This is an article by Reg Howe and is posted at his Golden Sextant web site. I thought you would be interested in the analysis if nothing else.
Barrick’s business model is a very clever piece of financial engineering. In simplest terms, it consists of two parts: a mining business, which produces gold, and a financial business, which earns a spread. The gold producer -- call it “Goldco” -- is a real business: it generates financial information that is captured in published financial statements. Goldco is a collection of very fine mining properties assembled over a period of about 18 years. It provides the raw material for the pictures and much of the commentary in the annual reports; there are physical places you can go, tires you can kick, employees you can talk to.
The financial entity -- call it “Hedgebook” -- is a virtual business. It exists “off balance sheet,” and generates a net yield that is not captured in published financial statements. Hedgebook consists of a file drawer full of contracts no outsider has seen and a giant pool of cash proceeds from short sales of gold over a period of about 14 years. You can’t see it, you can’t touch it, and generally the only mention it gets is a paragraph or two in the annual report.
Goldco and Hedgebook are approximately equal in size and significance. As of yearend 2001, Goldco had $5.2 billion in total assets, while Hedgebook weighed in at $5.5 billion. As stated in the 2000 Annual Report, “Barrick manages this asset as closely as it does its mines to generate the highest returns at the lowest risk.”
Every year, Goldco reaches through a cyber-membrane and pulls some numbers out of Hedgebook. These numbers are thereupon exposed to the light of day, and go directly into Goldco’s reported results. Understanding how Hedgebook generates these numbers, and how they cross over onto Goldco’s books, is the key to understanding Barrick. Kids, don’t try this at home.
A Star Is Born
Hedgebook is the spawn of a creative financing technique: the so-called “spot deferred” forward sale. The spot deferred made its public debut in Note 10(c) to Barrick’s 1990 financial statements. For all its future significance, it got a rather low key introduction:
The Company has also entered into contractual arrangements with several major financial institutions to deliver 1,035,000 ounces at prices ranging from $390 to $428 per ounce. Delivery under these contracts can be deferred at the Company’s option for up to 5 to 10 years depending on the individual contract.
The architect of this stunning innovation remains anonymous. One is tempted to speculate that it was CEO Randall Oliphant himself, who was promoted to Treasurer from Assistant Treasurer in January 1991, having joined the company from Coopers & Lybrand, its auditors then and now, in April 1987. Whoever he was, the inventor of the spot deferred should be celebrated in company lore and song, for this was the financial equivalent of discovering the Goldstrike Mine itself. This technique permitted Barrick to monetize that mine’s future revenue streams and harness them to the awesome power of compounding, over a timeframe to be selected by Barrick, and to do all this off the books. The critical feature is not the forward contracts themselves, but rather their funding, which Note 10(c) did not address: each forward contract generated current cash proceeds from a corresponding short sale in the spot market. That cash was to be invested, earn interest and grow into future values which would be booked as revenue only at such time as Barrick decided, in its sole discretion, to settle the account. O brave new world!
Seven years later, in its 1997 Annual Report, Barrick placed proud and proper emphasis on the genius of this structure by describing it thus:
Interest on Gold in the Ground
While Barrick has developed sophisticated tools for its hedging program, the core process is straightforward. The Company sells its gold at the current spot price while the ounces are still in the ground, and earns interest on the proceeds from the spot sale before delivering its production against the contract.
The Company works with a bullion dealer and a central bank, which lends gold from its reserves to the dealer for the sale. When Barrick delivers its gold, which is used to repay the central bank, it receives the net proceeds from the sale: the original spot price, plus accumulated income earned, minus the cost to borrow the gold.
The net interest is the forward premium (“contango”) that each Barrick ounce earns because of hedging. Current contracts will earn over 7% interest on the proceeds from the spot sale while paying 2% interest on the borrowed gold, generating a premium of over 5% a year.
Premium and Protection
Through the use of spot deferred contracts (which it pioneered), the Company may either sell its gold at the hedge price when the contract matures, or - if the spot price is higher - sell its gold at spot instead and roll the contract forward. Barrick, which already had the ability to roll contracts forward up to 10 years, recently negotiated with one of its bullion dealers to extend the roll forward period to 15 years. No other company has this degree of flexibility, which has been granted Barrick because of the unequalled size and quality of its reserves and balance sheet.
How simple. How elegant. How inadequate are mere words to do justice to this great and beautiful idea.
That first amount “on deposit” arising from that first short sale implied by Note 10(c), augmented by over a decade of contango earned on ever bigger sums received on ever more favorable terms, has grown into today’s Hedgebook: a $5.5 billion, throbbing, brooding omnipresence, the product of over 18 million ounces of gold sold short, bubbling, seething, compounding (apparently) tax free; in 15 years this thing could eat Fannie Mae. |
