You should recognize this guy Enigma didn't you have an interest in Sutton Resources at one time?
James Sinclair is Chairman & CEO of Tan Range Exploration
TNX on the Toronto Stock Exchange. He was Chairman of Sutton Resources from 1989
to 1995 when he personally funded that company into the development of the
Bulyanhulu property
before its sale to Barrick Gold. He has written three books
on commercial metals, precious metals and economics.
The Rationale of Complacency
By
HD Schultz & JE Sinclair
University business school students being introduced to Hedging 101 are told to repeat 100 times, "Once a hedge position is established you never abandon it." If that is not enough of an introduction to the "Complacency of a Derivative Book", the famous Harvard Mathematics Professor Glibenrote, then has you repeat 200 times: " All mathematical relationships between opposing legs of a hedge position will return to normal as soon as the anomalous supply/demand event is absorbed into the equation. Therefore no properly constructed hedge will ever fail." Now in order to get the prerequisite 3.7 grade on "Hedging Theory" so that you qualify for a position at Enron as head of their Derivative Trading Department, you must repeat and believe what you have been taught.
Complacency then becomes the mindset of the derivative hedging players. This is how Morgan's Derivative trading department can accumulate a 60 - thousand million-dollar derivative gold position. Yes, $60,000,000,000 nominal value gold derivative position. It is like piling groups of plates, two at a time, and four at a time on top of each other with the intention through time of unwinding the pile of plates at a profit. Well, from time to time things change, like interest rates, catangos (difference between cash gold price and forward gold price), corporate policy and availability of cash. Yes, once in a while even the direction of the gold market, although after 22 years that is hard for derivative departments to believe. Eventually these mountains of transactions take on a life of their own whereby the constructor becomes the only living entity that can actually value them. That is the best guarantee that the head trader at Morgan will never become redundant short of incarceration or death. It is like having your company's books done in Tugalug then firing the Tugalug speaking accountant. When Ashanti failed, no one in Ashanti knew by how much. Goldman Sachs had to send their in-house rocket scientist to figure out how much Ashanti was in the hole. Goldman Sachs made it quite clear that Ashanti had not dealt with Goldman Sachs but rather with J. Aron, a subsidiary of Goldman Sachs. This revealed to Ashanti that they had not dealt with the famous bank holding company but rather with one of its subsidiaries.
This morning the Chairman of Newmont is getting a pedantic lesson from his in-house Derivative expert on "The Complacency of Hedging" and on " All relationships that move out of mathematical hedging synchronization as a result of supply/demand anomaly move back into proper relationship after the anomalous event is digested into the market equation". Does that sound familiar? They probably have old professor Glibenrote on hand in his purple robes, glasses falling off the end of his nose and pocket protector showing through his robes.
This will calm down the chairman who had a really bad nights sleep thinking about his $430,000,000 loss since gold went up a few cents at the Comex opening.
So what is wrong with this picture? Two things;
1/ Loss of future earnings.
2/ Counter party failure.
Assuming that the hedges are plain vanilla (usually not) then the risk lies in turning Newmont into a Gold Utility. A Gold mining company gains it's attractiveness to most individuals and many of its institutional holders because it allows the investor to benefit from an appreciation in the gold price. Hedging in a bull market (that is what management of Newmont says they believe we are in the initial stages of) will limit the potential of participating in an appreciation in the gold price to the degree of how much gold is hedged, not of the total reserves of the company, but determined by times yearly production. Play with words if you want but what was just said is the bottom line.
What is wrong with changing Newmont from a gold mining company to a gold utility? Nothing if you pay a dividend that will attract the utility crowd and you like trading like the motions of old road kill. From 1971 to 1976, we were the largest consumer of South African gold shares outside of South Africa. You can ask Tony Mahowski in London who was one of our brokers at the time. South African shares were at that time Gold Utility companies. They paid huge dividends but did very little price wise. If Newmont can pay a 15% to 19% dividend and wants to become a utility they certainly have a right to do that.
Newmont says one of the ways out of their Australian hedge conundrum is to deliver on their deferred gold sales at modestly higher prices for the next few years with $303 being the target for this year's hedge delivery. This is loss of future earnings potential and the transition to a Gold Utility to the degree of the hedge position deliveries.
Counter party risk is predominant in Mini-Max and so called No Margin Call hedges. In these cases the gold producer has debits and credit flowing through their hedge account at one or several gold banks. The theory here is that credits will cover a lot of the debits and the gold bank will finance any debit overage into an indefinite future.
That looks good on paper until you realize that there is no clearinghouse function on the majority of these complicated deals. What that means is that if our gold bank went belly up (they certainly can) than the receiver will seek to collect from the gold producer all the debits owed while you will have to sue for the credits. This is true because in the majority of cases there is no "right of offset" in the agreement with the gold bank to prevent this. Even if there is, then those contracts with that gold bank explode by non-performance, causing in all probability a miss-match in the hedge, which is a key ingredient of hedging failure.
You can bet on "Complacency in Hedging" because it takes a courageous person to face their mistakes and accept them head on.
It is so prevalent in modern society to hide from your errors, employ spin-city public relations specialists and pray the day of reckoning never arrives. Well, the Day of reckoning is here today for the $30,000,000,000 worth of gold that all the producers have sold short in one form or another against their future production. If you want to go breathless, then consider the fact that the gold producers represent only 11% of the total notional value of all gold derivative on the books of commercial banks for the 48 nations reporting to the IMF. Then if you want to turn blue, look at the footnotes that say to avoid double counting, the huge number of all reporting commercial banks has been halved to avoid double counting. Most CPA's reading this just fainted on that glib move.
So you really want to Hedge. - Here is how.
Negotiate with your gold bank two-year puts. A put is the right but not the obligation to deliver gold at an agreed upon price for an agreed upon time. However the execution must be on a public exchange where gold puts are already listed. Then there is a clearinghouse facility, transparency, price reporting and regulation. All you are doing is manufacturing new open interest, which is permitted by exchange rules as long as the trade is made on the floor with open out cry. Consider what you pay for the put as the cost of insurance. I wager no gold bank will do it. Then ask yourself, WHY?
You say this does not satisfy the lenders who facilitated your non-recourse development loans. Well, if you are unwilling to accept the risk of financing a new project by taking full responsibility on the new production project loan at $310 gold, then call the largest major gold producer and sell your company. Under $250 there is no company whose average TOTAL cost of mining will preserve them in the gold business. If you have no confidence in the future of the gold price, then at these levels what are you doing in this business? Sell and leave, please.
HD Schultz can be reached at www.hsletter.com. JE Sinclair at www.tanrange.com |
