For those following my reports on Novagold Resources (NYSEMKT:NG), you know I believe that management has made some promises that will be very hard to keep. Most of those promises revolve around their Galore Creek project in Western BC.
Galore Creek is a huge copper/gold deposit high in the mountains that NG is trying to ‘fast track” into production by 2010. NG is actively seeking a joint venture partner to help shoulder the $2B capital costs to turn Galore Creek into producing mine. Unfortunately, Novagold is not alone. Several large in-situ projects owned or optioned by JMCs have opened data rooms to find partners. These include Northern Orion (NTO), Peru Copper (CUP), Northern Dynasty (NYSEMKT:NAK) and several others with projects that will require major mining partners with deep pockets.
Most of the large in-situ deposits now held by JMCs are not new discoveries. In fact, most have changed hands many times among the majors over the past 30 years. CUP’s Toromocho project, in Peru, was first discovered in 1966. NTO’s Agua Rica was discovered in the 1970’s and Galore Creek in the early 1960’s. NAK’s Pebble was found in 1988 and thus qualifies as a relatively recent discovery.
With metal prices low in the late 1990’s, many projects were optioned to juniors who then raised speculative equity capital, primarily on the Toronto Stock Exchange, for further development. These financings were fueled by Canadian mining tax credits and “flow through” financings. The idea was to let the juniors do the “heavy lifting” advancing the projects to feasibility, with other people’s money. The majors could then “back-in” with financing or simply buyout the junior. The past decade of consolidation in the mining industry has provided some of the juniors with highly qualified management and geologists. With the recent bull market in metals prices, most of these companies have expanded their stock listings to US and European stock exchanges. Investment capital has been abundant so the market is now full JMCs cranking out drilling results and expanding resource estimates.
The problem is that with higher metal prices have also come huge increases in construction/operating costs and growing shortages in mining equipment. Labor costs have also risen dramatically as workers worldwide are demanding a bigger share in mining profits. Political, social and environmental risk has escalated throughout the world. This is something that the major companies clearly understand, something that the JMCs do their best to conceal and something that the average investor tends to ignore. Message boards for these juniors are full of shareholders who simply multiply in-situ reserves by current metal prices to arrive at a stock value.
Valuing a mining project is a very complicated process. After years of drilling to define reserves, the ore must be tested to find if the metal can even be extracted. Then, a mine plan must be developed to deal with all the issues of economical production and define project risks. Social and environmental issues must be addressed. A budget is outlined and future cash flows are estimated and discounted to arrive at a NPV (net present value) of the project. This report is known as a Feasibility Study or Technical Report. It is made up of many independent reports from analysts who specialize in different areas of mine development. If it is complete enough, it may be called a Bankable Feasibility Study, meaning all the information is present for a financing decision to be made on the project.
The Canadian government under National Instrument 43-101 governs standards for technical reports and all other disclosures regarding mining projects. NI 43-101 goes a long way to govern drilling requirements, metallurgical testing and reserve calculations. However, it lacks uniform guidelines for metal prices, cost contingencies and discount rates used in the final feasibility studies. Therefore, it is hard to compare one FS to another without reading through the 300-400 page documents. SEC regulations allow the use of 3-year average metal prices for NPV calculations. The juniors often use these prices, but do banks and investors use the same numbers for projects that are years away from production?
Specific geopolitical, environment and construction/operating risks are seldom factored into the NPV. In fact, they are often excluded from project costs. Many of the studies, now being produced, assume stable construction/operating costs, constant dollar exchange rates and include no financing costs. Every feasibility study clearly states that it is meant solely for the use of the Company in making development decisions. However, most juniors “cherry pick” the reports and provide highlights to help support their stock price. While it easy to overwhelm the public with “highlights” from these studies, it may be much more difficult to impress the major mining companies able to help finance these expensive projects. Most JMC shareholders are long-term bulls on metal prices, but the majors realize the cyclical nature of prices and will chose their investments very carefully. Especially when looking at these huge projects with $2B+ capital costs that are years away from production.
Novagold and Northern Orion have both released their bankable feasibility studies in the past 60 days. Based on the “highlights” both projects appear to have robust economics. But reading through the studies and applying some more conservative assumptions, the economics start to fall apart. Both assume no cost increase for construction. While they do include contingencies of about 10%, this should not be confused with cost increases. Contingencies are for unforeseen (but anticipated) work, plan changes, equipment additions and additional expenses during construction (such as overtime). They do not include the cost increases for equipment, supplies and labor from June 2006 until actually purchased or contracted. They also have no allowances for increased operating costs, even though the mines will operate for over 20 years. They use 2006 prices for labor, energy and consumables costs.
Neither study includes financing costs, as the industry standard is to assume 100% equity and allow the banks to determine the interest costs. Financing costs for the potential partner are two-fold. First, the amount of interest actually paid, and second, the cost of money to “buy” their interest in the project. Lastly, both studies fail to account for the cost of other issues such as environmental studies, permitting and right of ways.
Galore Creek and Agua Rica boast billions of pounds of copper and millions of ounces of gold. One must wonder how a major mining company can resist these sizable reserves. Novagold has indicated to shareholders that they have potential partners “lined up” to buy into Galore Creek. One thing is certain, neither Novagold nor Northern Orion can develop these projects by themselves. Both projects have their own problems and associated risks in development and mining the reserves.
In Part 2, we will take a peak into the data rooms for both projects.
Disclosure: The author is long NTO and has no current position in any other companies mentioned in this report.