From the Calandra column you noted:
Derivatives may be the real bomb
Questions asked about Barrick Gold's 'mark to market'
John C. Doody, editor of the numbers-crunching Gold Stock Analyst newsletter, figures Barrick Gold (ABX)
in its latest reported quarter saw the mark-to-market value of its so-called hedge book drop to a negative
$121 million as of March 31 from a positive $380 million on June 30, 2001.
Barrick, one of the world's largest bullion miners, uses
written "call" option contracts and other derivative
devices and gold lending practices to enhance the price it
gets for its ounces of gold. The so-called hedging in the
"spot-deferred market" works well when gold is flat or
down in price, not so well when gold prices are rising, as
they are now.
Doody at Gold Stock Analyst puts the negative swing of
the company's hedge book at $507 million. "This swing
far offsets the net profits earned of $46 mil in the first
quarter of 2002 plus the $66 million in the third quarter
of 2001 plus the $82 million in the fourth quarter of
2001. The net is a loss of $313 million."
In a conference call last week, Barrick's executives assured questioning Wall Street analysts, who asked
numerous questions about the company's gold-hedging, they were monitoring the situation. Yet some
observers are not convinced.
"The sensitivity of the derivative portfolio now stands at about $21 an ounce," says Douglas Pollitt at
Pollitt & Co. in Toronto. "Each $1 an ounce upward move in the gold price sees the mark-to-market (of
Barrick's derivative contracts) drop by about $21 million. At $350 an ounce, the mark-to-market would be
over $1 billion in the
red." Gold prices this year have risen to $312 an ounce
from $270 at the start of January. (See more.)
Pollitt calculates the notional value of Barrick's
spot-deferred contracts at 18 million ounces. "Add to this
another 5 million in written call options, (which the
company now calls 'variable priced sales contracts'), and,
one way or another, the company is short about 23
million ounces of gold. This is a fantastic number and begs
the question: Could Barrick cover even if they wanted
to?"
CBS MarketWatch placed a call to Barrick's Toronto
headquarters on Monday regarding the company's exposure to the hedged market and was awaiting a
response.
The writer of a call option is giving the purchaser of that contract the right to buy something, in this case
gold, at a strike price written in the contract. In exchange, the writer of the option receives a little money, a
premium. The strategy for selling a call option is usually to enhance the value of a security or a commodity
when the investment is declining in price, something that had been happening to gold for years, until
January.
Barrick, to its credit, said in its report to investors that it will reduce exposure to hedging this year. The
Toronto company, world's second largest gold producer after Newmont Mining (NEM), says it earned $46
million for the March quarter, down from $87 million in the year-ago three-month period.
Barrick, according to its quarterly report, sold half its gold in the spot-deferred market for $365 an ounce.
The fact that it sold the other half in the spot market was a first for the company. Barrick stated it expects
half its gold for the remainder of the year to be sold in the spot market, where an ounce of gold is attached
to no derivatives and gets exactly what the spot market is dictating for bullion.
Barrick also estimates that for every $25 increase in the gold price, the company's annual earnings and cash
flow rise by approximately $70 million. "In total, 22 percent of reserves, or 18 million ounces, are sold
forward using spot-deferred contracts at an average minimum price of $344 per ounce, deliverable at the
company's option over the next 15 years," the company stated to investors. "This position is down from
18.2 million ounces in the last quarter of 2001 at an average price of $365 an ounce."
Of course, if gold prices were to shoot far higher, in rapid
fashion, Barrick, as a writer of call options, could find
itself required to deliver gold to buyers at prices that are
below the spot price of gold. Other distortions of the gold
market are possible in a gold rally.
Pollitt, the Toronto analyst, says theory and reality are
like night and day. "Converting dollars into gold is quite
different than converting gold into dollars," he said
Monday morning. "When the dreaded yellow metal was in
the doldrums and nobody cared, well, Barrick might have
had a way out. But now? Now you've got good company
on the bid, now you've got all those dollars chasing what
little gold is left. And any whiff that Barrick had stepped into the ring looking for 23 million ounces would
set the market ablaze."
Large gold producer Anglogold (AU) in South Africa this year said it would continue to reduce its reliance on
the forward-sale, or hedging, of its gold production. Non-hedged gold miners, led by Gold Fields (GOLD) of
South Africa, have seen their stocks outpace the gains of hedgers Barrick and Anglogold by wide margins this
year. Gold Fields, its shares poised to shift to the New York Stock Exchange on Thursday, is up almost 175
percent this year vs. a 30 percent stock price gain for Barrick and 60 percent for Anglogold.
The use of derivatives in many different forms has supporters, lukewarm and otherwise. Federal Reserve
Chairman Alan Greenspan in February testimony said derivatives have "contributed to the development of a
far more flexible and efficient financial system."
Greenspan was not referring to any particular industry, like waste management. Those sewers are best left to
derivative accountants, Buffett and Munger would say |
