Yesterday, Reuters published a note which caused many mining stocks with Ecuador exposure to drop significantly (but also significant was the relative low volume of the selling compared to other panic days). As is well documented, I recommend Aurelian Resources (ARU.to) as my top pick in the country, and to the drop it suffered yesterday can hardly be called welcome. So it's worth having a good look at the report in question.

Here's the link to the English version, here's a link to a later Reuters article that gives useful resumé of the key points, and my preferred Spanish version is on this link. The note also contains a lot of analysis and opinions from various sides, but the money lines are when the report directly quotes the leader of the Constitutional Assembly, Alberto Acosta, as saying the following things*;

1) The text of the new constitution will propose a state majority control in projects that exploit natural resources. Specifically Acosta said, "We will take back the majority control of the State over strategic resources."

2) Acosta also spoke about how the state control would be implemented. He said, "We would prefer that they were joint ventures with state majority, but there may be exceptions."

3) On a slightly different level, Acosta was reported as saying the new constitution would allow for the re-election of its President, which would mean in the near term that Rafael Correa would be able to run again.

4) The new constitution may also incorporate the concept of "illegitimacy and illegality" of external debt, although it will not be retroactive in nature.

5) Acosta, an economist by profession, also mentioned something about his own philosophy for the macroeconomic future of Ecuador when he said, "The (free) market is a good servant, but it has always been a bad master."

So what to make of all this? As usual, these comments affect a wide range of things, but I'm going to concentrate exclusively on how it affects my recommended stock of Aurelian. Be clear that circumstances may change when it's Dynasty, Corriente, Repsol, Petrobras, or whatever other company operating in Ecuador.

The first, and most important thing to understand is that the draft constitution being debated by the Assembly is not the same thing as the draft mining law currently being prepared by Ecuador's Ministry of Mining and Petroleum (MEM). That may seem like a basic point here, but all the same it's worth stating it clearly. The comments of the last two weeks or so from MEM that have allowed ARU to rebound strongly come from a different place and are about a different document (here's where we've discussed all this before...plenty of other posts too). MEM head man Galo Chiriboga says that the new law will allow miners to operate in Ecuador. That's fine. Acosta says the new constitution will take back majority control over natural resource businesses. Not the same thing.

So with that nice and clear, lets look at the Acosta statements as they apply to Aurelian (ARU.to). It's pretty clear that the thrust of the "natural resources" comments are aimed at Ecuador's lifeblood industry of oil, especially when one considers he talked about taking back control, as large scale mining has never existed in modern day Ecuador so there's nothing to take back. A constitution is not the same thing as a law, and what the constitution seems to being aiming for here (my interpretation, be careful here) is to protect the country from losing majority control over its oil resources/revenues in future years. With that said, the Acosta comments as stands equally apply to the mining industry. So therefore from a direct and logical interpretation of Acosta comments we can easily imagine a situation where ARU is obliged to become part of a joint venture with the state to operate Fruta Del Norte (FDN).

So let's imagine a worst case situation here, where we have a draft mining law to be published on June 27th that will allow responsible mining in the country, but a wider constitutional dictate that insists on Aurelian going 49/51 on FDN. What would this mean to Aurelian's stock price?

Firstly, it means that Aurelian is on solid ground as a company. It means that the mine will go ahead in Ecuador, and that can only be a good thing. But on the other hand, it will lose 7m oz of the reserves at FDN. And although it would benefit from only having to find 50% of the capex to construct the mine and processing plant, it would lose half its gross revenues etc etc.

There are many ways of pricing a gold mining company, but one of the most common, especially for junior/exploration stage companies, is to consider its "ounces in the ground" compared to the company's market value. With ARU at C$4.61 at present, this means the company has a market cap of U$614m (US dollars, converted at CS1 = U$0.9833). As the FDN 43-101 compliant resource currently stands at 14.1M oz Au eq (of which 13.7m oz is gold, an extremely high ratio of gold to by-product), this means an ounce of Aurelian gold in situ is currently being valued at U$43.55.

This is very cheap, especially when one considers the recent prices paid by large miners for exploration/junior gold miners. Due to the nature of the beast (a long and complicated story with many permutations, but basically meaning that the high grades at FDN would make for a low cash cost operation), if a buyout offer is made for ARU it should be at least U$150/oz in situ and will almost certainly be significantly higher. This would seemingly position ARU as worth at least four times its current stock price value.

So if the state suddenly takes away half of FDN, this means we can do the same calculations for ARU but using, let's say, 7m oz Au eq. This puts ARU's gold at U$88/oz in situ, which still means it's at a significant discount to the probable market buyout value. For argument's sake, let's say a bid comes in at $175/oz Au, which would double ARU's stock price overnight.

So to recap, this is my "worst case" situation:

1) The new mining law is announced 27th June, and as most people now expect after hearing the varied assurances from Correa and his ministry people, the law provides a framework to allow large scale responsible mining in Ecuador, and a fiscal framework that may not be a bargain, but it totally workable for ARU (I'd agree that we won't know for sure that the new law is "miner friendly" until we've seen it, but humour me on this one, yeah?).

2) The new constitution means ARU loses 50% of FDN.

This would, in my worst case scenario, mean ARU should double from today's stock price. I also believe this double would happen quite quickly, as the pain of losing half of the FDN deposit is alleviated by the knowledge that the legal framework is fixed in stone, everybody knows where they stand, and the miners can get on with the real job of building a mine and producing metal. In the end, that's what miners are good at doing.

However, that's the worst case, and there are plenty of mitigating circumstances to be added to the mix. Here's just two of them (there are more, but this post is getting long).

• Acosta talks about "exceptions" to the rule. How can there be "exceptions" to a constitutional article without having something specifically mentioned. After all we're talking about Magna Carta for a country, not just a law passed by a parliament. And if we remember that the thrust of Acosta's argument is about the oil industry, there is every chance that the mining industry is either less affected by this part, or likely not affected at all.

• Everyone...I mean everyone...knows that FDN is not stopping at 14.1Moz Au. ARU has been drilling and still has plenty of outstep and infill work to be done. The deposit is still open at depth and at two extremities. The cutoff grade used for the first resource report was pretty high and can be adjusted down now that gold is at $900+. This means there is plenty more valuation upside on the table once Aurelian gets back to work. Your guess is as good as mine here, but 18m to 20m oz would be a reasonable ballpark right now, in my humble opinion.
  

So all in all, and even if the new constitution pulls another fast one on Aurelian, I have no hesitation in reiterating my strong buy recommendation on this stock. Once the new law comes out on the 27th, sub $5 prices will be confined to history.

You making notes, Eric? LOL!