Novagold (NG): Call option for the megarich
The one thing that really scares the ultra-rich is the prospect of becoming poor. And aside from the possibility of bad decision-making laying waste to their riches (after years of success) the only event feared by the ultra-rich that would set them on a road to poverty is for hyperinflation to hit the world and make their classic,financial assets and devices close to worthless. As an example, why not ask a Joe Ordinary Zimbabwean what it feels like to be a local currency billionaire and how diligently saved Zim banknotes have been holding up in his savings account recently. In this way we introduce our discussion on the recent action in Novagold (NG).
The recent moves by John Paulson and George Soros as regards Novagold (NG)(NG.to) have been a big talking point in the gold mining community. Paulson’s U$100m position and Soros’s U$75m position (taken via directly controlled funds and companies) were both struck at U$5.50 per share, with the resulting market noise of “good enough for them, good enough for me” seeing the stock move up, closing the week at U$7.23 on stong volumes and insto interest.
The Paulson/Soros investment in NG needs to be looked at carefully. I am on record as belittling Novagold, calling it the decade’s biggest goldmine confidence trick and noting its cash cow status for owners compared to its singular lack of success at any of its projects. So it would seem at first that little old me has some seriously heavy hitters taking the contrary position and let’s face it, it really is a “little me” situation when up against the likes of megarich and über-successful market winners Soros and Paulson. However before this little piece goes any further, let’s make it 100% clear that I have not changed my view on Novagold and I still think the company is a dog. However, I do understand why people such as Paulson and Soros would want a multimillion dollar slice of the company and this apparent juxtaposition is the reason for writing today. In a nutshell, it is my contention that they regard NG as a call option on gold and ultimately a very large insurance policy on their total net worth.
First let’s check the basic company numbers, starting with the assets held by NG. This chart adds up all gold, silver, copper and zinc held under either a reserve of resource count according to company literature. Note it only counts the 50% of the Donlin Creek and Galore Creek properties held by NG (eg, NG reports the Donlin Creek Proven and Probable Reserves at 29.3m oz gold, of which half belongs to NG and half to Barrick (ABX)).
| Novagold (NG): Current Metals Reserves and Resources | |||||
| | Donlin Creek | Galore Creek | Nome Ops | Ambler | Totals |
| Gold P+P Moz | 14.65 | 0 | 0.5 | | 15.15 |
| Gold M+I Moz | 3 | 3.65 | 1.9 | 0.5 | 9.05 |
| Gold Inferred Moz | 2 | 2.45 | 0.3 | 0.3 | 5.05 |
| TOTAL GOLD Millions of Oz | 19.65 | 6.1 | 2.7 | 0.8 | 29.25 |
| | | | | | |
| Silver Moz (all categories) | | 106.5 | | 51 | 157.5 |
| Copper M+I Bn Lbs | | 4.45 | | 1.5 | 5.95 |
| Copper Inferred Bn Lbs | | 2 | | 0.94 | 2.94 |
| Zinc Bn Lbs (all cat) | | | | 3.5 | 3.5 |
| source: Novagold fact sheet Feb 2010 | |||||
The above table really shows nothing more than the bones of the reserves/resources and we’re not going into things like the cut-offs, grades, recoveries and all sorts of et cetera. But what we can say is that, assuming resource count accuracy and taking the resource numbers (esp the inferred) at face value, NG has control of 29.25m ounces of gold, 157.5m ounces of silver, 8.9Bn lbs of copper and 3.5Bn lbs of zinc. The copper, silver and zinc are all very nice, bound to lower cash costs as a credit in the event of mining taking place etc, but the whole ballgame here is the amount of gold. Now that the two new financings have closed, NG has 220m shares outstanding (around 290m F/D) which gives us a market capitalization for the company of U$1.591Bn at today’s share price. Do the quick math and that works out at U$54/oz Au in situ (again, ex-credits and assuming accuracy in all reserve and resource counts).
To sum up this part of the article, we can state that there’s good reason to value the gold held by NG at U$54/oz at today’s parameters. Of course we can argue the toss about the differences between projects, the resource/reserve split (which I’d be the first to admit is very important to fully understand) the differences between contained gold and recoverable gold (e.g. Donlin’s contained gold is marked at 29.3m total, but after the projected recovery rate is taken into account then NG/ABX expect to extract 26.2m oz Au successfully, some 3.1m oz less) or any number of details about these parameters. But what that “29.5m oz Au held by NG” gives us is a basic and fairly useful handle on how we can value the company.
This is what Paulson and Soros are getting for their money. Paulson’s 8.3% of the company and Soros’s 6.2% of the company give them the equivalent share of that reserve/resource booty of gold, which is what I believe they’re looking for here. Paulson, for example, has just taken control of around 2.45m oz Au (worth around U$2.7Bn at today’s spot prices) for a U$100m outlay. This moves us towards the reason why this kind of investment makes sense for the likes of the billionaire Gulfstreamers, but before getting there we need to examine the NG projects in a little more detail.
As those who crunch numbers for a living know (or at the very least suspect), the NG assets are lipsticked pigs and the company’s track record as a “miner” (term used as loosely as possible) is poor. We can look at the Nome operations headed by Rock Creek and note that the company abjectly failed to move the mine into production in 2008 and had to close down ops soon after opening due to serious technical flaws. We can remind ourselves of the capex debacles of both Galore Creek and Donlin Creek, where construction costs were underestimated by several billions of dollars due to highly dubious and very flawed mining plans. But perhaps the latest revised feasibility study for the flagship Donlin Creek project gives us the best idea of the situation. The new feasibility study for Donlin, published by AMEC in April 2009, puts capex and sustaining capital costs at U$5.2Bn. And as we can see from this table taken from the news release that accompanied the feasibility study (1)...
Average Annual Gold Production Unit
First Full 5 years ounces 1.6 million
First Full 10 Years ounces 1.5 million
Life of Mine ounces 1.25 million
Total Start-Up Capital(3) $ 4,481 million
Total Sustaining Capital(3) $ 803 million
Unit $725/oz $900/oz $1,000/oz
Average Annual Cash Flow(4)
First Full 5 years $ (M) 521 790 944
First Full 10 years $ (M) 415 663 805
Average Total Cash Costs
First Full 5 years $ per ounce Au 394 398 400
First Full 10 years $ per ounce Au 442 448 451
Life of Mine $ per ounce Au 467 473 477
Financial Results
Undiscounted Cumulative Net
Cash Flow After-Tax (NCF)(5) $ (M) 1,103 4,166 5,876
IRR Pre-tax % 3.0 9.4 12.3
IRR After-tax % 2.3 7.7 10.2
Payback Year years 15 7 5
.....at U$1,000/oz gold, the internal rate of return (IRR) (using a modest 5% NPV discount after tax) is around 10.2%. In other words, Novagold (or its backers) has to find U$2.6Bn and can expect a 10% annual return assuming gold stays above $1,000/oz.
That, ladies and gentlemen, is an awful lot of cash to spend on a gold mine. The projected cash costs per ounce of gold at Donlin look pretty good at around U$477/oz, but you have to put up a great deal of money to get the operation running first. Now for sure having 50% of the project in the hands of Barrick will help ease the worries, as Barrick actually knows how to mine gold profitably and is pretty darned good at it too, but you have to wonder about the mining abilities of the NG based on its own company track record. Buying a used car from that man is one thing, but handing him $2.6Bn and telling him to take good care of it is quite another.
On the other hand, the IRR starts looking far more interesting if gold continues to rise. If we assume (looking at the AMEC figures and extrapolating) that 2.5% is added to that IRR for every rise of U$100 per ounce of gold, once we reach U$1,500/oz, the project IRR is over 22% (making the large assumption of costs that do not rise in a disproportionate manner). Suddenly, not only does the Donlin Creek project look feasible on paper, but it offers the type of margins (and margin cushion) that would get people to actually move forward and make it a mine. This gets even more true if gold goes to U$2,000/oz....or U$3,000/oz..... or as far as your mind would like to travel on this.
But what would cause the gold price to go over, let’s say, U$2,000/oz? The answer to that one is one simple word; inflation. And we’re not talking normal common or garden 2% or 6% annual CPI rates here but a large and longer term inflationary effect caused by the undermining of currencies. In short, what the world knows as hyperinflation, even though the word is commonly used to describe a double-figure plus annual inflation rate when technically it should be reserved for a 20% per month scenario.
Hyperinflation caused by the collapse of the dollar is the billionaire’s single largest nightmare, as the buying power of money that Mr/Mrs Mogul has patiently and diligently collected over a series of decades would be wiped out in short order. But as goldbugs know (and preach non-stop), ownership of gold protects the investor from the perils of a total collapse in fiat currencies. So the next step is simply to note that if a person takes a position in gold, that person is protecting a percentage of their wealth from the ravages of a possible future laden with hyperinflation. It’s a darned good reason to own the stuff, in fact.
That’s as true for us little guys as it is for the biggest of the big guys. It’s why Soros and Paulson have already taken large positions in physical gold, via setting up their own physical gold funds (Paulson) or buying bigtime into the gold ETF (GLD) (Soros). Let’s take John Paulson as our main example today; he is understood to have made billions on his successful short of the US housing market in the 2007-2009 period and according to Forbes now has a net worth of U$12Bn. That’s a lot of money, but even that wedge is beaten by George Soros’s U$14Bn, according to Forbes. Paulson is now understood to have taken a U$270m position in physical gold (via his fund). That approx 2.3% of his total net worth isn’t much on a relative basis and is likely to be greatly outweighed by assumed long positions in more traditional financial positions such as stocks, bonds, real estate etc. But what the slice of cash held in gold gives him is a hedged position in case of the outbreak of a high inflation/hyperinflation scenario that would ravage the rest of his portfolio. He’s a hedge fund operator, so hedging makes a lot of common sense to the man. He’s also 100% non-stupid when it comes to finances and he knows “what gold is”. Gold isn’t there to make people rich, it’s there to stop people from becoming poor. So with a position taken his wealth in gold would rise substantially even as his other investments suffered at the hands of our theoretical persistently high inflation. On the other hand if inflation remains benign, world business stays good and gold loses its allure as a protection against an armageddon scenario for world finances, gold may lose (for argument’s sake) half its value. So our man Paulson makes serious money on his (let’s say) $10Bn worth of longs in stocks, bonds, real estate etc and loses half of $270m as the downside. Sounds like a deal to me.
This author submits that Paulson is not seeking alpha in his gold position. It’s nothing more or less than an insurance policy. Taken in this light, moving $100m into Novagold (NG) instead of another $100m in physical gold makes total sense. With $100m in NG, Paulson gets control over a theoretical 2.45m ounces of gold worth maybe U$2.7Bn if all dug up and sold today. But those same ounces are worth U$3.7Bn at $1,500/oz gold and U$4.9Bn at U$2k/oz Au. That’s serious leverage, folks. So in our theoretical high inflation scenario, Paulson’s “traditional” investments might be put to the sword but his gold positions (via physical and his NG holding) plug an enormous gap in those losses. In our theoretical benign inflation scenario, he loses maybe half of the value in his physical gold position ($135m) and the whole of his $100m in Novagold (because the mines never get built), but his approx $235m loss is far outweighed by the strong performances registered in the ‘traditional’ areas of his portfolio.
Novagold appeals as an investment to the megarich and superwealthy, not because of its current value but more because of its ability to act as a call option on gold due to the large absolute amount of ounces controlled by the company compared to its relatively low market cap; if gold moves up from today’s $1,100/oz to the $1,500/oz, $2,000/oz, $5,000/oz levels expected by the hardcore goldbug community, people like Soros and Paulson will still be rich. But if gold doesn’t move up and NG just stays where it is for the next two years or five years or 10 years or whatever, Paulson and Soros and other like them will be even richer by other means. NG gives people this opportunity due to the absolute size of its reserves and resources of gold (and perhaps the silver, copper and zinc, but the real story is the gold) compared to its market cap today. And that ratio of gold “owned” over market cap (our U$54/oz number mentioned earlier) is low for the simple reason that at today’s levels, Novagold is not a good investment proposition, economically speaking. In this bizarre world of finances, Paulson, Soros (and others) have worked out that Novagold is attractive for them at today’s prices because it’s the owner of an uneconomic business plan at today’s prices (and note the emphasis there) that, importantly, happens to involve nearly thirty million ounces of gold.
So the big question: “Is NG a good investment for us mere mortals?”. The answer is “most likely no” but as usual it all depends on your own situation as regards the classic Risk/Reward equation. For the megarich, betting $100m on a dubious management team and marginal assets makes a lot of sense because for the megarich $100m is something akin to loose change and makes for an excellent call option/hedge on gold. For the megarich, the risk/reward equation is very different than for us mere mortals, too: If U$100m is less than 1% of your individual net worth it’s pretty easy to spend it as an insurance policy on the other things that you own. Or put another way, relatively speaking the risk is minimal and the reward is “not suddenly becoming poor”. Or framed in a slightly different manner, if you have a net worth of U$1m (an actual, good old-fashioned millionaire) I’m not going to say you’re stupid if you own 1,000 shares of NG because that kind of cash isn’t likely to change things one way or the other.
But when the absolute size of the NG gold reserve/resource isn’t as important a a ratio to your total net worth, the perspective is radically different. Looking at today’s playing field, this author is quite certain there are far better places to park some gold investment cash than in NG if you don’t belong to the megarich brigade. If you want exposure to gold, why not invest in a company that has 2m ounces and can extract them efficiently and profitably and make all those around a great return? Soros is good about taking 6.2% of a company like Novagold. He’s not worried about the meagre 10% IRR at U$1,000/oz gold and for him it suits far more than 6.2% in Dynasty that will return an IRR of 30%, 40% or more at the same gold price.
Speaking personally for a moment, I generally avoid high leverage gold and silver plays. NG is one of them. Great Panther Silver (GPR.to) is another, Andina Minerals (ADM.v) another and we could compile a great long list of them. I like low cash cost/prospective cash cost vehicles that will fulfill rule one* with ease. But personal taste aside there is a school of thought that likes the higher cash cost realms of the PM miners precisely because of the leverage they offer, so let’s just examine the case for a second. By way of example, if we move away from NG and look at the GPR.to chart....
.....it shouldn’t come as much surprise to note the big jump in the share price happened at the time when silver the metal (via proxy SLV here) broke out and over U$16/oz, because at $16/oz+ even a patchy and high total cost producer like GPR.to makes money.
So there’s money for someone to be made in these high leverage things, but they’re not for me. The financials do not appeal, there’s too much left to market vagaries and the (over)promotional aspect is normally much stronger. If the gambling aspect of stock market investment suits you more then that’s fine and I’ll cheer you on and congratulate you if you nail a big winner. But even if the high cost/high leverage end of the market is more your style, even though I don’t like it myself I’d wager that Andina Minerals (10m+oz Au M+I+I) at its current $135m market cap would appeal to you more than NG. Over at ADM, even if we only count the likely recoverable ounces at around 6.5m oz, that’s a $20/oz in-situ for you. It’s also led up by a man in George Bee that actually knows how to build a mine, isn’t awarding himself zillions of options, is actually actively running a miner instead of sipping champagne and isn’t going to gouge himself a millionaire’s paycheck the way that Rick VN does at NG, year in and year out.
The bottom line is that Novagold makes sense as an insurance policy for very very rich people or institutions, but if you’re not one of them it makes little sense to own it. The newly bought in Soros and Paulson don’t care a fig about the paper gain of U$1.73 a share they’ve made on the position so far and equally won’t bat an eyelid if the stock falls back to $5 or below in the future. NG isn’t in their portfolio to make them rich. NG is in their portfolio because it’s a no time limit call option on gold that may, one day, stop them from becoming poor. At $7 it’ll turn out to be a bargain if gold goes to $1,500/oz or beyond (which is true for nearly all gold stocks right now). On the other hand it’ll turn out to be very expensive if gold drops to $700/oz....unless of course you’re only using it as a hedge on much greater things.
*rule one: make a profit