Barrick has a pretty good description of their hedging on the website now http://www.barrick.com/3_Financials/
I have bolded the part discussing spot deferred contracts. I too think spot deferred means they have the choice to sell at spot on original expiration of the contract, and defer delivery of gold to close out the contract to a later date.
I should point out that although Barrick suggests here that if the spot POG is higher than the hedge price when the contract term ends, they can sell the production to the spot price and roll over the contract. This is an option, but not necessarily what Barrick would do in the present gold bull, low interest rate environment.
Indeed Barrick has recently stated that it is their intention to close out half of these contracts coming due over the next two years, and I take that to mean they will deliver into them even if the spot is higher than the hedge price to reduce their level of hedging. For 2003 they have 2.8 million oz of contracts coming due, so if they deliver to all of them closing out the hedge they will still receive $340 per oz for those oz, but additionally will receive whatever the spot is for the other 2.8 million oz of production. If gold goes to $400 tomorrow and stayed there for all of 2003, Barrick would average $370 per oz for all 2003 production, whereas the completely unhedged producer would get $400 per oz.
Next year (2004) if they did the same thing and gold stayed at $400 only 1.65 million oz of hedged gold come due so Barrick would average $382 per oz for 5.6 million oz of production. The hedge position declines each year you go out so Barrick will average closer and closer to the spot price in subsequent years, and in 5 years their new mines will come onstream increasing further the unhedged production.
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1. What is the current status of Barrick's hedge program?
Barrick's Premium Gold Sales Program is a fundamental component of the Company's approach to the gold mining business and has been for the past 14 years. The Company has always managed this Program on a conservative, disciplined basis. This Program was developed to allow Barrick to participate in a rising gold market, yet be protected in times of declining gold prices.
Barrick presently (as at March 31, 2002) has 18.0 million ounces of its reserves sold forward which is 22% of total reserves, in line with historic parameters of 20-25%. In any one year the company will deliver a maximum of 50% of its production against its hedging contracts. This allows the Company to ensure earning sufficient cash flow to cover cash requirements for the year, which include capital spending programs, yet at the same time allows the company to benefit immediately as gold prices move higher.
The Company also has sold 5.3 million ounces of variable price gold sales contracts (previously written long-term call options and min-max contracts) which are spread evenly over the next decade. Variable Price Sales Contracts are contracts whereby we will deliver a specified quantity of gold on a future date that is determined by us.
All of the Variable Price contracts have expected delivery dates in 2005 and beyond. Furthermore, we have the right at our sole discretion to set a delivery date for any Variable Price contract for up to 15 years from its inception date. The contract price equals the gold spot price subject to a specified maximum (“cap”) based on market conditions in the years indicated in the table below, plus a fixed fee. The contract price will be adjusted in the same manner as price adjustments to spot deferred contracts for the period from these dates to the expected delivery date in 2005 and beyond. Certain of these contracts also have a specified minimum (“floor”) price. In addition, the Company has a short term call option program. The number of options outstanding varies depending on market conditions but are always covered by quarterly production.
Barrick expects to realize a minimum average price of $365 per ounce through 2002 and $340 through 2005 on the ounces of production that participate in the program. If the gold price rises above the contract price, the spot deferred contract can be rolled forward and the ounces sold into the market at spot. Thus, Barrick is able to realize the higher of the contract price or the spot price These contracts currently incorporate a gold lease rate assumption of 2%. The Company has locked-in lease rates, through 2005. The fact that Barrick is the only company in the industry with an "A" credit rating in combination with its strong balance sheet has allowed it to produce a unique hedge position with very flexible hedge lines. The Company can choose to roll contracts forward for up to 15 years if the spot price is above the contract price.
The impact of a rising gold price on the Company's off-balance sheet mark-to-market is not of concern. Though the mark-to-market value of the hedge book may decline, the realized price remains the same and the value of these underlying hedged ounces rises by the same amount as the gold price. As long as gold prices rise, so does the value of the overall Company because the majority of its 82.3 million ounces of gold reserves are unhedged. For example, with every $25 rise in the gold price, these unhedged reserves go up in value by about $1.5 billion.
As at March 31, 2002 this Program has earned the Company additional revenue each year, totaling $2.2 billion in premiums since its inception 14 years ago. The purpose of Barrick's Premium Gold Sales Program is three fold: to earn the most possible for each ounce of gold the Company produces; to provide shareholders with insurance that the value of these ounces is protected in the event that gold prices decline; and to provide the opportunity to participate in increases in the gold price through flexible program.
Current Position
2. What is gold price hedging?
Barrick's hedging program is designed to manage the risks associated with fluctuations in the gold price. Future gold prices command a premium to the spot price. Gold price hedging takes advantage of this unique characteristic, using forward contracts to sell gold for delivery in the future at a higher price than today's price. The forward premium, known as contango, is computed by taking into account the interest earned on dollars from the sale of borrowed gold, after deducting the gold borrowing costs. That interest rate differential, compounded over time, generates the higher forward price.
3. How is this possible?
Because gold is more than a commodity, and has monetary value, central banks have large reserves of gold on deposit. They lend this gold to bullion banks at an interest rate that is substantially lower than that earned on U.S. dollar deposits. This is because gold has historically been a good hedge against inflation, so gold interest rates typically have the "inflation" taken out. The gold trading banks sell this borrowed gold at today's spot price and place the proceeds on deposit to earn US$ interest (which is higher than gold interest rates, or "lease" rates). It is the original money from the sale, the interest it generates, minus the gold lease rates, that Barrick receives in the future when it delivers its own gold.
4. Here is how a contract works:
To earn the higher future price under the forward contract, bullion banks borrow gold from central banks and sell it at the prevailing market price. These proceeds are placed on deposit to earn US$ interest. Barrick enters into a contract with the bullion bank to sell its gold forward. The "contango" that Barrick receives on its contract in the future is the difference between the US$ interest earned on the proceeds and the gold interest (lease rate) paid on the borrowed gold. The interest paid to borrow the gold can fluctuate but has normally averaged less than 2% per year. The higher forward price is achieved since the U.S. dollar interest rate applied to the invested funds is higher than the interest rate charged on the borrowed gold.
At the end of the contract period, Barrick delivers its newly produced gold which is used by the bullion bank to repay the central bank, and receives the net proceeds (the original spot price plus accumulated compound interest earned minus the interest, lease rate, paid to borrow the gold).
Barrick uses a version of the forward contract for its hedging called the spot deferred contract. A forward contract is a commitment to deliver a specific quantity of gold, on a specific date, at an agreed price to a purchaser. A spot deferred contract is similar but the delivery date and corresponding forward price for a spot deferred contract are not fixed. The flexibility of spot deferred contracts means that when the spot price is higher than the hedge price, Barrick is able to sell its production at spot, and roll the contract forward for up to 15 years. When the hedge price is higher, the Company delivers its production against the contract. Thus, Barrick is able to realize the higher of the two prices for its gold. Barrick will earn contango of about 4.0% each year on each ounce in its spot deferred program. For example, we could realize $360 per ounce by the end of 2007 if we sold that year's production today at $300 per ounce.
How it works
5. What is the impact on Barrick's hedging strategy of high gold lease rates?
Although a prolonged period of high gold lease rates would have an impact on forward prices, Barrick can reduce the effect because the Company has the ability to invest funds for longer terms, thereby achieving higher interest rates than the short term dollar interest rates. By taking advantage of the dollar yield curve, Barrick is still able to earn attractive contango despite a high gold lease rate environment. Though lease rates can fluctuate, they have always returned to more normal historical levels over time.
Barrick has benefited in the past and will continue to take advantage of troughs in the lease rate market to lock in favourable lease rates when they exist.
6. How do the accounting rules on spot deferred forward contracts affect Barrick?
The accounting rules would have no impact on cash flow or in the way Barrick manages its hedge program.
When Barrick's hedge price is greater than the spot price, as it has been for more than a decade, the accounting interpretations will have no effect on reported income.
Under US GAAP accounting is based on the realized price for each ounce of gold sold in that year.
Although the annual revenue may not match the actual cash flow, over the life of the hedge contract, company revenue will be the same. The year-to-year differences are simply timing
7. If Barrick has already entered into these contracts for the next couple of years, how can it benefit from a rising gold price? Isn't it locked in?
No, it is not. The Company can take advantage of a rising price.
Remember that by using spot deferred contracts the Company has the choice of selling gold at the prevailing price if it is higher than the contract price at any time during the next 15 years. In that case, Barrick extends the spot deferred contracts further into the future to be used when the price of gold declines and falls below the contract price.
Futhermore, Barrick is 50% hedged, leaving 50% of its production available to participate in rising spot prices.
8. Doesn't the forward price of gold reflect people's expectations of future gold prices?
No, the forward price is calculated as a function of interest rates as described above.
9. It sounds so easy and attractive. Why doesn't everyone take advantage of this hedging program?
Not everyone has that ability. The right to roll contracts forward is directly related to the financial and credit strength of the producer -- areas where Barrick has a major advantage as reflected in its strong balance sheet. Because of its strength, the Company can defer delivery up to 15 years. This provides ample time for contracts to rise in value should gold rise well above today's price and stay at the higher level, or for the Company to wait for the next trough in the gold market.
10. Could Barrick lose money on its hedge program?
No, because all its hedge contracts are at prices in excess of the cost of production. Barrick could have an opportunity cost if the spot price of gold consistently exceeded the rising price of our contracts for the next 15 years. However, for a small percentage of our production, we are prepared to make this concession in order to limit the risk to our shareholders of gold's possible downside.
11. Has Barrick benefited from the increase in the gold price?
Most definitely. Barrick has one of the largest reserve bases in North America and the majority of these reserves are unhedged. The size of the reserves gives Barrick shareholders excellent leverage to the gold price. Thus, an increase in the price of gold raises Barrick's value significantly through the benefit of future earnings and cash flow. In the event that the gold price rises significantly above Barrick's hedging price, there could also be an increase in reserves. Material that is uneconomic at lower gold prices becomes ore at higher gold prices, increasing Barrick's already large reserve base.
12. Will Barrick continue hedging?
Barrick is committed to its hedge program and is able to take advantage of rallies in the gold price. If the gold price rises through Barrick's hedge price, the Company will sell its gold at the higher spot price and keep the contracts for a future date when the gold price may not be so attractive. The contracts will likely continue to rise in value the longer they are outstanding.
13. How will increases in the gold price affect Barrick's share price?
The Premium Gold Sales Program is structured to allow the Company to take advantage of rising gold prices. Barrick's shares have moved up over time showing a strong correlation to movement in the gold price. Thus, Barrick's shares are likely to appreciate consistently with a rising gold market and, at the same time, offer the comfort of downside protection through its unique hedging program.
Let's look at an example.
When the gold price is above the hedge price, we deliver at the spot price of gold. When the spot price is below our hedge price, we deliver against our hedge contracts. Thus, we take advantage of the peaks and smooth out the troughs to maximize gold revenue over time.
The right to roll contracts forward is limited only by the financial strength of the producer - an area where Barrick has a unique and major advantage. Barrick's financial strength enables the company to arrange trading lines to roll out these contracts up to 15 years, making the strategy very effective. Barrick's contracts are with the world's leading gold trading banks and bullion dealers who have the best credit ratings.
If the spot price of gold exceeds the contract prices of Barrick's hedge position, Barrick would deliver against the higher spot price and extend its hedge coverage into the future. |
