And now the rest of the story...hope all have found it enlightening.
The Dance of the Ashanti
Goldbugs are paranoid by nature, and we get especially cranky when we’re in the dark on the kinds of basic questions posed above. Our anxieties, as they relate to the prospect of ending up somehow with Barrick paper in a bid for Gold Fields, center on one hellish scenario: a collapse like that of Ashanti Goldfields Ltd. (NYSE:ASL) in the wake of the Washington Agreement in September 1999.
Confession time: we were long Ashanti. Not by much, but still, we’ll never forget the awful sight of hedgebooks blowing up, and the acrid smell of burnt toast wafting out of our portfolio. All because the price of gold rose. (And they wonder why we’re paranoid.)
Now, there are a number of obvious differences between the hapless Ashanti and the swashbuckling Barrick. To begin with, Barrick is not the typical prey of the derivatives sharks described in Frank Partnoy’s FIASCO. Randall Oliphant is a financial maven, not a miner, and Hedgebook is a financial business, not a mine; if anything, it would seem Barrick consistently eats the bankers’ lunch.
Add to this the important differences in the reported terms of the forward contracts themselves. Ashanti’s book, we learned after the fact, consisted of an assortment of amusing little delicacies cooked up by those merry chefs at Goldman Sachs. See, e.g., L. Barber & G. O'Connor, “How Goldman Sachs Helped Ruin and then Dismember Ashanti Gold,” Financial Times (London), Dec. 2, 1999, reprinted at groups.yahoo.com. It featured treats like Margin Call Marengo and Death by Chocolate Delivery Requirements.
Not so our spot deferreds, according to Company pronouncements. Barrick’s SVP and CFO, Jamie Sokalsky, put it thus in a letter to the editor published in the November 23, 2001, edition of Canada’s The Globe and Mail:
Critics cite a few high-profile cases of companies running into trouble with their hedging programs when the gold price rose. Barrick’s program is different in kind and quality. For one thing, we have no margin calls to worry about. But the most important difference is that if the gold price rises, Barrick has the unique flexibility to defer its contracts for up to 15 years.
To give an example, if the price of gold shot up to nearly $600 tomorrow and stayed there for 15 years, we would realize every cent of that increase.
Now that’s a striking assertion. Let’s think about its implications for a moment. According to the 2001 annual report, Goldco has proven & probable reserves of about 82 million ounces, and produces at the rate of about 6 million ounces per year. If, in Mr. Sokalsky’s hypothetical, Barrick were to sell all its output in the spot market for all 15 years rather than close out the accounts, at the end of that period it would be out of gold in the ground but the obligation to deliver under those spot deferreds would remain. So unless Barrick succeeded in adding another 80 million ounces of reserves over that 15 year period (how much do new reserves cost in a $600 gold environment, we wonder, and just how plentiful are they?), Mr. Sokalsky’s counterparties would be left holding a rather large empty bag. Now they may not be as smart as the Barrick guys, but it strains credulity that they would just stand by and watch their position disappear altogether. Assuming a normal commercial relationship, at some point they will turn the screws, contract niceties or no.
How Is a Bullion Bank Like an S&L?
Readers of a certain age may remember the S&L crisis of the late 1980’s and early 1990’s, a time long ago when greed, fraud and and incompetence stalked the financial landscape, and the federal government ended up “resolving” scores of bust financial institutions through innovative and costly receivership and liquidation techniques. Behind the colorful personalities (Who can forget Charlie Keating?) and the garish irregularities, there lurked a simple problem: the S&Ls had been locked into a classic funding/yield mismatch. They borrowed short, with floating rate funding, and loaned long, in fixed rate mortgages. This worked just fine in the stable, monochromatic world of Leave It to Beaver, but broke down entirely in the gonzo world of Apocalypse Now, as short rates streaked north and the S&Ls’ books went negative.
Consider the parallel in the funding structure of a spot deferred. The bullion bank borrows gold from a central bank on a short-term basis (we understand the typical maturity is under one year), and the loan is routinely rolled over. Hedgebook, by contrast, borrows long from the bullion bank. Not just long, but indeterminate - they pay it back when they want to, as Mr. Sokalsky points out. So the bullion bank is caught in the middle with yet another classic funding/yield mismatch. In the stable world of, say, The Truman Show, this would be fine, because non-linear events do not happen; central banks never change their minds and ask for their gold back, gold prices always stay suppressed, and yield curves never invert. Now it so happens that for the past seven years or so, the gold market has been in a similarly artificial environment [The Greenspan Show?], with events conspiring (oops - there’s the “c” word - it just slipped out, honest!) to produce steady, linear results for players on the short side. Give or take an Ashanti.
But even in The Truman Show, Truman escapes and his world suddenly becomes non-linear. Are we to believe, with Mr. Sokalsky, that if the bullion banks come under pressure from the central banks to return the gold, that the bullion banks will not in turn find a way to force Goldco to hand it over, no matter what the contracts may say? Query, as we say in the law.
Does Moody’s Give an A for Effort?
Barrick’s annual reports cite its “A” credit rating as the reason why it gets such favorable terms on the spot deferreds. We wonder, though, whether in fact the rating is a condition rather than merely an explanation: is it possible that the flexibility of the spot deferreds is, explicitly or implicitly, dependent on maintenance of that “A” rating? The question is of more than academic interest.
In Note 16C to its 2001 financial statements, Barrick informed us that, with respect to the spot deferreds:
The favorable fair value of the contracts at December 31, 2001 was $356 million, and is estimated based on the net present value of cash flows under the contracts, based on a gold spot price of $279 and market rates for Libor and gold lease rates.
What a difference a quarter makes. In its 1st Quarter Report 2002, Barrick made the following statement:
Our outstanding gold and silver sales commitments at March 31, 2002 had an unrealized mark-to-market loss of $127 million (calculated at a spot price of $302 per ounce and $4.64 per ounce for gold and silver respectively, prevailing market interest rates and volatilities).
[Memo to file: Silver again. Hmmm.]
That’s some swing on a paltry $23 increase in the price of gold: Four Hundred Eighty-Three Big Ones, or about $21 million for each dollar of spot increase, for the arithmetically challenged. Uncharitable readers will already have noted that the spot price of gold is now around $310, $8 north of the baseline for that first quarter calculation. Randall Oliphant stated at a recent investor conference that Barrick’s mark-to-market sensitivity is about $18 million per dollar increase in the gold price. That suggests we’re looking at another $144 million in negative swing if gold holds $310 through the quarter, which would bring Hedgebook’s total mark-to-market loss to $271 million.
Following the recent unpleasantness at Enron, how long will the rating agencies grant Barrick a pass on an increasingly negative Hedgebook? Forever? Maybe. But if not, what will the counterparties say if that vaunted “A” becomes something less attractive? What consequences may then be set in motion? Gives us the willies just posing the question.
If a Counterparty Falls in the Forest, Does A Hedger Hear It?
Maybe Mr. Sokalsky is right, and the spot deferreds are so airtight in favor of Hedgebook that the banks are on the hook for all the risk. Terrific. What happens if the banks, despairing of their desperate lot and staring in the face the grim specter of diminished bonuses, simply decide to exit the business? Like Credit Suisse First Boston did, for instance. Like Morgan is rumored to be doing, for another for instance. (Said rumors are rife out here on the lunatic fringe, at any rate.) Who ends up holding the paper? Will they be gentle? Perhaps the central banks, as the ultimate parties at risk, will step into the shoes of their former agents, and we will be treated to a real time demonstration of top-down disintermediation. Wonder how the central banks would react to a downgrade of their new direct counterparty, if such should come to pass.
Holding the Maginot Line
We may soon get some answers to our questions. Last week Barrick announced two changes in Hedgebook’s policy which got our antennae twitching. These were both contained in a press release issued on May 8:
Source: Barrick Gold Corporation
Barrick to Simplify Premium Gold Sales Program
WILL FOCUS ON CORE SPOT DEFERRED CONTRACTS AS CALL POSITION REDUCED; ALL AMOUNTS IN UNITED STATES DOLLARS
TORONTO--(BUSINESS WIRE)--May 8, 2002--[…] Barrick Gold Corporation announced today at its Annual Meeting in Toronto that it is simplifying its Premium Gold Sales Program. The Company said it will not renew its gold call and variable price sales contracts, which should result in a 3-million ounce reduction in the position by the end of the year.
"A simple spot deferred program makes more sense in today's environment," said Jamie Sokalsky Senior Vice-President and Chief Financial Officer. "The overall Program will be simpler, smaller and better positioned to take greater advantage of rising gold prices. At the same time, it will continue to generate significant additional revenues and provide secure and predictable cash flows."
Overall, at the end of the first quarter, the Company had 18 million ounces of spot deferred contracts, representing 22 percent of reserves, and 6 million ounces of call and variable price sales contracts in the Premium Gold Sales Program.
Barrick is simplifying the Program in two ways. First, it will not renew call and variable price sales contracts, and expects this position to decline by at least 50 percent, or 3 million ounces this year. Secondly, the Company will no longer invest a portion of its spot deferred contracts in corporate bond funds, and will instead leave all proceeds invested with its average AA-rated bank counterparties.
These changes are further to Barrick's previously announced decision to sell 50 percent of its production at the spot price, for the first time in 14 years. In prior years, 100 percent of annual production was delivered against the Premium Gold Sales Program.
What is most interesting about this announcement is that the headline should have read: “Barrick Stands Firm on Hedging Policy Despite Heavy Pressure from Shareholders; Premiums to Decline.” There are three reasons why this is so.
First, note that the much ballyhooed sale of 50% of production in the spot market represents an extension of the spot deferred program, not a reduction. You don’t reduce a hedge position by needlessly prolonging the agony. With the addition of the Homestake production, it would seem that Barrick could reduce the hedge at almost twice the rate possible pre merger. Instead, it is delivering into the contracts at a rate which will be only 10% less than that of 2001 (61%) and 2000 (63%). The statement in the release that 100% of production was delivered into the program in prior years is inaccurate (see excerpt above from the 2001 annual report).
Second, elimination of new premium from the sale of calls will eliminate a big swallow of the extra juice on the notional price per ounce calculation, tending to make future such calculations more closely correlated with pure, low octane contango.
Third, it looks like we won't have the corporate bond portfolio to kick around anymore, as all the cash has been pulled right back into the banks. This too should take some of the sizzle out of the price per ounce calculation. But more intriguingly, this has a funny look to it. Who’s driving the bus? A wild guess -- the banks. Come home to Mama. Is this sort of like a margin call in a contract that doesn’t feature margin calls? Just asking.
So Barrick is going to tough it out, despite the prospect of reduced premium and the risk of an increasingly negative mark-to-market. Whose interests are served by such a theological adherence to the strategy that won the last war? We don’t know, but they sure aren’t ours.
Conclusion
Call us kooky, but after our little romp through the Book of Barrick, we’re just a wee bit uncomfortable with the prospect of substituting Barrick paper for that of our beloved GFI. Too many issues for our simple taste. So here’s hoping it was all just a misunderstanding. If not, here’s hoping it’s a cash deal.
May 15, 2002
DISCLAIMER & CONFLICTS
THE FOREGOING ESSAY IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. NEITHER MR. LANDIS NOR GOLDEN SEXTANT ADVISORS LLC (“GOLDEN SEXTANT”) IS SOLICITING ANY ACTION BASED UPON IT, NOR IS EITHER MR. LANDIS OR GOLDEN SEXTANT SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY SECURITY. THE CONTENT OF THE ESSAY IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE RELIABLE, BUT NEITHER MR. LANDIS NOR GOLDEN SEXTANT MAKES ANY REPRESENTATION THAT IT IS EITHER COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED ON AS SUCH. MR. LANDIS AND GOLDEN SEXTANT AND ENTITIES UNDER THEIR RESPECTIVE CONTROL MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT, IN ANY SECURITIES MENTIONED, AND ANY SUCH POSITIONS MAY BE CHANGED AT ANY TIME FOR ANY REASON. |
