I recently chose Midway as “stock of the week” on March 14th, as this promising company appeared to be oversold, not thinking that the unlikely worst-case scenario would become a reality. However I was proven wrong, and the recent developments have cast significant doubts about Midway and its credibility. As a result, the share price has plunged 80% since picking it on March 14th. This event has not only raised questions about Midway, but also about the competency of Gustafson Associates, the consulting firm responsible for the resource modeling as well as the feasibility studies. It is actually quite surprising that Midway elected to have Gustafson carry out the recently updated resource modeling. Perhaps the blame does not lie with Gustafson.
In this article, I will be comparing three different resource models of Pan. The 2011 pit-constrained feasibility reserves (864,245 proven and probable ounces), the 2015 pit-constrained updated resource estimate (503,800 measured and indicated ounces), and the comparison pit-constrained resource estimate using the 2015 pit shell model but limited to 2011 data (788,300 measured and indicated ounces). I mention this now to avoid confusion with all of the numbers and comparisons I use within this article.
I chose the company after they issued a construction update for their Pan Project, in which they also acknowledged that early production test work had shown the grade of their deposit was possibly lower then what was modeled; and that an independent review was underway. Following the press release and leading up to the time that I chose MDW as stock of the week, the share price had already declined 37%. I felt this potentially provided a good buying opportunity with reasoning’s explained in my write up. I mentioned at the time that the 37% share price decline represented a $60 million reduction in Midway’s market cap. With a 10% decrease in Pan grade equating to a reduction of $40 million in the after-tax NPV of the project, I felt at the time that the $60 million reduction had already priced in a 5%-10% decrease in grade, and that an error in grade of more than 10% for feasibility-level reserves would be very unusual and unlikely. However, with the recent resource update for Pan, the grade had in fact decreased 15% in the measured and indicated (M&I) category, and an astonishing 38% in the inferred category, much more then I had expected.
Even more, the (M&I) ounces of gold contained within the new 2015 pit shell model have decreased to 503,800 ounces from the 788,300 ounces contained in the 2011 comparable pit shell. This is a result of 284,500 of those ounces being either downgraded into the inferred category or completely omitted from the new pit shell. It should also be kept in mind that these downgraded ounces, in combination with the ounces lost to a reduction in the current pit size compared to the 2011 feasibility model, actually has the 864,245 proven and probable (P&P) reserves of the 2011 feasibility model shedding 320,000 ounces; either downgraded into the inferred category or completely removed. This essentially threatens to wipe $288 million from the life of mine revenue modeled in the feasibility study, and will certainly shorten the life of mine (LOM) at Pan.
In the inferred category, the ounces of gold have increased to 141,100 from 10,200 as a result of the downgraded (M&I) ounces. What is particularly concerning is that the grade of the previous (M&I) ounces now in the inferred category has declined 38% to 0.31 g/t. However, where the impact really occurs, aside from the lower grade of the (M&I) and inferred ounces, is the number of (M&I) ounces that have been either downgraded into the inferred category and are now at the lower grade mentioned above, or else have been completely omitted from the new pit-constrained resource. If the updated (M&I) tonnage had remained the same as the original reserve tonnage, yet at a 15% lower grade, it would have ramifications, but this could be offset by an increase in the average (LOM) gold price to $1380. That scenario would generate the same revenue as what was modeled in the 2011 feasibility study. I say this because many believe $1,200 gold to be near the bottom and expect higher gold prices in the medium-long term, so it is a possible scenario.
However, the decrease in the (P&P) reserves used in the 2011 feasibility study represents 320,000 ounces, with close to 180,000 of those ounces being completely removed from the new 2015 pit-constrained resource. So even if the average (LOM) gold price was to climb to $1380 and offset the 15% decrease in (M&I) grade, there are still the 180,000 ounces that will somehow need to be made up for, as well as the 141,100 ounces now in the inferred category at an even lower grade (0.31 g/t). It would actually take a further $525 increase in average gold price to offset the decrease of 320,000 (P&P) ounces. That means at this point if nothing else changes and considering the updated (M&I) ounces exclusively, it would take a gold price of roughly $1,900 to generate the same returns as the cash flow model displayed in the feasibility study. I am speaking in very simple terms in regards to the effect of a higher gold price. There is a balance where a certain gold price increase will equate into additional low-grade material becoming economical, and therefore generating leach-pad feed resulting in an increase in (LOM) gold production.
Despite the drop in (M&I) ounces, there are the inferred ounces to consider. Since inferred ounces are of low confidence, not considered economically viable, and are prohibited for use in pre-feasibility or feasibility studies, the current 141,100 inferred ounces are considered as “waste”. However, these inferred ounces are contained within the updated pit shell, and would be mined along with the ore. Therefore it is possible that a portion or all of the inferred ounces would either be stockpiled as low-grade material for future leaching, and/or blend material to be placed onto the leach pads along with the ore. So there is the potential to recover those ounces, and there is also the potential to upgrade those ounces into reserves in the near-term with additional drilling. The company will need to determine what makes sense economically, and continue to modify the pit shell and optimize the mine design in hopes of mitigating the impacts of these recent issues while trying to salvage the project. An updated feasibility study is expected by the end of June, and will provide clarity to these issues and much more. The development of a new mine plan and an updated statement of reserves will be completed as part of the feasibility study.
What is surprising is that normally using a smaller pit-shell would increase the grade, though at a cost of lower overall ounces, as a smaller pit-shell will typically have the flexibility of isolating a higher-grade core. Yet in this case both the ounces and the grade have declined compared to the feasibility reserves. This may be because the company elected to use a lower cut-off grade (0.14 g/t) compared to the feasibility study (20 g/t and 27 g/t), although the lower cut-off used makes the downgraded/decreased number of ounces even more concerning. What is also interesting is that the company has provided us with the 2015 pit-constrained resource and also a resource based on these same pit shells using 2011 data. Within these identical pit-constrained resources, 284,500 ounces have been removed from the (M&I) category, with 130,600 of those ounces downgraded into the inferred category and 153,900 ounces completely omitted from the new pit-constrained resource. This reveals that there were significant deficiencies with the initial raw data and/or the calculations and assumptions used in the 2011 resource estimate. The 2015 resource estimate includes an additional 44,000 feet of reverse circulation (RC) drilling and 5 additional diamond drilled core holes. What is perplexing about this whole event, is that the cost of that additional drilling is roughly $2 million give or take, yet it is this additional drilling that has exposed/confirmed a serious and potentially fatal issue affecting the entire Pan project, and perhaps the company as a whole. It would no be surprising to see some sort of lawsuit emerge as a result of the negligence shown in preparing the 2011 reserve estimate and associated feasibility study.
All things being equal and with the current resource estimate, in order to generate the same revenues that were displayed in the 2011 feasibility report, we would need all of the current inferred ounces to be upgraded and processed, as well as an average gold price above $1,500 over the life of the mine. There is also the expansion potential at Pan that may add additional ounces into the mine plan and extend the LOM. This would therefore lessen the dependency on a higher gold price to offset the lost revenues. The Wendy Deep zone, as well as the extension of North Pan and South Pan to the north and south respectively, are all targets of the 2015 drill program. In addition there is the Goldrock project that is located 10 km away, and although I am unclear about the logistics, perhaps this development stage project may be able to provide future feed for the leach-pads and extend the life at Pan. It is hard to say at this point.
With the lower grade, lower ounces, and decreased mine life of the deposit now a reality, it will equate into lower projected revenue and profit margins. This seriously calls into question the company’s ability to service their debt. Therefore, unless there is a significant increase in the gold price and number of recoverable ounces to offset the lower grades and downgraded ounces, Midway’s balance sheet will certainly suffer and will likely be a cumbersome and potentially debilitating issue weighing on the company over the life of the Pan mine. As mentioned below, asset sales are one solution to removing this burdensome debt scenario.
The company released a corporate update on May 21 2015; the day after their extended waiver with the Senior Debt had expired. As stated in the update, “the company may now be in technical default of its loan agreements”. Also, “the company is in active discussions with its senior lender to obtain conditional waivers”. Midway also mentioned that they are exploring strategic alternatives to replace the Senior Debt in order to provide the company with the flexibility it needs to advance its business operations. This may come in the form of an alternative loan, a partnership, an asset sale, or some other monetary alternative. Unfortunately, Midway is in a very precarious situation, and vulnerable to predatory offers. These strategic alternatives will likely come at a high cost.
MDW Pan LLC, a wholly owned subsidiary of Midway Gold and the owner of the Pan Project and related assets, would not be the only collateral at risk in the event of an early Pan default. The $53 million Senior Debt Facility with CBA is secured against all of the assets of MDW Pan LLC, and all other entities of the consolidated group (ie. essentially Midway as a whole). Therefore, it is essential that the company is able to obtain the necessary funds to pay off the Senior Debt in full and remove this threat.
There is really no way for an investor to have predicted this lower grade/lower ounce issue with Pan, as there was little in the resource estimation or feasibility study to cause concern or raise questions. However, it is examples like this that should help to remind investors that we have to be extremely careful of what we are investing in and truly understand the risks and uncertainties associated with mining and mineral exploration. No matter how good a company is doing or how promising their outlook is, we should never be putting all of our eggs in one basket. Geology is too complex, metal prices are too unpredictable, and mining has too many variables for any project to be a guarantee. In addition, open pit operations are large tonnage operations, and due to their economies of scale, are that much more sensitive to fluctuations in the metal price and/or grade. Also with bulk mining methods such as open pit mining, when a final pit shell is designed and put forward, there are multiple implicit factors/errors that can combine to leave this final pit shell somewhat displaced in relation to the actual resource. This displacement or error, can significantly affect the company’s anticipated production performance once operations commence. A slight miss of the pit shell will have the company digging up more waste and less ore than anticipated.
Until the ounces within a resource have been classified as reserves (Proven and Probable), there is much less of a guarantee that those ounces will come out of the ground in the same fashion as they were modeled. Although what is perplexing about the case of the Pan Project, is that the 2011 feasibility was based on proven and probable ounces. You will notice in the power ranking section of Tickerscores, that I will highlight the fact that a company has completed a PEA based solely on inferred or indicated ounces. I warn of this because investors need to be aware of the uncertainty of resource estimation, and the susceptibility of the economics to any errors in the resource estimate or mine design. For example, I mentioned that Rubicon Minerals, a high-ranked developer in the Ontario category, is proceeding with construction having only completed a PEA, and furthermore, that PEA is based solely on indicated and inferred ounces. Although the story looks promising for Rubicon and their high-grade Phoenix Project, investors need to keep these things in mind.
In regards to the CEO of Midway and his lack of buying, he had effectively joined Midway on December 10th, at which point he was awarded 1,757,576 options at an exercise price of US$0.75 per share. Between his inauguration as CEO and now, there has been no insider buying of any sort from any insiders. It is possible that considering some of the construction setbacks as well as the sensitivities at the moment, that management is likely under a blackout period.
In conclusion, Midway will first need to dodge the impacts of a default scenario, where they would be potentially forced to immediately pay all unpaid amounts under the Senior Debt Facility. If they are able to negotiate or waive/amend certain compliance issues, or obtains the capital needed to remove this burdensome loan, then perhaps there is a chance for the company to rectify the situation. If they are able to put their debt issues to rest, it will provide Midway with the necessary flexibility to advance their business operations. They will need to optimize their mine plan and show to the market their ability to still generate a reasonable rate of return, as well a solid plan to extend the now reduced mine life. As mentioned before, a higher gold price will certainly help the company overcome this potential crippling scenario, but they will need to also be successful in discovering/upgrading additional ounces of gold during subsequent drill programs in order to replace those ounces lost in this debacle. The company is spending $2.5 million on expansion drilling this year, which may result in upgrading inferred ounces as well as a possible expansion of the pit shell model to include more ounces.
I hope this has shed some light on this unique and puzzling situation, as we await the updated feasibility study to answer our many questions. There is still value in Midway considering their three main assets. What that value is will be hard to know until everything plays out in the months ahead.
Sincerely,
Aaron Andronyk
Tickerscores
Mining Analyst
MAY
