Canadian copper explorer NovaCopper Inc, (NCQ) is currently trading at $1.93, or at a market cap of $90.06 million.
The company currently has 2 major projects, the Ruby Creek Zone and the Ambler Project. We will focus on the Ambler Project, as that is currently passed the preliminary economic feasibility stage, meaning that a mining project on the site has been determined to make economic sense. This in our view creates a compelling strategy.
The Ambler Arctic site alone has the following estimated mineral resource:
Now, if we put the above into dollar terms for you we get the table below:
As we can see this translates to a whopping nearly $17 billion of resources sitting under the ground of indicated and inferred resources. Of note is that a vastly larger proportion of the mineral resource observed is in the more likely indicated category, that is 67% of it in dollar terms. This is comforting, as often at this stage of exploration, a much more significant amount is in much higher risk inferred category. Investors please note that indicated resource estimate is made at a reasonable level of confidence, but is still not certain.
Capital costs have been estimated to be around $430 million for a mine on the site. Looking at the potential under the ground, clearly this investment looks like a no brainer, with NCQ sporting a miniscule market cap of a mere $102 million or currently at $1.97 a share. The market cap is currently so low is because there won't be actual production for some time, plus there is worry about environmental opposition and the wait for Government approvals
An analysis has been conducted at the wish of NCQ by an external consultant which assumes the mine will come on line in 4 years time (we think this is realistic), and determines an NPV for the project of $756.5 million, at a discount rate of 8%. At the current value of NCQ this investment already makes sense. But even more compelling is that this base case is estimated only including the indicated resource estimate (i.e. not any of the inferred amounts), and the base case uses significantly lower copper, gold and silver prices than today's. For example, copper is the major holding, and this value is calculated on a $2.50 per pound basis, it is trading today at around $3.70 per pound.
The external report also undertakes an analysis using prices that are more around today's levels for gold, silver and copper, which is $1,650, $30 and $3.41, respectively. This results in an NPV of $1.4 billion. This model as stated does not include the possibility of the additional inferred resources either, which would obviously increase this NPV even higher.
The above does not include either their Bornite deposit, of which they have estimated to contain an indicated resource of 179.7 million pounds of copper and 883.2 million pounds of inferred copper.
Based on this analysis, a company with this much potential resource sitting under the ground, which is economically viable unless there is a major crash in commodity prices, is certainly asking to stand up and be noticed. To put things into perspective, the company is currently valued at $1.97 a share and in the Arctic site alone there is a potential indicated and inferred amount of resources sitting under the ground at a current market value of $363.14 a share.
Investors need to note the major risks here that are indicated and especially the fact that inferred resources are by no means definite amounts and this may change. Further, as mentioned previously, commodity prices could drop significantly before production begins making mining not economically feasible. Finally, one needs to remember that relevant government permits for mining or environmental permits may not be allowed. These environmental "go aheads" are, to us, the major risk, but more about that later. At present, based on the above analysis this looks like a great speculative play at what could turn out to be a mid cap sized minor, or also a potential excellent takeover target for a large miner to snap up at the current price considering all the potential resources being held.
How to Play this Opportunity
There is the obvious simple trade here of buying shares in NCQ. However, there is that large risk of commodity prices dropping significantly thus affecting NCQ's share price and the long wait to see whether the mine can move into production. If there is a small drop in commodity prices, fundamentally it should not drop the value of NCQ. However, we do not know how market sentiment may react to this.
Our play here would be to make a gain over the next few months for those, like us, who don't see a significant decline in commodity prices occurring, but are worried about a mining operation being allowed in this region of Alaska in the long term. As we see it, the market is significantly undervaluing NCQ at present on what is potentially available resource wise and therefore it is unlikely to drop much more. However, the market does not seem to want to go higher price wise. Therefore, we recommend a covered call being taken on NCQ. The strategy is for a 5 month period as to mitigate the risk of mining approvals and environmental intervention for the company in this Alaskan region, as in this period it is unlikely any major decisions will come to pass.
This would entail simultaneously purchasing shares in NCQ and writing June 2013 expiry options at a $2.50 exercise price for $0.10 each, as we see below.
Now, to the pay off, assuming NCQ is at current price of $1.97, the trader writes the call and receives 10 cents per share.
If NCQ drops below $1.87 the trader will lose money upon expiry. Let's say it goes down to $1.65 (NCQ's lowest price since they began trading), the total loss to the trader will be 22 cents or 13.3%. However, one can still hold onto the purchased share and based on current fundamentals hopefully expect for it to regain in value.
If NCQ trades between $1.97 and $2.50, the option holder makes the trading price less the $1.97 plus the 10 cents profit. Potentially up to 32%.
Any trading above $2.50 will result in a 63 cent profit or 32%, as the NCQ share will be sold on expiry for $2.50 (53 cent profit) due to the call option, plus the 10 cents for the written call.
Profit potential on this trade ranges from to 5% to 32%, excluding trading costs, in the 5 months to expiry.
As the price of NCQ is very much linked to the price of copper, if you foresee the price of copper dropping significantly before June, then this trade should not be undertaken. Ian Henderson, adviser to JP Morgan sees it holding at current levels and sees it as being well supported at current levels. Those who think otherwise should stay out of this trade idea.
We can also see potential in a purely long trade in NCQ based on the resource. But that idea, unlike the covered call idea, will leave the investor much more exposed to the catalysts of environmental and governmental decisions significantly affecting value on the downside should they not be in NCQ's favor.