noted above, Anglo has approximately 8x the measured, estimated resources compared to its proven reserves compared to Impala (103 m ou of proven PGM metals and 804 m ou of PGM resources). These numbers not only indicate high future cash flows for Anglo -- significantly higher than its current market capitalization of $35.7Bn -- but also a dominant position in the PGM industry.

Anglo's two largest mines merit some discussion in detail, as they represent the largest earning assets of the firm. Rustenberg is Anglo Platinum's largest mine by output, 100% owned by Anglo Platinum, which produced 833,000 ounces of platinum group metals in 2005. Anglo plans to increase production up to 900,000 ounces to 950,000 ounces of annual production by 2010. During 2007, due to safety concerns, Rustenberg was shut down for 7 days which has caused output to be lower than expected for the full year, but no adverse long term effects are expected. During the first half of 2007, Anglo spent R4.7Bn on Rustenberg, R3.0Bn which was for expansion purposes and R1.7Bn to maintain operations. The mine has a proven reserve life of approximately 18 years at current production rates, and has an additional probable reserve base of 15.8M ou PGM, which translates to an additional 16 years of mine life based on probable reserves, translating to a total reserve life of 34 years based on proven and probable reserves.

Amandelbelt is Anglo's 2nd largest mine and highest operating margin mine, 100% owned by Anglo, with an impressive 64.1% operating margin for the first 6 months of 2007. Amandelbelt accounted for an estimated $US700M in operating profit for Anglo in 2006. Anglo expects Amandelbelt to produce 625,000 ou PGM in 2006, and plans to increase production to over 700,000 ou by 2012, as mine upgrades impact production. Based on proven reserves, the mine has a 61 year reserve life, and based on probable reserves (excluding proven reserves) Amandelbelt has an additional 60 year reserve life, translating to a 121 year total reserve life based on proven and probable reserves.

Is Anglo Platinum at Risk due to Technological Change or Lower World Economic Growth?

The greatest risk to Anglo and the PGM industry over the long term is substitution in the autocatalyst market for PGM metals. Both Mazda and Nissan have reported breakthroughs in experimental catalytic converter technology, which could lead to 70-90% lower platinum use per converter, utilizing nanotechnology (see here for details). RBC Capital Markets has stated that the technology is potentially commercial in 3-5 years from mid to late 2007, but cannot quantify the potential impact of the technological change. As such, development of this new technology remains a risk for Anglo investors to watch closely in future years.

Related, the demand for PGM metals is dependent on economic growth, particularly economic growth in China and India. Much of the additional demand for industrial usage of PGMs and jewelery usage comes from Asian countries. If there is an economic slowdown in China and India, then demand for PGM metals will drop and Anglo's profitability will be negatively affected.

Third, a risk to Anglo is its location in South Africa, which could potentially have resource disputes between the various ethnic groups. Further, the South African government, while historically supportive of its domestic mining industry, could pass laws requiring greater taxation of mining profits. At this point in time, the odds (by the author) of significant taxation issues has not been analyzed in detail, so the author has not quantified this risk.


Anglo Platinum is the world's dominant producer of Platinum group metals and has vast reserves of PGM metals, resulting in a good probability of high future profitability, and therefore represents a compelling long term buy. Compared to its most close competitor, Impala, Anglo is several times larger on a reserves basis currently (at 11/07), but sells, unjustifiably in the author's opinion, at a discount. Anglo is also relatively cheap compared to its future expected profitability based on proven reserves alone. Risks are mainly exposure to the PGM metals prices, and potential government issues, but these risks are partially mitigated by the positive prospects for economic growth of China and India, the pressure to add catalytic converters for environmental reasons, and the historical moderate governmental treatment by South Africa of its domestic mining industry.