By Adrian Day
Adrian Day's Global Analyst
Box 6644, Annapolis MD 21401
November 18, 1999
Following the recent rally in the gold price and the
difficulties some companies are experiencing because of
their hedging, some of you have asked about the
practice of hedging. In this note, I'd like to address
that topic.
Hedging for gold producers, as for the producer or
indeed consumer of any commodity, can range from
prudent to aggressive, event reckless. There are
different forms of hedging and different objectives,
too. These are not always clear-cut distinctions, but
rather points along a continuum.
Hedging can have many goals.
Hedging can be defensive -- to ensure survival, for
example, in the case of high-cost producers -- or it
can be offensive -- to generate a premium, for example,
or even to speculate on the future price of gold. We
have seen a good deal of additional hedging by gold
companies as the price fell in recent months. Two
influences were at work. On the one hand, more and more
companies saw the need to protect their falling
profits, while the longer the price decline went on,
the more "riskless" hedging appeared.
Hedging in different forms can protect downside;
enhance the upside; limit the upside; or even put the
company at risk. The main forms of hedging are the
following.
The main types of hedges:
1. Forward sales. This is when a company sells its
future production today, for a price based on the
prevailing price plus a forward premium, which varies.
Some contracts have a lease rate, the cost of borrowing
the gold, which can be a fixed or a floating rate.
Forward sales can be effected for any of the main
objectives above and, depending on how they are
structured, can enhance or limit upside.
2. Spot deferred. Some forward sales can be converted,
at the company's option, into a spot sale, if the spot
price is higher. Typically, such sales can be deferred
for a period of time. The company would have to pay a
lease rate until the gold was delivered into the
contract.
3. Purchase of puts. A put gives the owner the right to
sell the gold to the counter party at a specified price
and time. If a company buys a put with an exercise
price of, say, $280, the company can sell its gold at
$280 regardless of how low the price goes. A put
purchase costs money, but it protects the downside,
without limiting the upside. Many companies started
buying puts as the price of gold fell and approached
their break-even levels. It's like the cost of
insurance.
4. Sale of calls. When a company sells a call, it is
committing to sell future production at a specified
price and date in the future. It has the obligation to
sell at that price, if the counter party demands, but
not the right to sell. In return it receives a premium.
If a company sells, for example, a December 2001 call
at $360, it must sell its gold at $360 at that time,
however high the spot price might be. Many companies
that purchased puts -- a defensive move -- chose to pay
for them with the premiums received from the sale of
calls -- a speculative move. In many ways, selling
calls can be the most reckless of all hedging
practices, since it limits the upside while doing
nothing to protect the downside, with only a modest
benefit.
5. Purchase of calls. Some companies that have
otherwise hedged some output, may buy some calls --
which give the owner the right to buy gold at a
predetermined price regardless of the prevailing price
in order to allow participation in a much higher
market. For example, a company might sell forward some
production at, say, $360, and purchase offsetting calls
at $440. Thus, the company has a floor of $360 on its
sale, however low the prevailing price might be at the
time of delivery, and it gains any upside over $440,
but if the price is between $360 and $440, then it
sells for $360 and loses some upside.
One should note another important aspect of hedging.
Most is done using over-the-counter contracts, which
has two important considerations. First, even two
similar contracts may have different terms and
conditions, and costs. And secondly, one is relying on
the counter party to meet its obligations. A contract
to sell one's gold at, say, $420 in December 2001 is
only valuable if that other party to the contract is
able to buy the gold at that time.
If you don't understand, you shouldn't invest.
So it sounds rather complex and there are many factors
to be considered in assessing the aggressiveness of a
particular hedge program. However, it's worth noting
the words of the CEO of one large gold company with
whom I was discussing hedging. I had peppered him with
technical questions and mentioned that the subject was
very complex and not easy to understand. "Not at all,
Adrian. You obviously do understand. I would say that
if you are not clear about a company's program, then
there is probably something risky about that company's
program."
In many ways, I think that is a good summary. The more
complex the strategies, the more can go wrong.
Who's hedged and who isn't:
Below I've categorized the major mining companies in
the world as well as some juniors. Please note two
things: Company hedge programs can change, so nothing
here is set in stone. In June, for example, I would
have called Newmont "unhedged" and Gold Fields'
"lightly hedged." In recent months, Newmont peculiarly
decided to start hedging right at the bottom, while
Gold Fields, as gold started to rally, closed out
essentially all of its hedge book in order to
participate fully in the gold rise. And note that while
one wants one's gold stocks to provide exposure to any
rise in gold, a company with a heavy hedge book is not
necessarily at risk or even a poor investment.
ESSENTIALLY UNHEDGED: Franco-Nevada, Freeport Copper &
Gold, Gold Fields, Harmony, Battle Mountain, Goldcorp,
Agnico-Eagle.
LIGHTLY HEDGED: Newmont, Homestake, Meridian, Teck
Corp., Kinross, TVX, Durban Deep.
HEAVY HEDGE BOOK: Barrick Gold, AngloGold, Normandy,
Placer Dome, Cambior, Ashanti, Viceroy, Echo Bay,
Eldorado, Bema.
One would have to go into a lot of detail about each
company's specific hedge book -- some of which are
relatively static and others (for example, Barrick) are
very dynamic -- to judge the extent to which the upside
is limited or the company is at risk. A company, for
example, could be "heavily hedged" with, say, 60
percent of its production for the next three years sold
forward at $440, but another company could be "lightly
hedged" with 35 percent of its production for the next
three years sold forward at $280!
To a large extent, the companies listed under
"essentially unhedged" and "lightly hedged" are giving
up little upside, if any, and have essentially no
margin or other risk to viability. Of the "heavily
hedged" companies, Barrick, Anglo, and Normandy in
particular have comfortable hedge books with virtually
no risk, if any.
Of course hedging is only one of the factors to
consider in judging which companies are the best to
own. Below, I list the largest 10 gold mining companies
in the world, ranked by next year's anticipated
production (together with special case, Franco-Nevada).
My buy and sell comments are not intended as current
advice on the stocks based on current prices. Rather,
it a longer-term comment on the company: the companies
marked "strong buy" and "buy" are the companies you
want to own if you believe we are going to experience a
relatively strong gold market in the next year or two.
Top Ten Gold miners in world, based on 1999/2000
production:
Anglogold, 6,772. HOLD. Solid operations, balance
sheet, yield.
Gold Fields, 4,175. STRONG BUY. Aggressive, growing,
virtually unhedged, leverage.
Newmont, 4,098. STRONG BUY. Strong operations,
nearly unhedged, leverage.
Barrick Gold, 3,857. BUY. Strong operations, growth,
top balance sheet; less leverage
Placer Dome, 3,021. HOLD. Acquisition problems not
over; balance sheet OK.
Homestake, 2,370. SELL. Why hold Homestake? There
are better companies.
Freeport Copper, 1,983. STRONG BUY. Cheapest of
seniors, unhedged; Indonesia risk.
Normandy Mining, 1,937. STRONG BUY. Entrepreneurial
management; growth; hedges OK.
Ashanti, 1,662. SELL. Too much unknown in hedge book.
Harmony. 1,256. STRONG BUY. Unhedged, growth,
aggressive; high leverage.
Franco-Nevada. BEST BUY. Quality, balance sheet, strong
growth; unhedged. Franco's production is 250,000
ounces, but its royalty interests make it a much larger
company. Using market capitalization as a measure, it
is the fifth largest gold mining company in the world.
-END-
egroups.com |
