Tracker - August 18, 2020: What might the updated Decar PEA of FPX Nickel look like?
FPX Nickel Corp has been a Bottom-Fish Spec Value rated Favorite since the start of 2020 when it was trading at $0.16, based mainly on Tracker Dec 13, 2019 which outlined the likely path a revision of the PEA done by Cliffs in 2013 would take. Since then there have been two important developments that have helped FPX develop a market uptrend. The first was news in early January 2020 that the 65% nickel concentrate possible through FPX's new flow-sheet of grinding, magnetic separation and flotation was amenable to conversion into nickel sulphate, the higher purity version of nickel needed for the electric vehicle sector's lithium ion batteries (Tracker January 7, 2020 explained why this was a big deal). The second was a a decision to proceed with an updated PEA now expected in September 2020 and discussed in Tracker Feb 27, 2020. This Tracker publishes my attempt to visualize what the updated PEA might look like. Because of the high CapEx long-lived nature of Decar the project's NPV is very sensitive to the discount rate used and the nickel price within a fairly narrow range of $5-$10 where the project is worthless at $5/lb but at $10/lb it has an after-tax range of USD $2.6-$5.4 billion (at 10% and 5%) and 32.8% IRR, which at 179 million fully diluted would translate into a future price range of CAD $19.30-$39.46 if no further dilution. Those are not realistic targets because it will cost another CAD $35 million and 5-6 years to bring Decar to a permitted mine construction decision, but the valuation framework I have constructed does make it clear how sensitive the project is to the future nickel price assumed by any major who buys out FPX Nickel Corp for the privilege of investing a couple billion on a 40 year mine. The speculative question for now is what cost numbers will underpin FPX's PEA, followed by at what price does FPX raise $10 million to fund a PFS expected to be complete by Q3 of 2022, and what percentage of the indicated NPV would a major be willing to pay to own the project. If the PEA numbers are similar to mine or better, FPX Nickel goes to a Good Spec Value rating if still trading below $1, and a Fair Spec Value rating if it has re-priced into the $1.00-$1.50 range where it will likely attract the funding needed for the PFS.
I have been tracking FPX and the Decar story since 2009 and it is my favorite nickel play because of its unique characteristic; nickel occurs as a nickel-iron alloy best described as natural stainless steel. The ultramafic deposits at Decar contain no sulphides, but underwent a metamorphism that created the awaruite. Nickel comes from two primary sources, laterite deposits formed from ultramafic igneous rocks such as those at Decar that have undergone nickel enrichment through tropical weathering which require acid and energy intensive processing (ie HPAL), and sulphide deposits formed by magmatic processes within igneous complexes which are converted into concentrates from which a smelter liberates the nickel. A third source emerged during the China super-cycle where low grade laterite ore not suitable for HPAL processing was strip mined and shipped as whole rock to China where legacy blast furnaces were deployed to create "nickel-pig-iron" which could be fed directly into stainless steel mills to create a product acceptable for Chinese standards. The Philippines and Indonesia were the primary source of this "NPI" ore which suppressed the price of nickel and discouraged the development of new nickel supply from conventional laterite and sulphide sources. Nickel pig iron bypasses the warehouses in which refined nickel is stored, which has helped distort the market's understanding of nickel supply and demand dynamics. The situation has been complicated by new demand for a higher purity version of LME refined nickel required by the battery market, which can be created by either reprocessing refined nickel or extending the HPAL flow-sheet for laterite ore. Nickel pig iron is not a feedstock for nickel sulphate because it is most effectively used for low quality stainless steel.
Starting in 2008 FPX has been developing a fourth type of nickel supply in the form of a mineral called awaruite, essentially a natural stainless steel alloy comprised of nickel and iron created when metamorphic forces liberate nickel from the lattice of a magnesium-iron silicate called olivine common in ultramafic rocks. The grade of this awaruite style of nickel is low, typically below 0.2% nickel, but, unlike laterite and sulphide nickel ores, it lends itself to low energy extraction processes that have minimal downstream emissions. Initially FPX management thought the world would redound with deposits that have this overlooked style of nickel mineralization, but a worldwide exploration effort eventually led back to the Decar project in central British Columbia as a unique collection of billions of tonnes of fairly uniform, coarse grained awaruite ore that has no contaminants such as sulphides. The initial goal was to produce a concentrate that could be fed directly into stainless steel mills in a manner similar to nickel pig iron, but without the whole ore "melting" stage and the need to deal with a dirty slag remainder. The potential to convert the 65% nickel concentrate into nickel sulphate opened up the possibility for an offtake market other than stainless steel mills, namely the growing electric vehicle market which currently only represents 5% of global nickel demand, but is expected to grow to 20% over the next 5-10 years.
When Tesla's Elon Musk urges companies to find and develop more nickel mines, he is really only talking about nickel supply that not only is cheap to convert into battery grade nickel sulphate, but can also be certified to meet ESG standards. ESG stands for "environmental, social and governance" criteria, a new concept that is emerging as a counter-balance to a profit-based business model that has been the basis for textbook free market theory and the concept of "just-in-time" globalized supply chains. The topic is very complex and revolves around 2 not quite related themes. The first is that a business should serve a public good that goes beyond creating profits for its shareholders, not just in refraining from dumping costs onto powerless downstream victims, but also through the very nature of the business creating a common good whose benefits do not necessarily flow back to the business. The second is the concern that a mindless pursuit of profit through short-term, just-in-time opportunism creates exposure to unforeseen calamities that down the road harm the profitability and even the viability of the business. As the Covid-19 pandemic disrupts global supply chains in unpredictable ways, often at the whim of whatever personality cult is in power, and as a great power rivalry develops between the established American hegemon and upstarts like China and also-rans like Russia, there is a new focus on resiliency rather than efficiency where more localized and diversified supply chains, and by that nature more expensive, are attracting attention as the price to pay to hedge against fatal supply shocks.
The first theme has long been the target of "do-gooders" such as non-governmental organizations (NGOs) which portray themselves as altruistic champions but in most cases are mainly focused on self-sustenance (are we pulling in enough donor money under the pretence of saving the world so that we are saving our personal lifestyles?). Increasingly a much broader audience is embracing the "common good" concept, led in part by people of all ages with a scientific understanding of how the world works, and by younger generations, whom I call the Post Boomers, who fear that their long term future is being sacrificed through a Boomer disregard of processes such as climate change whose mitigation requires some degree of near term sacrifice.
The second theme is the target of "activists", theoretically shareholders in the business, who want the business to adopt policies which shield the business against long term disaster. The corporate governance branch focuses on stupid or criminal things done by management that harms shareholder interests. This now includes a focus on the company's supply chains. Until recently optimizing the supply chain on a lowest cost, just-in-time basis such as pioneered by Walmart has been gospel. But the assumption of a rules-based global trade order is today being questioned as individual nations succumb to populist anger stirred up by the ruthlessness of free market competition, and others like the United States and China who are supposed to be trading partners square of asf geopolitical rivals. The corporate governance activists are asking companies to rethink the just-in-time optimized business model to include hedging against potential future disruptions.
The environmental and social branches seek to pre-empt damage to the sustainability of the business model caused by either regulatory action or a brand-damaging consumer backlash. Brands such as Apple and Tesla have packaged themselves as champions of a common good, which makes them vulnerable to accusations of producing "dirty" products because they cannot demonstrate that their supply chains create environmental or social harm, or worse, get caught using inputs that create such harm. The explosion of social media and its viral nature that enables a single influencer to unleash widespread brand damage has pushed ESG into the forefront of things a corporation like Tesla and Apple must worry about. The unique nature of the Decar nickel story allows FPX Nickel to tap into the ESG boom because as a single, large, easily monitored source of nickel supply it can bestow ESG credits to its offtake customers. Although the lowest grade nickel deposit ever to be considered as a development candidate, Decar will be of great interest to a major producer eager to supply ESG certified nickel to customers for whom brand purity is mission critical. Sulphide nickel comes predominantly from Canada and Russia, with most of Russian supply coming from the giant Norilsk nickel-cobalt-pgm mine owned by an oligarch. Norilsk rivals China as a source of pollution, but in late May 2020 Norilsk entered the supreme ESG doghouse when a giant aging diesel tank collapsed due to thawing permafrost and spilled 20,000 tonnes of diesel oil into an Arctic river system. The Norilsk Oil Spill even caused Vladimir Putin to fly into a rage about it. Refined Russian nickel ends up in LME warehouses as a generic product where it ends up in all sorts of products such as Teslas marketed at ESG enthusiasts. Most of the rest of the nickel comes from laterite deposits mined in countries like Indonesia and the Philippines with dubious environmental practices. FPX's Decar nickel supply is special because it does not need third party smelter treatment where it ends up comingled with nickel from other sources. Decar's uniqueness allows chain-of-custody verification.
FPX Nickel's Decar project already meets ESG criteria in general terms based of the simple nature of the deposit, its flow sheet and geopolitically unproblematic location, but the possibility of becoming a direct feedstock for nickel sulphate above and beyond a feedstock for stainless steel is a bonus reason for a major to own and develop Decar. But Decar offers another intriguing ESG bonus that is very difficult for the mining sector to secure. The holy grail for a mine is a carbon neutral footprint where carbon dioxide generation through energy intensive activity such mining, crushing, grinding and various chemical processes are offset by either utilizing a source of energy that does not generate carbon dioxide (ie no electricity powered by diesel, coal or natural gas), or accomplishing some form of carbon sequestration that offsets carbon dioxide output caused by energy consumption. That is quite hard to do for a mine not next door to a nuclear energy plant, hydro-electric dam, or a renewable source such as wind or solar power not generally located near a remote mine site.
One of Decar's big problems is that recovered nickel is only 0.1% of the ore mined. The rest is tailings that must be disposed of. The new proposed flow-sheet will use crushing and grinding of ore finer than proposed by Cliffs in the 2013 PEA which when subjected to magnetic separation will concentrate the nickel into 10% of the original mass for a recovery of 85%. That 10% of the original mass will consist of awaruite, a 75:25 nickel-iron alloy, plus magnetite. The Cliffs flow-sheet attempted to use gravity to separate the awaruite from the magnetite, but it was only partly successful, with the result that the concentrate was only 13% nickel, with most of the rest consisting of iron-oxygen minerals. The innovation FPX brought to bear was to ditch gravity separation in favor of flotation which separates the awaruite mineral (ie natural stainless steel) from the magnetite. One might have thought replacing gravity with flotation would have impacted OpEx, but the flotation plant only has to handle 12,000 tpd so the impact on a per tonne mined basis has been modest. The resulting concentrate that FPX believes to be saleable is 65% nickel, 25% iron and 10% "other stuff". The magnetite ends up as a concentrate with 62%-65% iron which may have a market whose value offsets or even exceeds the disposal cost. The potential ESG bonus, however, comes from the high magnesium content of the 90% tailings which transforms into a magnesium hydroxide called "brucite" which absorbs carbon dioxide. FPX is studying how much carbon the magnesium part of the Decar tailings could sequester and if there is anything that can be done to enhance the sequestration process. (See Tracker May 2, 2018 for background on this concept.) It is difficult to assign any monetary premium to the ESG value of Decar being carbon neutral or coming very close, but it would be a factor in the rationale behind a major's takeover bid of FPX Nickel for the privilege of investing USD $1.7 billion or more to develop Decar as a 120,000 tpd open pit nickel mine.
The news about the possibility of making nickel sulphate from the nickel concentrate otherwise sold directly to stainless steel mills was one important development. The other was news that FPX had finally decided to proceed with a an updated PEA that would incorporate key changes management had made since acquiring 100% ownership back from Cliffs in 2015, as discussed in Tracker Feb 27, 2020. One was drilling off the Southeast Baptiste Zone which delivered a high grade resource addition that will serve as a starter pit which I estimate at 294 million tonnes of 0.15% nickel during the first seven years, followed by the rest of the 1,680,000,000 tonnes at an average grade of 0.11% nickel. Another was the development of a new flow-sheet which replaces gravity separation with a flotation cell that delivers a 65% nickel concentrate clean enough to be saleable as direct feedstock for stainless steel mills, allowing up 95% payable of contained nickel at LME price. A third change has been greater attention to the tailings facility which has helped boost the CapEx for a project FPX is increasing from 114,000 tpd in the 2013 PEA to 120,000 tpd today. The updated PEA will be published in September 2020 which will be an important milestone because the 2013 Cliffs PEA relied on a USD $9.39/lb nickel price which today is close to the $10/lb price I use as fantasy price for nickel. The company has struggled during the past five years to overcome a market perception that Decar needs a nickel price the optimistic end of the projected future price range.
In an effort to anticipate what the updated PEA will look like I have created a speculative discounted cash flow model that incorporates key changes FPX nickel has achieved. I have created an 120,000 tpd open pit mining scenario whose ore is concentrated to a 65% nickel concentrate through a flow-sheet of crushing, grinding, magnetic separation and flotation which produces a 62%-65% by-product iron concentrate consisting of magnetite to which I assign zero value. CapEx, based on guidance from FPX management that it will be considerably higher than proposed by Cliffs, I have pegged at USD $1.7 billion with sustaining capital at $1.2 billion spread evenly over the 39 year mine life. Tax is 15% federal and 12% provincial with a special 13% BC mineral tax that is applied to operating cash flow and deductible before application if the 27% federal and provincial income tax. Sustaining capital is expensed in the year incurred and CapEx is depreciated on a straight line basis over 10 years. The PEA will accommodate a more complex tax treatment that will make my approach conservative. The 65% nickel concentrate is subject to a USD $75 per dry metric tonne transportation cost which allows delivery to Asia. The first 7 years processes ore grading 0.15% nickel with the remaining years at 0.l1%, all of which generates an 85% recovery with 95% of the recovered nickel payable at the LME nickel price. The waste to ore rate is 0.17 tonnes waste for 1 tonne ore processed for the life of mine.
I have constructed a speculative DCF model within my spreadsheet system because the ability to front-load the ore schedule with a higher grade zone is critical to the economic viability of Decar, which my Outcome Visualization system cannot do because it is built on a computational platform that can only handle life-of-mine average values. The OV system is intended for projects for which an economic study has not yet been published, which in turn means that the data granularity required to justify an ore schedule is not available to non-insiders. Ironically the 2013 PEA by Cliffs used just LOM averages, but that was partly due to the homogeneity of the deposit at the time; the Southeast Baptiste zone with grades running 0.14%-0.16% was not delineated until 2017 and presents a distinct opportunity to boost cash flow in the early years of production that was not available to Cliffs in 2013. In my model I am eyeballing that the SE Baptiste zone will provide 294 million tonnes at 0.15% (the chosen number is a fudge to deplete that zone in the first 7 years at 120,000 tpd); when the company publishes its PEA we will find out what it thinks the number will be, though we may not see the details until a technical report is published on SEDAR within the required 45 days. The use of my spreadsheet model allows us to see the sensitivity of Decar to different nickel prices in a way that is not possible with my OV system.
The after-tax sensitivity graphics for the Decar project show not only extraordinary value leverage within the range of $5-$10/lb nickel, but huge outcome differences created by the discount rate range of 5%-10%. In gold based economic studies everybody uses a 5% discount rate because that generates a very pleasing after-tax net present value compared to 10%, but because gold projects tend to have a mine life of 10-20 years the difference is usually about 50% higher for 5% than 10%. But for very long lived high CapEx mines such as Decar, which can supply ore for 40 years or more, the difference is much bigger. For example at the current price of $6.56/lb the AT NPV at 5% is USD $1,938,000,000 compared to $652,600,000 at 10%, almost 200% higher (the IRR at 16.1% is the same regardless of discount rate). It worsens as you move toward $5/lb where the 10% NPV becomes a negative number while the 5% NPV is still positive. At the opposite $10/lb end the 5% based NPV is only 100% higher than the 10% NPV. What this implies is that the value of Decar will reside in the eye of the beholder, and the only beholder that counts is a major mining company capable of putting up USD $1.7 billion (or whatever the PEA comes up with) to develop Decar and operate it for the next 40 years. Assuming there is competition among majors to own a long-lived asset like Decar in a secure jurisdiction with important ESG credits and the potential capacity to make nickel sulphate more cheaply than current methods, it becomes a question of what internal nickel price projections the major has, and what percentage of the NPV it would be willing to pay so as to own the "privilege" of investing another USD $1.7 billion in constructing the mine.
So how do we in the meantime price FPX Nickel? The Rational Speculation Model is based on the idea that the fair value of a quantifiable outcome is that value multiplied by the certainty of that outcome becoming reality. There is a huge range of possible fundamental outcomes and associated uncertainties, which implies that assigning a fair value is a random act. However, the market naturally performs this task through the value it does assign to the company, adjusted for the net interest in the project. It then becomes the individual investor's task to unpack what the market is thinking in order to determine if the market is correct. The table below contains an uncertainty ladder which shows the certainty range applicable for a geologically plausible outcome at each exploration stage based on the sort of information available at each stage. It may seem counter-intuitive that at the grassroots stage a $100 million prize has the same certainty of becoming reality as a $1 billion prize, but it is implicit that professional work has already been done to make plausible the various fundamental outcomes. At the earliest stage you can let your imagination run wild, but as the project proceeds through the exploration stages the gathered information gradually constrains what you can imagine as the fundamental outcome in the form of a physical orebody with "discovered" extraction costs. By the time a project reaches the PEA stage where the certainty is 10%-25% all that is left to dream about are what the future metal price will be and the final costs established by a feasibility study that has met all conditions for a mining permit. When a junior publishes a PEA a fair market value would be 10%-25% of the projected after-tax NPV, provided the NPV and IRR clear important production decision hurdles such as the NPV matching or exceeding CapEx and the IRR being 20% or higher. That still leaves lots of room for price variation. For example, at $6.56/lb nickel the NPV at 10% translates into a $4.80 stock price while the 5% NPV delivers $14.26. Applying the low end of the uncertainty range for a project at PEA stage, namely 10% to $4.80 generates $0.48 as a fair value, while applying the upper 25% to the $14.26 price delivers $3.57 as a fair value.That is still a wide range, but at least it is a range, and you can explain why you think the fair value will end up where, which you can debate with others. The Rational Speculation Model is not a definitive outcome generating blackbox but simply a framework to define and compare different outcomes.
Many juniors deliver a PEA and that is where everything often stops because the next stages of feasibility demonstration, namely a PFS and then an FS (sometimes called BFS or DFS), require substantially higher expenditure without making the fundamental outcome better, and more often than not, making it lower as costs increase and grades shrink as infill drilling moves the resource into reserve category. A decision to proceed with a PFS is thus an important milestone because that justifies moving the project into the next stage where the uncertainty range is 25%-50%. In other words, if we assume the PEA NPV outcome range will survive completion of a PFS, 25% of $4.80 becomes $1.20 while 50% of $14.26 becomes $7.13 (technically I should be referring to the absolute numbers, $652,600,000 and $1,938,000,000 because these are constant relative to the model assumptions, but the current 179 million fully diluted can easily become bigger as the junior finances the next stages). I have constructed and presented this speculative DCF model to provide an advance framework of what we might expect when FPX Nickel publishes its updated PEA in September. Once that happens I will replace all my "best guess" variables with the ones used in FPX's QP qualified 43-101 disclosure. Meanwhile, if you accept my speculative PEA assumptions, and believe that the long term nickel future resides in the $6-$8/lb range, then you have to ask what percentage of the potential outcome value would a major pay to own the asset and what internal discount rate would the major use to calculate the outcome value? I don't know, but what I can say is that at $0.49 the market is saying that a major might pay 10% of the $4.80 NPV generated by $6.56 nickel and a 10% discount rate. That is rock bottom from where the pricing can only get better.
The IPV chart above shows how the market is currently pricing Decar on a 100% ownership basis in CAD, namely $87 million compared to the USD $66 million in my absolute NPV based DCF model chart. The blue, yellow and red channels in the IPV charts at KRO represent the fair value ranges for each stage for different CAD outcomes: $2 billion, $500 million, and $100 million. This allows the viewer to see what sort of outcome the market is expecting, which in the case of Decar, assuming the market is heeding the rational speculation model, is a CAD $500 million outcome. If FPX publishes its updated PEA and soon after announces that it will proceed with a PFS, the current stock price would be under-valued relative to a future $500 million outcome and we could expect a price increase so that Decar's implied value stays parked within the yellow channel. CEO Martin Turenne tells me that a PFS would cost about $10 million earmarked for additional metallurgical studies at greater scale and geotechnical drilling for pit and tailings facility design. None of this information will be of any interest to investors, though money will be spent on the nickel sulphate conversion process which would boost the ESG premium for this project. Good news on that front would be well received for the current PEA plan does not assume any cash flow boost from conversion of the 65% nickel concentrate into nickel sulphate. Turenne would not expect delivery of a PFS until Q3 of 2022. Assuming nickel prices have held up or improved the next milestone would be a feasibility study which Turenne estimates would cost $15 million and take 18-24 months to complete. At the same time FPX would need to initiate the permitting cycle which Turenne estimates would cost an additional $10-$15 million and take up to 4 years to result in a mine permit and a construction decision. So we are looking at 2026 as the earliest a major could start building the Decar mine.
The most important upcoming milestone is the publication of the updated PEA, which will gives us a clear idea about the nickel price optionality of Decar based on the improvements FPX has achieved since acquiring 100% back from Cliffs in 2015. This we shall find out in September. The subsequent critical milestone will be raising $10 million to fund the PFS over the next 18-24 months. If the updated PEA is similar to my speculative DCF model, I expect the FPX stock to re-price into the $1.00-$1.50 range to reflect the fair value of the 10% discount rate generated AT NPV. The ability to raise $10 million within that price range will depend on the broader market's reception of the PEA. What has impressed me over the past few years is that FPX has consistently funded its operations through zero warrant private placements taken down by management insiders, large shareholders, and even from the original lender whose USD $5 million loan enabled FPX to claw back 100% of Decar from Cliffs and whose interest now resides in equity rather than debt. The appointment on August 17, 2020 of Stuart Harshaw as a director is another vote of confidence. Harshaw spent 28 years at Inco and then Vale after it acquired Inco. His area of expertise was marketing nickel in the various forms that mines produce it, expertise that is extremely relevant to FPX Nickel which proposes to market a new type of concentrate potentially loaded with ESG credits. Harshaw first approached FPX a year ago after he had retired from Vale because he was very intrigued by the Decar project. Coming on board is a big knowledge boost for FPX as it begins to deal with potential suitors after publishing its updated PEA. I have followed FPX and Decar since 2009 and it continues to be one of my top Favorites. I still have a Bottom-Fish Spec Value rating because we need to see what management's PEA numbers are, and, if they are similar to mine or better, the stock will deserve a minimum Fair Spec Value rating or even a Good Spec Value rating if the market is sluggish to respond.
If FPX Nickel proceeds to the PFS stage and raises the required capital, it will spend some of the money on a first ever drill test of the Van target on Decar. Much of it is over-burden covered but the outcropping parts have yielded high nickel grades similar to those of the Southeast Baptiste zone. The mineralogy at surface is the same as Baptiste, so whatever metallurgical work done as part of the PFS would apply to the Van system. Because of the homogenity of these deposits at Decar it would not take much drilling to delineate an initial resource for the Van deposit. If it represents 1 billion tonnes of 0.14%-0.16% nickel (Davis Tube) with awaruite grain size distribution similar to or better than the Southeast Baptiste zone, the PFS focus could be shifted to the Van deposit. Processing high grade ore for 20 years instead of just 7 years would have a profound impact on the minimum nickel price needed to develop a mine at Decar. In addition to watching FPX as a nickel price tracking optionality and gaining ESG credits on the carbon neutral and nickel sulphate research fronts, FPX shareholders could get some discovery related excitement in 2021 if the nickel system becomes "better" than currently assumed.
*JK owns shares in FPX Nickel Corp