Promises, Promises: The Battle Between Novagold and Barrick Continues

In my November 16 report I outlined the hostile takeover battle between Novagold Resources (NG) and Barrick Gold (ABX).

The Barrick offer expired midnight November 21st. They were tendered some 13.2 million shares, which would have made them Novagold’s largest shareholder. Barrick’s “best and final” offer has turned out to be “not so final” as they chose to extend it until December 6. It remains to be seen if $16 is indeed their “best” offer. The stock has continued to trade slightly above the offer price. It remains to be seen how many shares will be tendered after the new deadline. One would assume that there are substantially more shares in the hands of arbitrageurs, as this battle has raged on now for over four months. A controlling stake would be about 55MM shares. Will Barrick raise its bid to wrestle additional shares from the arbitrageurs? Do the arbitrageurs have enough shares for Barrick to gain control, even if the bid was raised?

Barrick says no! They promise they will not pay over $16. They have added the deteriorating economics at Galore Creek, Rothschild’s resignation as financial advisor and newly filed lawsuits at Rock Creek to their list of other justifications. With the price of gold rising and gold stocks moving higher, Barrick’s latest move is a bit of a mystery, as about 9MM shares were actually withdrawn since the previous extension. So, they continue to play a precarious game of “chicken” with the arbitrage community. I doubt many of the arbitrageurs are buying Novagold as a long-term hold and they might quickly exit the stock if Barrick pulls its bid. Under normal circumstances, the bid would simply be raised, just enough, to get these shares. The question remains: is this normal?

Novagold management and their ultra-loyal shareholders are jumping for joy while claiming a sound moral and financial victory. Rick Van Nieuwenhuyse, President and CEO of Novagold, has been very outspoken and has defended his company gallantly. He has ridiculed Barrick for their handling of the takeover attempt calling them the “800 pound gorilla”. He has also made some very hefty promises to his shareholders.

While Barrick has failed to even come close to a controlling stake, they have promised to stick around and make Van Nieuwenhuyse’s life very difficult. They just may start by pulling their bid and the $16 support for Novagold shares.

Long term, Novagold’s prospects appear to be very bright to anyone who is bullish on copper and precious metals. They have two world-class projects in Galore Creek and Donlin Creek and have assembled a first class management team that is capable of developing both projects. They have an Alaskan gold mine that should be in production in 2007. They own a large stake in US Gold, the Rob McEwen venture that is amassing a large prospect portfolio in Nevada. They also have a pipeline of additional projects in mining friendly Alaska.

Unfortunately, in its takeover defense, Van Nieuwenhuyse has made the following promises to shareholders that make Novagold a very short-term story:

• Rock Creek will begin production of 100,000 ounces of gold by Q2 2007.
• Novagold will secure a joint venture partner and/or financing for Galore Creek by Q1 2007, and have permits in place and road construction will begin in Q2 2007. Mine construction will begin in 2008.
• Novagold will prevail in court against Barrick and will retain 70% of Donlin Creek or Barrick will fail to meet its back-in requirements by November 2007.

Rock Creek

I may be willing to concede that Rock Creek production will begin by Q2 2007, even though very few gold mines open without a hitch these days. However, last week a lawsuit was filed against the Army Corp attempting to block construction. While Novagold contends that the lawsuit is without merit, it has brought up the fact that the permit was issued without a full environmental impact study. The lawsuit may not prevail, but it might delay first pour to late 2007.

Galore Creek

Galore Creek is on a very fast track. I have now read the Feasibility Study twice and I have a hard time believing that financing is eminent. At a 5% discount, the base case [$1.75 copper, $525 gold and $8 silver] for Galore Creek shows a Net Present Value [NPV], of future cash flows, of $599MM. But at a more reasonable 8% discount the NPV drops to $233MM. Novagold clearly does not have the equity to borrow $2B for capital costs based on this NPV. They have promised they will secure a joint venture partner willing to buy 40% of the project for $250MM [40% of the NPV].

Sensitivity analysis shows that NPV is most sensitive to the price of copper followed by USD/CAD exchange rates, then capital/operating costs. A 10% increase in the CAD drives the NPV [at an 8% discount] to about $0. Most disturbing is the fact that the study assumes a USD/CAD exchange rate of only .81. Last I looked, the exchange rate was closer to .88 and in September when this study was being devised, the exchange rate was over .90. The rationale used by Novagold is that a higher Canadian Dollar also means higher metals prices. While this may or may not be an acceptable theory for future production, they have also applied this “three-year average” exchange rate to capital costs which will begin to be expensed next year. While many of the capital costs will be in CAD, many will not or be will subject to cost increases [i.e. the cost of a Caterpillar 944 will increase with the exchange rate].

The other problem I have is that, longer term, the USD clearly has problems that the CAD does not. Budget deficits, balance of trade and international integrity issues could decouple the CAD as a purely natural resource currency. I also think that copper may not necessarily track precious metals and oil in a declining economy.

Additionally, at Galore Creek, a 20% increase in either capital costs or operating costs will also drive the NPV to $0. Considering mining costs and construction costs have recently risen about 15% per year, it is very aggressive to have NO provisions for cost increases in the Feasibility Study. Again, anyone who is bullish on metal prices has to be uncomfortable with zero cost increases for capital and operating costs. It is again the rationale of Novagold that higher capital costs mean higher copper prices.

Despite the resource, Galore Creek economics are not all that attractive. Novagold’s promises may seem realistic to devoted shareholders, but joint venture partners may be harder to impress.

Can Novagold deliver a joint venture partner in the next few months, as promised?

First of all, it is doubtful that a major company will use Novagold’s projections of permitting this huge project in just six months. Both BC and Alaskan permits will be required for the project. The access road to Galore Creek will be a monumental project and will cross hundreds of fish-bearing rivers and streams. The road will connect to Galore Creek via a tunnel that will also connect the land-locked Alaskan peninsula to British Columbia and the continental highway system. This is something that Alaskan politicians have been trying to do for 20 years, but Novagold is going to get it permitted in six months and have it built in eighteen months?

Lastly, the tailings and waste rock dump site is now in the hands of Barrick through their acquisition of Pioneer. This issue is now going to court. While Novagold will likely prevail, it will undoubtedly take more than a few months.

Donlin Creek

Prevailing over Barrick and retaining 70% of Donlin Creek is also not a sure thing for Novagold next year. It is also doubtful that any judge, in Alaska, will really intervene and redefine a Bankable Feasibility Study for Novagold. Certainly, any judgments to the contrary will be appealed and likely be tied up in courts for a very long time. I have read the joint venture agreement, listened to the NG conference call and spoken to their CEO. I tend to side with Barrick. There is nothing about permitting requirements in the definition of a Bankable Feasibility Study. The pre-Feasibility Study is being finished now and if it shows DC to be economical, Barrick should have little trouble delivering a typical industry recognized BFS by November 2007. As for a decision to construct the mine, the power problems will probably bail out Barrick for years to come.

I have reported on the problems delivering power to Donlin Creek. But after further due diligence, it appears that most of these power problems are of Novagold’s making. To help fight the takeover, NG commissioned a Preliminary Economic Assessment of Donlin Creek by SRK. It was this study that increased the mill to 60k TPD and gold production to over 1.8MM ounces a year. Needless to say, the report subsequently showed very robust valuation figures. However, the increased production also increased power requirements far beyond the available mega-watts in Western Alaska. As late as September 2005, Barrick was still envisioning a more reasonable 40k TPD [1MM oz/year] mill with a manageable peak power requirement of 80MW compared to 140MW for the Novagold plan. Since 1996, no less than 20 different options have been reviewed to power a 40k TPD mine, with no real concrete solutions. Barrick is only required to deliver a mine plan with annual production of 600,000 ounces. I believe that Novagold has expanded the production at DC based on reserves, not on a viable mine plan. It is doubtful that the mine plan in the SRK study could be permitted and built at Donlin Creek in the next ten years, if ever.

To support my opinion, I spoke with a VP at Golden Valley Electric Cooperative [GVEC] about Donlin Creek. While they would be willing to build a new power plant at Nenana, [the tie-in location of the proposed intertie line] it would be on a “take or pay’ basis. In other words, DC would pay through demand charges for the construction of the plant. According to the PEA, a coal-fired plant would have to be built at Healy to lower electricity costs to support economics at Donlin Creek. But, DC would have to pay for the construction of this plant through demand charges, as well. The demand charges for the Nenana Plant would not go away. The cost of building an additional coal-fired plant would be added to the demand charges at DC. In spite of this, electric charges are very optimistic, they do not compensate GVEA for all their investments and they leave no room for cost increases. Furthermore, GVEA has indicated to DC that they have no interest in serving rural Alaska off the proposed 230kV line. In fact, GVEA has indicated that they would recommend a high voltage DC line to reduce voltage loss on the 350-mile line. DC power would be worthless to any other potential users due to the high cost of converters, according to GVEA. Might the State be willing to subsidize this line to provide power to rural Alaska, as Novagold claims? Not without heated debate and subsequent discussions about simply building a power plant where power is needed.

When a top GVEA official was asked what it would take to get power to Donlin Creek, he replied: “you simply need to relocate your gold mine”.

Promises, promises. Who will keep them and who will not? Right now I am betting that Barrick will keep its promise and not pay over $16. I am buying NG January $15 puts, expecting Barrick will pull its bid before they raise it. Not that I trust Barrick, but this is a low cost “all or nothing” play. I believe the risk/reward for the calls is over 5/1.

In 2007, I think Novagold has “promised the moon” and will have a hard time delivering. They will likely spend more time in the courtroom than in the boardroom. Even the most zealous shareholders may become disillusioned as they realize that management has overvalued its two main assets. It could be a very difficult year for an independent Novagold Resources delivering on all its promises. In a very good market for gold stocks, Novagold is “dead money”.

Disclosure: Author is short Novagold