Why Invest in "Prospect Generators?" – Mishka Vom Dorp

Mishka Vom Dorp, an Investment Executive at Sprott Global Resource Investments Ltd., believes the ‘prospect generator’ model can produce returns for investors – with less risk than most junior exploration stocks. Prospect generators maintain a portfolio of projects on their books and then create joint venture partnerships with other firms. It’s their partner firms who conduct the drilling and shoulder, in many cases, most of the financial burden of exploration.

As Mishka explains, a prospect generator is a means of spreading risk across many potential projects, increasing the odds of hitting a winner. In a recent note, he laid out four key benefits to owning shares in prospect generators:

1. Risks spread across multiple projects…

A traditional exploration firm usually has one big project at a time – the hopes and dreams of shareholders rely on that project turning into a major new discovery. The odds of this outcome are very slim. If the exploration project ends in failure – as most do – the junior may lose almost all of its value.

Prospect generators, on the other hand, have a number of projects on their books. Each individual project might have slim chance of success. By increasing the number of projects in play, the company’s success may not be tethered to any individual high-risk project.

2. Lower “burn rate” can mean less dilution…

Carrying out a drilling program is a capital-intensive task that can cost upwards of $1 million dollars for a single hole. Exploring an anomaly or delineating a deposit – in order to find out its potential mineral content – can require hundreds of drill-holes. Because exploration of a single target is very costly, most companies can only focus on one major project at a time. Otherwise, they might burn through their cash reserves before they can accomplish meaningful work on any single target.

Prospect generators are able to participate in multiple ongoing projects, thus diversifying their risk, by striking “joint venture” deals with other companies. The partnering company will shoulder most of the financial burden for a drilling program. In exchange, the partner will receive an ownership stake in the developing asset. These partnerships mean that the prospect generator can spend relatively little capital, and potentially end up with a big share of a new discovery made by one of its partners. Because the prospect generator spends little of its own money, they may be less likely to require future financings, which would dilute existing shareholders.

In the oil and gas sector, exploration can be even more expensive. An offshore oil and gas well costs upwards of $150 million! A traditional exploration company may need to raise capital over and over, diluting shareholders at each raise, in order to keep going until it hits a winner. A prospect generator, however, can survive much longer and take on a wider range of project without the need to load up with fresh capital for each new venture.

3. An investment in intellectual capital…

With traditional exploration, the specificities of a project often make the company. No matter how talented the mineral geologists on the team, the success of a drilling program is ultimately in the hands of fate – you drill a hole, and if you’re lucky, you hit a big ore body.

That is not to say that exploration is all luck. Some exploration teams have made multiple discoveries, while others have made none. Although it is usually impossible to tell for sure whether any particular project will yield success, a talented management team may be able to interpret data and analyze geological features in order to maximize the chances of success.

We often say that exploration is the “Research & Development” department of the mining world. We are attempting to solve questions surrounding potential ore bodies or mineralization trends that could yield high returns if we are correct.

With prospect generators, we can focus on investing in quality ‘researchers’ – those who are the best at recognizing which problems, if solved, will generate the most potential value for shareholders. By spreading the team’s efforts across different projects, we can invest in the intellectual capital behind the team, which can be independent from the success of any particular drilling project.

4. Some successes to go by…

The prospect generator model, while relatively new, has enjoyed successes in both mineral exploration and the oil and gas sector.

For instance, Africa Oil Corp. acquired properties in West Africa during 2000’s. It was able to find a partner to perform exploration drilling on its properties in exchange for a stake in the potential discovery. Africa Oil capitalized on its team’s ability to determine the best prospective locations, while allowing another company to shoulder the financial risk of drilling. Sure enough, this model worked out well, as Africa Oil’s share price rose from around $1.00 in early 2010 to over $10.00 by late 2012.

Another success story for prospect generators is Altius Minerals, which now holds royalties – the remaining stake in a project that has been developed by a joint-venture partner – in 12 producing assets. Naturally not all prospect generators have experienced this success. Prospect generators that fail to make economic discoveries can see significant share depreciation, and are also subject to the overall trends of the junior resource markets. Even Altius Minerals has seen little share price appreciation since 2010.

Prospect generators allow investors to invest in companies with relatively minimal exposure to any individual discovery play and with lower capital requirements, which means the risks of dilution caused by a capital raise are lower than with conventional exploration stocks.

How do you recognize a good prospect generator?

As Mishka put it: “They need to leverage their intellectual capital with other people’s money. You want to look for ones that can bring in partners with big bucks. Ideally, their partners spend their money to develop the project, and the prospect generator gets a free ride.”