It was one of those "life imitates art" moments.

On the plane ride to Denver, I had devoured John McPhee's Assembling California, in which the author recounts driving around with geologist Eldridge Moores, talking (mostly) about rocks. Two days after my arrival, I was whizzing along a dirt road in the passenger seat of a pickup that had a bumper sticker declaring "I (heart) Uranium." I'd tracked down a geologist of my own, and we were talking not only rocks, but stocks.

Moores, despite growing up in a mining camp, reports quashing the gold bug whenever he feels it taking hold. My geologist friend, Dave, on the other hand, has spent his professional life chasing gold, copper, and other goodies. After a rewarding career at Newmont Mining (NYSE:NEM), Dave struck off on his own as the CEO of a public exploration company (too tiny to mention here). He's also an active investor in the mining space. Given the diversity of his experiences, I just had to pick Dave's brain.

How to explore without going broke
While I won't go into the specifics of Dave's business, it follows the widely employed joint venture business model, which anyone considering investing in an exploration company should understand.

Like an early-stage biotech with R&D costs burning up cash and no revenue coming in the front door, a mineral exploration company is racing against the clock. Both firm types have to spend a lot of money and face a high risk of failure, but the upside to discovery is enormous. The key, then, is to sustain the slow, costly process of discovery without running out of money.

Rather than go all-in on a handful of projects, prospect generators following the joint venture model typically create a broad portfolio of opportunities by going out in the field and staking attractive ground. Dave has regional managers conducting this sort of activity in various countries around the world.

The next, and most crucial, step is to bring in joint venture partners to fund the expensive drilling programs necessary to delineate mineral resources. This enables a company like Barrick Gold (NYSE:ABX) or Agnico-Eagle Mines (NYSE:AEM) to earn a majority interest in a project by footing the multi-million dollar exploration bill.

While this business model limits the explorer's economic interest in any one project, it enables the company to maximize the number of drills turning -- and the chance that one will hit the next mother lode -- without having to continually raise more money and dilute the share count.

What's eating gold stocks?
After digging into the mineral-hunting business, our conversation touched on the disappointing share performance of precious metal companies, large and small.

Sure, shares of some rising players like Goldcorp (NYSE:GG) and Kinross Gold (NYSE:KGC) have been explosive over the past year, but big boys like Newmont and AngloGold Ashanti (NYSE:AU) have lagged the rising price of gold. Where did these companies go astray?

Dave hit upon one theme that I've discussed in the past, which is the impact of hedging. But he pointed out another issue that I've never seen addressed anywhere: When gold prices were sagging, the miners designed their open pit operations to enable a quick recovery of the highest-grade ore. These companies were trying to keep the lights on, not shoot the lights out. Now that lower-grade material is economic to produce, it's difficult to go back and alter the pit design. It's also no small matter that the richest ore has already been carted off and sold at much lower prices.

As for the "juniors," meaning the small exploration and development-stage firms, Dave argues that their share price slump has little to do with industry conditions or the price of gold. Most of these firms are listed in Canada, so their securities aren't marginable in U.S. institutional accounts. When the market tanked and margin calls started rolling in, these companies were tossed out of portfolios rather indiscriminately. The space remains in the doldrums to this day.

Looking ahead
Another matter holding back the juniors is that there hasn't been a truly massive discovery so far in this exploration cycle. While that puts a damper on enthusiasm for the explorers, Dave points out that this situation is very bullish for the gold price.

With the dearth of new discoveries, miners like Barrick and Newmont are hard-pressed to replace their reserves. That urgent need fuels their massive exploration budgets of $200 million and $220 million to 230 million, respectively. While investors have cooled to the junior explorers for the time being, these companies should have no trouble continuing to attract eager joint venture partners. That will keep the well-run shops in business until someone hits the big one. After that, all bets are off.

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