Interesting Gold Play That Seth Klarman Likes

Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

During the summer of 2012, shares of NovaGold Resources (NYSEMKT: NG) tumbled in the wake of an announcement that production at the Donlin Creek gold play would be delayed for several years. Like mining giant Barrick Gold (NYSE: ABX), NovaGold owns a 50 percent stake in the property's potential proceeds. Obviously, a diversified miner like Barrick can afford to sit on Donlin Creek for far longer than a smaller firm like NovaGold. In fact, Barrick's decision not to expedite the permitting process for the mine is the principal cause of the delay.

After spinning off its NovaCopper (NYSEMKT: NCQ) subsidiary earlier in the year, the company had morphed into a straight play on production at southwestern Alaska's Donlin Creek property. NovaCopper lost half of its value since the spinoff.  NovaCopper is currently losing money so it has been beneficial to get NovaCopper off Nova Gold's balance sheet.  

About NovaGold Resources and Barrick Gold Corporation

Vancouver-based NovaGold Resources is a small exploratory miner that owns properties in the coastal mountains of British Columbia and Alaska. However, the Donlin Creek property represents its principal asset and will ultimately determine the company's future. The property covers more than 80,000 acres to the east of Bethel, Alaska and is expected to produce over 1 million ounces of gold per year after coming online. Until recently, NovaGold also owned substantial copper-producing properties in northern Alaska.

Toronto-based Barrick Gold is one of the world's largest publicly-traded mining companies. It operates an international portfolio of gold and copper properties as well as a small roster of proven oil and gas patches in various parts of Canada. Barrick's most profitable mines are located in Africa, South America, North America and Australia. The company is heavily invested in exploration and is a significant force for innovation in the global mining industry. In 2012, Barrick earned $3.4 billion on $14.2 billion in gross revenues.

What Is at Stake

Most impartial experts agree that the Donlin Creek property has a tremendous amount of production potential. According to NovaGold, the property has between 33 and 39 million ounces of accessible gold and should be capable of producing at least 1.1 million ounces of gold annually. The mine's average extraction costs would hover around $400 per ounce for the first five years of its operational life and rise to just under $600 per ounce for the remainder of its lifespan.

At gold's current price of more than $1,600 per ounce, the mine would be wildly profitable. Although NovaGold and Barrick have land-lease agreements with the Alaska Native tribes that own the surface and subsurface land rights, these are not expected to cut into the property's profit potential to a significant degree. The royalty payments that NovaGold and Barrick must forward to the tribes have been locked in on a long-term basis and should not introduce any uncertainty into the arrangement.

Assuming that the two companies continue their 50-50 arrangement, NovaGold stands to reap at least 16 million ounces of gold from the Donlin Creek property and remain in the black for two decades to come.

Complications and Conflicts

However, the Donlin Creek property faces substantial headwinds from the permitting process. Although the formal application process began in early 2012, Barrick has expressed reservations about fast-tracking the property's approval. Under normal circumstances, it can take three to five years to obtain a gold mining permit in the United States. However, the legal and financial heft that Barrick brings to the table could expedite the process somewhat.

Understandably, Barrick's apparent reticence to expedite the development of the Donlin Creek property has shaken confidence in NovaGold's prospects. The company lost 25 percent of its value on the back of Barrick's announcement and continued to decline during the subsequent months. At this point, it appears probable that the Barrick announcement was the result of a poor earnings report rather than a permanent change in its corporate strategy. However, further negative news could send NovaGold's shares lower. Alternatively, news that the permitting process is moving along could signal the start of a long-term uptrend in its stock price.

Long-Term Prospects, Likely Outcomes and Potential Returns

On its face, NovaGold represents a speculative bet that could pay off in spectacular fashion. This is not a traditional arbitrage opportunity: While there is a good chance that Donlin Creek will eventually receive its permit, there is a possibility that it will be denied. In this way, NovaGold represents an "option" on the Donlin play. Although further delays or an ultimate denial would crimp Barrick's bottom line, such events would not represent existential threats to the multinational mining giant. By contrast, NovaGold might not be able to recover from a major setback.

It should be noted that several prominent investors have opened large positions in NovaGold. For instance, Seth Klarman bought a large tranche of NovaGold's stock in November of 2012. The "smart money" appears to be making a major bet on Donlin Creek's approval. From its current share price near $4.25, NovaGold could appreciate by 300 percent or more on the back of a permit deal. In time, the company could challenge its all-time high above $20 per share.

In theory, NovaGold might also be attractive as a takeover target. The most obvious suitor would be Barrick. In fact, the mining giant launched a failed takeover bid for the company in 2006. Barrick's management team may be hoping for a drawn-out approval process that weakens NovaGold's resolve and leaves it vulnerable to a buyout.

At the moment, experienced investors with relatively long time horizons may have little to lose by opening measured positions in NovaGold at these levels. Since any post-approval updraft is liable to be sudden, there may be no better chance to get in on this Donlin Creek option.


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