What if hedging came back to bite Barrick?
Company denies risk
He says that while Barrick may not be in danger at current prices, the company could be hit with hedging-related difficulties it hasn't yet considered if gold undergoes the sea change he expects. "A lot of people think they have things perfectly hedged, as Long-Term Capital Management thought they had things perfectly hedged," he said, referring to the giant U.S. hedge fund that blew up in 1998. "All of a sudden something gets a little out of whack and you find yourself with a problem."
Paul Haavardsrud
National Post
Friday, June 21, 2002
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CALGARY - Gold bugs have railed for years against the perceived evils of bullion hedging and they've reserved their deepest contempt for Barrick Gold Corp., the biggest and most successful hedger of all.
To their thinking, it would be divine justice if Barrick's hedging policy came back to bite it.
Gold has enjoyed a breakout but gold bugs have company in the main investment community in saying this is just the beginning of huge bullish run. So what would happen to a major hedger if it got caught short?
Eric Sprott, while short himself on details on how such a scenario would unfold, has some real concerns, and since he manages some of the top performing mutual funds on the planet, it's worth a listen. He has made a fortune for investors during the bear market by playing the gold sector and shorting the broader market.
The chief investment strategist and founder of Sprott Securities Inc. recently laid out the case against hedged producers and warned clients in no uncertain words to be extremely cautious. While he is a gold bull, Mr. Sprott is short Barrick in his hedge fund.
Barrick, for the record, dismisses his concerns outright.
Mr. Sprott's worries amount to a gut feeling: If the gold market is headed much higher, then it must follow that at some point Barrick's hedge book will end up drastically offside.
"I don't fully understand all their hedges ... all I can say is somebody is always on the hook if something goes up and someone's short," he explained. "Now whether it's Barrick or the bank or whatever, somebody has to make a capital provision.
"You can't short something at US$300 [an ounce] and have it go to US$600, if you're a financial institution, and not make a capital provision, not that I'm aware of."
In a research note, Mr. Sprott also speculated Barrick may already be feeling margin call pressure from bullion banks.
"How many banks do you know that are willing to have what could potentially be billions of dollars of exposure with no collateral or margin?" he wrote. "If there is in fact absolutely no chance of a margin call, then why did Barrick pull its cash out of fund managers and give it to the banks that are counterparties to its gold hedges? This looks and smells like a margin call to us. A margin call by any other name is still a margin call."
Barrick flatly disagrees.
Jamie Sokalsky, the firm's chief financial officer, says the inference that Barrick has or will have a margin call is a misunderstanding and patently wrong.
"We have clearly stated that we have absolutely no margin calls at any gold price," Mr. Sokalsky said. "We've made this crystal clear, it's well spelled out, there is nothing at any gold price that has or will cause us to have to put up any margin with any of our trading counterparties."
Barrick's hedging program, which has netted the company more than US$2-billion since it was started 14 years ago, is in place to mitigate risk, not enhance it, he added. "We sleep very well at night when [the gold price] goes up because we've structured this hedge book to deal with not only falling prices but rising prices," he said. "There's a lot of misinformation out there and we want to set the record straight that this is something that is not a problem."
In the last decade, the gold industry has broken into two camps, hedgers and non-hedgers. Hedged producers such as Barrick, the world's largest with 18 billion ounces (20% of its reserves) committed to forward sales, use the strategy to offset the risk of volatile gold prices.
Simply put, a gold producer hedges by borrowing gold from a bullion bank, which had borrowed it from a central bank, selling it short into the market and investing the proceeds in fixed-income instruments. The company profits since the lease rate for borrowing the gold is usually lower than the interest rate earned from the fixed income investments.
When the company repays the borrowed gold to the bank, out of its own production, it also profits if the price of gold is lower than when it was leased, which it generally has been during the industry's secular downturn.
Last quarter, Barrick hedged 50% of its production, earning an average price of US$365 an ounce, US$75 more than the average spot price for gold in the period, the 57th straight quarter hedging has helped Barrick achieve that mark.
Whether Barrick will continue to find success through hedging or whether the practice will lead to eventual losses is unclear without knowing more about the firm's hedge book, said John Ing, president of Maison Placements Canada Inc. and a well-known gold bull.
Despite Barrick's assertion that its disclosure is industry-leading and provides full transparency into its hedge book, Mr. Ing believes that when gold prices rise, hedged producers will be exposed to mark-to-market losses that could strain balance sheets and bank covenants.
Again, Mr. Sokalsky disagreed. "We do not have a problem with this hedge book, full stop."
Rising gold prices, he explained, give Barrick's earnings a tremendous boost, since 80% of its reserves are unhedged. Meanwhile, its 15-year leasing agreements allow it to repay borrowed gold at its discretion and provide Barrick with the flexibility to avoid repaying the borrowed gold at a loss.
Still, Mr. Sprott's concerns linger, as he notes Barrick has never experienced a long-term bull market in gold with a heavy hedge book.
He says that while Barrick may not be in danger at current prices, the company could be hit with hedging-related difficulties it hasn't yet considered if gold undergoes the sea change he expects. "A lot of people think they have things perfectly hedged, as Long-Term Capital Management thought they had things perfectly hedged," he said, referring to the giant U.S. hedge fund that blew up in 1998. "All of a sudden something gets a little out of whack and you find yourself with a problem."
Mr. Sprott said investors should view the lack of transparency into the hedges of any producer, not just Barrick, as a red flag.
"There's nothing we're hiding, it's there for proper scrutiny for every investor," countered Mr. Sokalsky. "My view is that [Mr. Sprott] just hasn't taken the time to look at what's there, it's all laid out."
Right or wrong, Mr. Ing said it's difficult to believe Mr. Sprott's worst concerns, but it's hard to dismiss them outright, considering the fund manager's record. |
