An informative and very important to understand piece from Australia's Shaw Stockbrokerage on heging. BTW, I expect FN's involvement to change much of this, but they shouldn't linger. The transactions involved will create some excellent demand at a crucial time. This could be the long awaited, "give me the f___ gold" scenario I've posted about before.:
"It is instructive to examine the situation of some of the mines involved in these forward transactions to see how they might be impacted by a rise in the gold price. One company which has a complex book of hedges is the Australian gold miner Normandy Gold.
As at 31 March 2001 Normandy and its subsidiary companies had a total of 7.46 million ounces of gold sold forward through to the year 2010. In addition some 571,000 ounces were exposed via call options sold. There were also positions in put options and convertible options. Lease rates had been fixed for only an average of 158 days and the mark to market value (the cost to close all the positions) was a loss of A$250 million. Margin calls do not apply to any contracts. Normandy currently produces 2.2m ounces of gold per annum.
The first thing that is obvious is that Normandy has committed the cardinal investment sin of borrowing short and lending (investing) long. Lease rates are fixed for less than six months but the forward contracts range all the way to 2010.
What would happen to these figures if gold were to suddenly rise by US$100? The immediate impact would be to add US$746 million (A$1.5 billion) to the mark to market loss of A$250 million at 31 March 2001. This would virtually eliminate the possibility of closing these positions as a loss of A$1.75 billion would virtually wipe out Normandy's equity.
How about the impact on Normandy's revenue of a US$100 price increase? About 50% of Normandy's next year's production is sold forward, so some 1.1m ounces would benefit from the higher price, implying an increase in revenue of US$110 million (A$220 million). Sounds good, but it must be set against any increase in expenditure - and there is a big question mark here. What will happen to lease rates in these circumstances? It is logical to anticipate that a $100 increase in the gold price must be accompanied by a curtailment of Central Bank leasing of gold. Hence there will be competition in the leasing market to fund longer term forward sales (the alternative being to buy in the gold at a huge loss), thus causing gold lease rates to increase.
What will lease rates rise to? Fact is there is no upper limit, but for purposes of this example, we will assume that lease rates will rise to 12%, some 10% above current levels. There will have been some reduction in Normandy's total of forward sales as some production would have been delivered into these contracts and Normandy has not been doing any new forward contacts. Assume that forward sales are reduced by 1.1 million ounces to 6.3 million ounces when the gold price rises by $100.
The market value of 6.3 million ounces at US$370 per ounce is US$2.331 billion. A 10% extra lease payment would be US$233 million or A$460 million! So Normandy would have to set this huge extra payment of A$460 million against the A$220 increase in revenue, leaving a net loss of A$240 million to the company as a result of a US$100 increase in the gold price! Not a very nice situation for a gold mining company when the price of gold has had a dramatic increase.
This example illustrates what a time bomb these forward sales are, ticking away quietly behind the scenes, but capable of blowing up the company. Normandy shareholders need to pray that lease rates don't rise quite so dramatically or, better still, that someone on the Normandy Board insists on buying back these forward positions as soon as possible. It must be the correct decision to take a A$250 million loss now rather than jeopardise the financial future of the company. The first loss is always the best loss." |
