Essential Reading: ABX Hedging Program
As Exsrch has stated, Barrick has a very comprehensive explanation of their gold hedging program. Find this at:
barrick.com
Can't imagine that many other producers are not following this model exactly the same way. The "Premium Gold Sales" site information is replicated below:
Barrick Gold
Premium Gold Program
Though the gold price was weak in 1997, Barrick was strong. The Company's hedge program celebrated its tenth anniversary by delivering its best results ever.
The Company's hedge program generated a premium of $88 per ounce, or $269 million of additional revenue. That equates to $200 million of additional earnings. Barrick has been able to make this statement for ten straight years. So far, hedging has contributed a total of $765 in additional revenue and $580 in additional earnings to the Company. That equates to an average premium of $46 per ounce, for every ounce sold, over the entire ten year period.
The hedging assets make a great contribution to our ongoing financial strength. Yet they are not reflected in our balance sheet nor are they fully appreciated by the markets. The time has come for us to elaborate and to share our thoughts for the future -- what hedging has done for Barrick historically, and what we see going forward.
Barrick largely pioneered the hedging process in the gold industry. When the program began, it involved simple forward sales. Since then, it has become much more sophisticated generating better returns and great flexibility and we continue to earn a better return from it than others do. There are many reasons for this.
First, we hedge consistently. While we can select the timing of gold sales, we regularly add to our hedge position on a regular, disciplined basis.
The second reason is that we enjoy the most favourable terms for our hedge contracts. We have the large margin limits and ten-year lines. These terms recognize the exceptional size and quality of our reserve base, and of our balance sheet, which hedging helped to build.
The third reason we do better is that we, unlike other companies, manage the proceeds from the original spot sale very actively. With 10 million ounces hedged at over $400 an ounce, we have created a $4 billion asset, which at 5% net interest, earns us $200 million a year in interest income. At December 31, 1997, the mark to market gain was $800 million, representing the amount of money Barrick would receive if we purchased gold on the spot market and delivered against our 10 million ounce hedge position. We manage our hedge asset as carefully as our mines.
We have developed strategies for maximizing the returns on our hedge asset. We have managed to lower the cost of the borrowed gold and improve the yield from the money on deposit. The average yield in the money market these days for the term of our hedges is 5.5%. By choosing the investment vehicles ourselves, we are currently earning about 7.5% interest instead. Each 1% improvement in our interest rate earns us an extra $40 million a year.
With the 10 million ounces we have hedged at present and our ability to achieve forward prices on new hedge contracts, even if gold were to remain at current levels indefinitely, we could actually realize more then $350 an ounce on our entire 50-million-ounce reserve base.
When we look at the impact of our hedge program historically, it is no exaggeration to say that it has allowed us to be the kind of company we want to be.
First, we are financially strong. With the dependable stream of hedged cash flow behind us, Barrick can afford major projects, and we can choose our own timing.
Second, we maximize revenue and minimize gold price risk on each ounce produced.
Third, we have financial flexibility. We know our realized price going forward -- and not just for the three years of current contracts. Should we choose, we could blend various contracts to extend this hedge benefit out through the life of our reserves, or we can participate in gold price improvement.
Looking at the future, hedging will remain an ongoing, core activity of this company. We do not know where the spot price will be, but we do know that by earning a 5% premium for three years, Barrick ounces will realize, on average, at least the spot price plus 15%.
Barrick has very powerful ounces, in other words. You can see just how powerful they are when you look at earnings per ounce. One Barrick ounce earns four times as much earnings as our peer group. This margin will become even greater, as our operating costs decline. And since Barrick's reserve life is almost 50% longer than our peer group, we not only generate four times as much money per ounce, but we do so for a much longer period of time.
Hedging is a major factor in our success to date, and a major reason why our shareholders can count on the same success in the future. Hedging Profile
Barrick Gold's hedging strategy to maximize revenue and minimize gold price risk through gold price hedging is one of the principles on which the Company was founded. At year end 1997, Barrick had 10.1 million ounces hedged, or about three years' production. It has derived great benefit from the program, receiving an average of $46 for each ounce produced over the Comex average price for the past ten years. Over this period, Barrick has realized a total benefit of about $765 million of additional revenue due to the hedging program, or $580 million of net income.
Barrick's hedge price for 1998 should average $400 an ounce, $100 higher than current gold prices.
People tend to think of hedging primarily as protection from a weak gold price. It is important to understand that Barrick's unique hedging program works equally well in a rising market. Barrick is able to sell its gold at the hedge price or the spot price, whichever is higher.
What is gold price hedging?
All hedging programs are designed to manage the risks associated with fluctuations in price. Future gold prices command a premium to the spot price. Gold price hedging takes advantage of this characteristic, using forward contracts to sell gold today for delivery in the future at a higher price than today's market price.
The forward premium, known as contango, actually represents 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.
How is this possible?
It is possible because central banks have large reserves of gold on deposit which they are willing to lend to gold trading banks to fund hedging transactions. They lend the gold at an interest rate that is substantially lower than that earned on U.S. dollar deposits. The gold trading banks sell this borrowed gold at today's spot price at the direction of Barrick and put the proceeds on deposit to earn interest.
Here is how a contract works:
To earn the higher future price under the forward contract, gold is borrowed from central banks through one of Barrick's gold trading banks and sold at the prevailing market price. These proceeds are placed on deposit to earn interest. The interest (or contango) that Barrick receives on its contract in the future is the difference between the interest earned on the proceeds and the interest paid on the borrowed gold. The interest paid to borrow the gold is normally 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 trading bank to repay the central bank, and receives the net proceeds (the original spot price plus accumulated compound interest earned minus the interest paid to borrow the gold). It is just like putting money in the bank to earn interest -- after one year it is worth more and continues to increase the longer the money is on deposit.
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 ultimate 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. 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 5.5% in each of the next three years, resulting in a forward price in 2000 of $400 per ounce. The $340 spot deferred contract increases in value to the $400 forward price, as shown in the following chart:
If, in 2000, the spot price of gold rises through Barrick's hedge price of $400 per ounce to $420, Barrick would take advantage of the flexibility of the spot deferred contract by selling its production at the $420 spot price and rolling the $400 contract forward for an additional year. The hedge price would rise because the interest compounds to achieve a new forward price of $422.
The following year, Barrick would deliver against the spot deferred contract at $422, if the spot price remained at $420. If the spot price was higher than $422, Barrick has the flexibility under the terms of its spot deferred contracts to continue to roll the contract forward for up to ten years and sell its production at the spot price.
What is the impact on Barrick's hedging strategy of high gold lease rates?
High gold lease rates do not have a significant impact on Barrick's hedging strategy 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.
Barrick has benefitted 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.
How could the accounting interpretations on spot deferred forward contracts affect Barrick?
The accounting interpretations 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 a decade, the accounting interpretations will have no effect on reported income.
Should the situation arise that a spot-deferred contract which has been designated for a specific period is rolled over beyond that period, accounting revenue will be recorded at the hedge price. The difference would be recorded as deferred revenue on the balance sheet. In the year of delivery of the deferred hedge contract, company revenues would be increased by the amount of the deferred revenue on the balance sheet.
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 differences.
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 just like any other unhedged producer.
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 10 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. In other words, Barrick has the option to leave the proceeds invested to earn more interest.
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.
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 reserve strength of the producer -- two areas where Barrick has a major advantage. Because of its strength, the Company can defer delivery up to 10 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.
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 10 years. However, this is unlikely. Gold has never consistently risen in price and stayed there. It is a volatile commodity.
Has Barrick benefited from the increase in the gold price?
Most definitely. Barrick has one of the the largest reserve bases in North America and only 20% of these reserves are hedged. 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 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.
Will Barrick continue hedging in a rising market?
Most definitely. 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 in excess of $400, 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 rise in value the longer they are outstanding.
How will increases in the gold price affect Barrick's share price?
The hedging program is structured to allow the Company to take advantage of rising gold prices and investors have recognized this. 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.
This demonstrates how the gold price risk is reduced and yield is enhanced. In fact, though, since Barrick started the program the actual gold price has lagged behind the contract price.
This hypothetical diagram illustrates exactly how Barrick uses its hedge position to maximize earnings:
- - the dashed line indicates a possible gold price scenario;
· · · · · the dotted line plots the rising value of our hedge position.
When the dashed line or gold price is above the dotted line, we deliver at the spot price of gold. When the dashed line 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, as illustrated by the realized price line shown solid
The right to roll contracts forward is limited only by the financial and reserve strength of the producer -- two areas where Barrick has a unique and major advantage. Barrick's financial strength and reserves enable the company to arrange trading lines to roll out these contracts up to 10 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.
With its current hedge position, Barrick's production can be fully hedged for the next three years, at a minimum average price of over $400 per ounce. If the spot price of gold exceeds the contract prices, Barrick would deliver against the higher spot price and extend its hedge coverage into the future.
It is also important to note that by taking advantage of the dollar yield curve, we are currently realizing contango rates of up to 7.5 percent per year on the longer dated positions. |
