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Orezone's Issue

Monday morning, Orezone stock halted trading. Speculators like me hoped it was for news of a takeover bid. Not so: instead, the company announced that its pending resource update will likely reduce the oxide gold count at Bombore by 30%.

The market, not surprisingly, was pissed. ORE lost 39% on Monday and another 19% on Tuesday, to fall from $1.23 to $0.59 over the two days.

I talked with president Ron Little at length on Tuesday night. Before I get to what I think investors should do, I want to go through what happened and why.

Orezone used the engineering firm SRK to do its 2013 resource estimate. That resource was the basis for the Bombore feasibility study. A different engineering firm, Roscoe Postle Associates (RPA), did the feasibility study.

That means RPA took SRK’s resource and pulled a reserve out of it – identified which ounces were economic to mine.

The feasibility study happened during the bear market, and happened in a rush because Orezone needed the study in hand to complete its permit applications before Burkina Faso changed its mining code. As such, the final 50,000 metres of drilling at Bombore were not included in the resource or, therefore, the feasibility study.

As 2016 hit and the mining markets started to improve, Ron and his team started to look ahead. The next steps were to finish the permitting process, a goal they achieved last week when the Burkina Faso government granted final permission, and to raise the capital to build the mine.

In talking to lenders about construction debt, management realized they were going to be asked about the 50,000 metres of drilling that was not included in the resource estimate. Lenders would be concerned the work was being excluded because results weren’t as good as expected. As such Orezone decided to update the resource estimate.

The question then was: which engineering firm to use? SRK, which had done the previous estimate, or RPA, which had done the feasibility work? Ron and his team decided to go with RPA, because they were more up to date with the asset, having just worked the feasibility study.

Interestingly, Orezone was not even planning to make the resource update public. The team didn’t think the number would differ significantly from the earlier estimate and making the new resource public would require them to update the feasibility study, as per regulator requirements, which would be a hassle for a small change.

So RPA got to work. They recommended to Orezone a more regimented modeling method; in short, they recommended switching to wire frames instead of the computer-based resource zones that SRK had used. Orezone agreed.

“No one said ‘SRK’s got a bad model’,” said Little. “They just said if you’re updating the resource let’s do it to the most conservative standards so you pass every test on the debt facility.”

The process took a long time: it took ORE six months to created all the new wireframes – essentially to create the new resource model – and then RPA spent two months assessing the work. The model is based on 450,000 metres of drilling.

On Friday after close, RPA sent through their initial conclusions…including the fact that they were seeing about 30% less gold.

“The difference is, with the wire frames you only consider drill intercepts that are within each envelope,” said Little. “There is no influence from any other nearby grades. With SRK’s method they put boundaries on the main ore envelope, which is defined as better than 0.5 g/t, and then they let the computer search the zone just outside of that to determine where the low grade zone should extend and what they grade should be.

“The result is that zones with low grades, borderline in terms of being included in the resource, that happened to be adjacent to high grades next door were included with SRK. Now, with the RPA method of only looking at drill intercepts within each section, those low-grade areas have been re-classified as waste.”

There is so much to discuss here.

First, RPA used SRK’s estimate to define the reserve at Bombore. If the method was inappropriate, it seems to me the issue should have been raised then. RPA could have said, Hey we don’t think SRK went into enough detail in their estimate for us to slap a reserve on it.

Second, the entire situation points to the need to define standards that a resource estimate has to meet before it can support a reserve. Orezone’s experience says that every explorer out there has to really question the method and model used in its resource. That has always been true, but as computers become more powerful the method options have multiplied. Companies rely on independent engineering firms with expertise in resource estimation to complete reliable work. SRK has been around a long time and falls into that category.

In addition, it wasn’t SRK as a whole who completed the Bombore estimate – it was the couple of engineers in SRK’s Toronto office. So not only do companies have to put their trust in the firm, they have to put it in the specific folks doing the work.

And that’s difficult, because the only way to actually test whether a resource was accurate or not is to mine it…but only a tiny fraction of the resources that get estimated in our business ever get mined. In other words, most of these calculations never get tested. So it is very difficult to know whether the firm or the specific team is getting it right.

“We almost need some kind of referee who determines whether a resource model is robust enough to go to reserve,” Little said. And he’s right.

So the situation highlights one serious deficiency in how our sector operates. That deficiency hit Orezone hard. Investors are angry – and while Little is of course distraught over what it means for Orezone, he as much or more dismayed that a screw up like this might scare investors away from this arena.

What does it mean for ORE as an investment? First let’s go through what will happen from here. First, by September 7th at the latest (likely earlier) Orezone will release the new resource estimate. That release will firm up the discussion by putting new numbers on the deposit.

After the resource is out Orezone will redo the reserve estimate (i.e. have RPA redo the reserve estimate). That is arguably more important, as it will clarify how the change will impact the mine plan and economics.

The basic question is: has the reduction killed the project?

A 30% reduction brings the resource to 1 million oz. That’s still enough to probably feed an 8-year mine life (down from 11 in the current feasibility); it could feed a 10-year mine if a rejig decreases throughput, which would also reduce the cost to build the mine.

In other words, the oxide resource still works. The details of it working will come out over the next few months, but it still works.

The next question is: is ORE still a good holding?

I think the answer is yes, for two reasons.

First, Ron and his team are experienced mine planners and builders. From the information available to date it looks like Bombore’s oxide zone can still support a mine with a reasonable lifespan and good economics. The Orezone team will make it make sense – they won’t bluster forth blindly to prove some point.

Second, the other (arguably more preferable) endpoint for the ORE story is a takeout and that is still in play. The oxide operation is now less appealing than it was last week, because miners like size. However, there is a large sulphide orebody underneath the oxide resource that has seen less work but definitely adds a lot of potential to the project.

Orezone was already planning to work on a PEA outlining the costs and benefits of incorporating the sulphide resource into the mine plan. It would require expanding the process plant, but the resource would not be available for a few years anyway (have to strip off the covering oxide) so the expansion could be funded from oxide operation cash flow.

I think the sulphide body adds enough potential to Bombore that potential acquirers will still be interested. Moreover: Bombore is permitted for construction. As I have said repeatedly in recent months, very few projects fit that bill. Any miner that wants to increase its production this cycle needs to start building now, which means unpermitted projects are no help.

The situation is clearly very disappointing. It hurts my portfolio (and yours, for everyone who also bought into ORE) and it hurts our industry. Orezone’s share price declined so much that I am inclined to suggest buying more BUT I do not think there is a hurry.

The market will not start supporting the stock again until there is some positive information. The resource will not likely provide that, but the reserve number might. Remember, reserves are an economic classification. The number of ounces in the reserve depends on the price of gold. I am NOT suggesting that ORE use an optimistic gold price in their reserve calculations, but I am aware that the gold price has strengthen and thus $1,200 or $1,250 might be more suitable than the US$1,100 they used in the feasibility reserve estimate, and that increase would bring some of the excluded ounces back into play.

Once more information is available and the shock has passed, we can re-assess the best time to enter or average down.

I’ll give Ron Little the last word.

“Our business is flawed with all kinds of guys trying to figure out how to make their resource number look the best,” said Little. “That was not in any of our conversations. It is a huge dent to our egos because we have tried to build a reputation for being honest and technically strong. The SRK method slipped us by.

“Stick with one engineering group is the take-away from this for others. And spend a lot of time looking at the method.”

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