The plot and explanation continues:for the full story see www.goldensextant.com
Linear Results in a Non-Linear World
The reported results of this revolution in finance confirm the brilliance of its author. In the Letter to Shareholders portion of each of Barrick’s annual reports over the last five years, management has prominently and proudly noted Hedgebook’s contribution:
1997:
Hedging has contributed a total of $765 million in additional revenue and $580 million in additional net earnings over the last ten years. That works out to an average premium of $46 per ounce over the spot price, for every ounce sold, during that time.
1998:
Under its Premium Gold Sales Program, Barrick realized $400 per ounce on its gold sales in 1998, compared with $420 in 1997 ($415 in 1996). The Company generated a $106-per-ounce premium over the average spot price of $294 per ounce for the year, resulting in $340 million in additional revenue in 1998. Over the past 10 years, Barrick has realized $56 per ounce above the average spot price of $356 per ounce during the period, or $1.1 billion in additional revenues.
1999:
Our Premium Gold Sales Program contributed $391 million in additional revenue in 1999. Over the past three years, the Program has contributed $1 billion in additional revenue, and averaged a $100 premium over the spot price.
2000:
During 2000, our program realized an average price of $360 per ounce, an $81 premium to the average spot price, which translated into $300 million in additional revenues.
2001:
For the year, we realized a $70 per ounce premium over the average spot price of $271 on the 61 percent of production delivered into our Premium Gold Sales Program. This compares to a realized price of $360 in 2000 and a premium of $84 on the 63 percent of production delivered into the Program during the year. The balance of the ounces sold -- principally Homestake's production -- were sold at an average price of $277 per ounce in 2001. Overall, we realized an average price of $317 per ounce, $46 higher than the average spot price for the year, generating an additional $289 million in revenue.
Riddle Me This
When something seems too good to be true, it often is. And so we must wonder, what is really going on here? We have a number of specific questions, but two rather basic ones will suffice to illustrate our puzzlement:
1. What, exactly, are the prices on those spot deferreds?
A casual reader of Barrick’s more recent financial statements and annual reports may be forgiven for concluding that the spot deferreds have specific prices for ounces to be delivered in the future. For example, Note 5B of the 2002 First Quarter Report contains the following comment and schedule:
We have entered into the following spot deferred sales contracts, with various counterparties, that establish selling prices for future gold and silver production, and which act as a hedge against possible price fluctuations in gold and silver [emphasis supplied].
Scheduled for delivery in 2002 2003 2004 2005 2006+ Total
Spot deferred gold sales contracts
Ounces(thousands) 2,100 2,600 2,800 1,500 9,000 18,000
Average price per ounce $365 $340 $340 $335 $342 $344
Spot deferred silver sales contracts
Ounces(thousands) 12,000 8,000 3,000 2,000 1,000 26,000
Average price per ounce $4.75 $5.05 $5.10 $5.10 $5.10 $4.92
[Memo to file: Silver? We thought that was just a byproduct used merely to reduce operating expense at Goldco. So what's it doing over here in Hedgebook? And in size! In addition to spot deferreds, Barrick is short another 20,750,000 ounces through written call options, 10,000,000 for 2002 alone. Ay, caramba! Let's make a simplifying assumption: for purposes of this commentary, the silver issue does not exist. We'll let Ted Butler worry about that one.]
Negative, Captain. These contracts, as we know from careful exegesis of other portions of the text in question, do not in fact establish “selling prices;” rather, the “selling prices” are merely projections of the future values of existing cash balances using various assumptions on interest rates. Recall the description of how forward pricing works in the excerpt from the 1997 annual report: “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” [emphasis supplied]. The sale referred to is the short sale entered into to fund the forward, not the final sale on delivery. All Goldco gets when it closes out a particular spot deferred is the original short sale proceeds plus interest.
So a critical component of the “selling price” is the assumed rate of interest on the proceeds of the short sale. This explains the statement in the 2001 annual report:
Contrary to most businesses, we are adversely affected by lower interest rates rather than higher rates. In higher interest rate environments, we earn higher premiums for our spot deferred sales program because the forward price is primarily a function of US interest rates, as well as higher interest income on our cash balances [emphasis supplied].
Making such a big bet on interest rates involves risk. The cost of funds could spike up, the return on investment could go down; either swing could dramatically affect the size of the amount available on delivery. Barrick’s solution: derivatives.
The Company maintains an interest rate risk-management strategy that uses derivative instruments to mitigate significant unplanned fluctuations in earnings or cash flows that arise from volatility in interest rates.
But what about the rollover option in the spot deferreds? How does a decision to defer delivery affect pricing assumptions? What other costs are incurred in the exercise of this flexibility? Take a hypothetical example. Assume on a day when spot is $250, Goldco enters a contract to deliver 1 ounce on June 30, 2002. But when June 30 rolls around, spot is actually $400, so Goldco does the rational thing and elects to put off delivery for a year, selling its ounce instead into the spot market. Assume one year later spot has fallen to $200, so Goldco elects to deliver into the contract and book a gain. Who bears the loss of the “profit” that the bullion bank/central bank would have enjoyed if it had received its gold on the due date? It could have turned around and sold in the spot market then for $400, but now it’s stuck at $200. Can these contracts be so cleverly drawn that in every scenario, it’s heads Barrick wins, tails the banks lose? Or does each deferral trigger yet another actual or synthetic short sale by the bullion bank to lock in the profit deferred? Does this explain the phenomenal growth in J.P. Morgan’s derivatives position? If so, what is the corresponding adjustment to Hedgebook’s accounts? Or does each deferral just trigger some sort of payment or obligation which need not be disclosed, as it takes place beyond the cyber-membrane?
Grid and Bare It. That spot deferred “prices” are mere projections, changed as circumstances warrant, is demonstrated by the futility of attempting to track them across reporting periods. The following tables show the “selling prices” for gold under spot deferred contracts as presented in Barrick’s annual reports for the last three years and the first quarter of 2002:
2002, First Quarter:
Scheduled delivery 2002 2003 2004 2005 2006+ Total
Ounces (thousands) 2,100 2,600 2,800 1,500 9,000 18,000
Avg. price ($/oz/) 365 340 340 335 342 344
2001:
Scheduled delivery 2002 2003 2004 2005 2006+ Total
Ounces (thousands) 2,800 2,600 2,800 1,400 8,600 18,200
Avg. price ($/oz.) 365 340 340 340 344 $345
2000:
Scheduled delivery 2001 2002 2003 2004 2005 2006 2007+ Total
Ounces (thousands) 3,800 3,800 2,100 1,600 700 600 2,300 14,900
Avg. price ($/oz.) 340 340 362 364 355 357 360 350
1999:
Scheduled delivery 2000 2001 2002 2003 2004 2005 2006+ Total
Ounces (thousands) 3,700 3,700 1,800 900 900 500 2,100 13,600
Avg. price ($/oz.) 360 360 360 360 360 361 366 361
Try tracking the scheduled amount for delivery in 2002, just for fun (shown in bold in the tables). It starts out life in our series back in 1999 at 1,800,000 ounces, sporting an average price of $360. In 2000, the very next year, some committee or other apparently decided that it would be better for reporting purposes to beef it up to a whopping 3,800,000 ounces, but felt the need to chop the “price” by $20, taking it down to $340. Cooler heads prevailed in 2001, however, and the amount was reduced to 2,800,000 ounces, but what’s this -- the “price” was increased to $365, higher even than 1999’s version. One quarter later, at least the “price” stays the same, but the amount mysteriously declines to 2,100,000 ounces.
Notice a pattern here? Neither do we. These tables breathe new life into the tired term “random.” While we’re on the subject, we wonder precisely what an investor is supposed to make of this information. Whence are the “schedules” derived? Why are they changed so often? Of what utility is a “schedule” which varies as to amount and price so radically period over period?
Is this price derivation and schedule disparity thing a big deal? We don’t know, but the false rigor bothers us.
2. Why are they so much better than the prices everybody else gets?
It is also troubling that no other hedger comes close to matching these results. Fifty, eighty, hundred dollar premiums over spot, year after year? How do you get that at a passbook savings rate, even allowing for the magic of compounding?
Granted, Barrick has an A rated balance sheet, unique in the industry. But is that enough to explain such a huge difference? The financial markets are ferociously competitive, and a great idea has a proprietary shelf life of about a minute. How is it possible that over a 14-year period, swarms of aggressive young investment bankers have not taken this concept and applied it to everyone in the phone book, thereby causing a convergence of results?
Once again, the answer may be found in a synthesis of disparate portions of the annual reports. The MD&A section of the 2001 annual report informs us that Barrick gooses returns in three ways: First, it has until recently (see Holding the Maginot Line, below) put a slug of Hedgebook under the management of gunslingers, we mean, fund managers.
To improve returns, we have diversified [Hedgebook] by investing approximately $1 billion or 17 per cent of the overall Program into an off-balance sheet fixed-income portfolio of corporate securities with a number of top fund managers, with changes in fair value being reflected in the income statement and on the balance sheet.
Second, it takes directional risk on funding rates:
We have locked in gold borrowing costs on approximately two-thirds of the overall Program while maintaining floating lease rates on the balance to maximize the forward premium earned.
Finally, it adds apple juice to orange juice, tossing in premium from the sale of other derivatives:
Third, we sell gold call options to generate additional revenue. The calls are written at prices at which we would be comfortable adding to our forward sales program if we are exercised. We have the ability to convert the call options exercised, at our discretion, including related premium income, into spot deferred contracts, which accrue contango (US$ Interest Rate - Gold Lease Rate) the new delivery date. The call options and the premiums from expired options are recorded on the balance sheet and the fair value adjusted through earnings.
So is this the answer? They take the bread & butter Hedgebook projections, add in the juice from various derivatives, extend or shorten the schedule as needed, divide by some number of ounces which they have sold under this rubric or intend to sell or might sell or could sell unless conditions change, and presto! A super high price-per-ounce calculation, and sure-fire $X-greater-than-spot bragging rights for the annual report. But when the numerator is such a hodgepodge of unlike income categories, and the denominator appears to be a moving target, of what value is the information? What are we to make of this?
We don’t know, we don’t get it, and it bothers us that we have to work so hard to try to figure it out. |
