Optimal Baja Put Prices & Target Share Prices

Silver Stock Report

by Jason Hommel, October 19, 2007


Puts can give Baja Mining the right, but not the obligation, to sell copper at a set price, and offer the best and cheapest protection in the event of declining commodity prices.

For me, I'm most excited about the principles involved, which indicate to me that it is most profitable to avoid unnecessary obligations that come from unnecessary hedging.   We ought to make no promises about the future, and make no oaths (which is what a debt is, and what hedging is).

James 4:13 Come now, you who say, “Today or tomorrow we will go to such and such a city, spend a year there, buy and sell, and make a profit”; 14 whereas you do not know what will happen tomorrow. For what is your life? It is even a vapor that appears for a little time and then vanishes away. 15 Instead you ought to say, “If the Lord wills, we shall live and do this or that.” 16 But now you boast in your arrogance. All such boasting is evil. 17 Therefore, to him who knows to do good and does not do it, to him it is sin.

James 5:12 But above all, my brethren, do not swear, either by heaven or by earth or with any other oath. But let your “Yes” be “Yes,” and your “No,” “No,” lest you fall into judgment.

This is why hedging 5 years out is stupid and evil, not to mention, potentially very costly.  And if hedging is a requirement of a loan agreement already entered into, then it's my responsibility as a shareholder to advocate the absolute minimum and least costly hedging choices that are available, such as puts.

We all sin, and participate in evil.  I use paper money, which I've discovered violates each and every single one of the ten commandments. 
http://www.silverstockreport.com/email/commandments.html

I have a credit card, so I borrow money on occasion.  And the cash in my brokerage accounts is automatically swept into money market funds, which makes me a usurer and extortioner, Biblically speaking -- more than most people, because I now have nearly $400,000 in my money market accounts.  But I try to minimise that as much as I can, and so I typically keep less than 5% of my net worth in cash. 

To calculate the minimal, and optimum puts for Baja, it is "conservative," and realistic, to assume that Baja will at least earn only a part (perhaps 50%) of today's cobalt and zinc prices. (The manganese production, which is unknown at this point, is not included). 

Without the copper, what will Baja earn per year?
Cobalt:  3,383,140 lbs. x $30/lb. = $101,494,200 x 50% = $50,747,100
Zinc: 13,885,200 lbs. x $1.35/lb. = $18,745,020 x 50% = $9,372,510
Costs: - $65,000,000
Subtotal: $-4,880,390

Now, Baja needs to be able to earn on their copper:

$131,300,000 minimum needed per year to pay off their loan in 5 years.
+ $4,880,390 "shortfall" after assuming Cobalt and Zinc at 50% of current prices.
= $136,180,390

Now, to earn a minimum of $136 million, on 122 million pounds of copper is very simple math.

$136,180,390 / 122,873,000lbs. = $1.10 per pound.

To take it to the extreme the other way, we can also assume that the prices for cobalt and zinc go to zero, and in that case, the optimal, minimum copper put price would be:

$131,300,000 minimum needed per year to pay off their loan in 5 years.
+$65,000,000 expenses
= $196,300,000

Now, to earn a minimum of $196 million, on 122 million pounds of copper is very simple math.

$196,300,000 / 122,873,000lbs. = $1.59 per pound.  But that's an unrealistically high price to pay for puts, since the company will receive at least SOMETHING for the cobalt, zinc, and manganese, and this assumes the maximum put price if they receive nothing.  The point I'm making is that even puts to sell copper at $1.59 would be extremely cheap, compared to the potential disaster awaiting the company if they hedge and pre sell copper at fixed prices.  Furthermore, $1.59/lb is the maximum acceptable price for any copper puts required as a condition of any lending agreement, and anything over that must be considered as excessive gambling, and not in the best interests of shareholders who are investing in a mining company, and not a derivatives holding company or hedge fund.

The company's feasibility study was based on the modest prices of:
US$1.50/lb copper, $15/lb cobalt and $1,200/t zinc.

Now, it's very important that shareholders demand that the company either not hedge at all, or buy puts, instead of selling "part of the first five years' output from the $568 million El Boleo project at fixed prices" as was the prior plan of the company.

The difference, between puts, and outright pre-sold prices, to shareholders, in case copper prices double in 5 years, can be summarized as follows:

Baja Mining (BAJ.TO, BAJFF.PK) (Symbols work at Yahoo! Finance)
Share price: $2.16 Cdn
Fully Diluted Market Cap: $390,840,447
http://miningpedia.com/?s=baja+mining
Shares fully diluted:  188,454,750

Assuming fixed sales of 1/2 the copper at $3.50:
What happens if copper doubles in 5 years?  Assuming costs would double, too,
but that cobalt and zinc remain constant (relatively in decline).
In Year 5:
Copper (1/2 hedged at $3.50):  61,436,500 lbs. x $3.50/lb. = $215,027,750
Copper (unhedged) 61,436,500 lbs. x $7.30/lb. = $448,486,450
Cobalt:  3,383,140 lbs. x $30/lb. = $101,494,200
Zinc: 13,885,200 lbs. x $1.35/lb. = $18,745,020
Sub total: $783,753,420
Projected costs: Total operation costs are approximately $130,000,000/year
Sub Total earnings/year (EBITDA): $653,753,420
Minus debt repayment of $131,300,000
Total (EBITDA):  $522,453,420
(Hedging causes a loss of $215,027,750, that could have been earned on top of that. Already factored in.)
EBITDA: $2.77/share
Target share price, assuming P/E of 10: $27/share


Assuming puts at $1.10 that are never exercised:
What happens if copper doubles in 5 years?  Assuming costs would double, too,
but that cobalt and zinc remain constant (relatively in decline).
In Year 5:
Copper (all unhedged) 122,873,000 lbs. x $7.30/lb. = $896,972,900
Cobalt:  3,383,140 lbs. x $30/lb. = $101,494,200
Zinc: 13,885,200 lbs. x $1.35/lb. = $18,745,020
Sub total: $1,017,212,120
Projected costs: Total operation costs are approximately $130,000,000/year
Sub Total earnings/year (EBITDA): $887,212,120
Minus debt repayment of $131,300,000
(Purchased puts cause a loss of about $.15/lb., or $18,430,950, for puts that were never used.)
Total (EBITDA): $737,481,170  (minus debt and cost of puts)
EBITDA: $3.91/share
Target share price, assuming P/E of 10: $39/share


As you can see, the difference between the cost of standard hedges verses puts, in the event that copper prices double to $7.30/lb in five years, is substantial.

The difference to shareholders could be the difference between a share price of $27/share vs. $39/share!

The loss to the company if they hedge 1/2 their copper at $3.50 is over $215 million, per year!

The benefit of puts is that they don't lock the company in to bad copper prices.

Furthermore, as I showed a few days ago, at:
http://silverstockreport.com/2007/baja_hedges.html

--if the copper price rises another 5 fold in the next five years, to $18.25, and if the company hedges half of their annual production of copper at $3.50, then the hedging loss could be: $906,188,375.

My main complaint is that:

1.  I don't want the company to lose $900 million/yr, in the event copper rises to $18.25/lb.
2.  I don't want the company to lose $215 million/yr, in the event copper rises to $7.30/lb.
3.  I don't even want the company to lose the $18 million/yr required to buy puts!

In this case, the math clearly shows no need to hedge, unless there is a real risk that the company receives nothing for the manganese, and only half current prices for cobalt and zinc, and if copper prices go below $1.10. 

But really, what is the chance that copper prices will go below $1.10?

Again, the company has announced that they will be considering heding possibilities for the next several months.  Now is the time to tell the company what kind of hedges, if any, you prefer.

jgreenslade@bajamining.com
klow@bajamining.com
info@bajamining.com
enorton@bajamining.com
mlaflamme@bajamining.com

Disclaimer:  I own 588,700 shares of Baja Mining, have not traded any shares in over 5 months, and the company has not paid me to promote their company.  My wife recently sold 8000 shares of Baja Mining, against my advice, and has not yet repurchased any shares.

Sincerely,

Jason Hommel