Derivatives may be the real bomb
Barrick Gold answers queries about 'mark to market'
By Thom Calandra, CBS.MarketWatch.com
Last Update: 2:25 PM ET May 6, 2002
SAN FRANCISCO (CBS.MW) - Berkshire Hathaway's Warren Buffett is an insurance executive, so he's entitled to talk about risk from nuclear bombs.
Why shouldn't he? Palestinian supporter Sultan Abul Aynayn earlier this spring was quoted as saying, "If one hair on the head of Yasser Arafat is harmed, the U.S. had better protect its interests around the world. We are not like Osama bin Laden, but we have our own style of response." Aynayn heads Arafat's Fatah movement in Lebanon.
That's "a chilling warning," says James Dines, editor of pro-gold The Dines Letter in California. "Should the safety of all Americans depend on Ariel Sharon's decision whether or not to kill Arafat?" Sharon was in Washington on Monday, headed to the White House.
Buffett, the world's second richest person, made no reference to Middle East politics when he talked about the possibility of nuclear attacks on American soil. Buffett and his team of insurance executives, in their publicized comments this weekend, also talked about derivatives. He and his right-hand man rate derivatives somewhere below sewage. As the head of a large, multi-billion-dollar enterprise, Buffett and his partner, Charles Munger, are qualified to talk about the use of options, futures, lending, leverage and other practices known commonly as "derivatives."
Buffett figures derivatives will mess up lots of companies. Berkshire Hathaway's reinsurance unit, General Re, is registering some losses as it closes the loop on derivatives contracts. Munger was quoted this weekend, at the annual Buffett-fest, as saying, "To say derivative accounting in America is in the sewer is an insult to sewage." See Buffett article.
That would make Dell Computer (DELL: news, chart, profile), in a $1 billion-plus derivatives boo-boo, an insult to sewage. (See related story.) That would make scores of companies that take off-balance-sheet hits to earnings because of their once-fancy artificial hedges, joint ventures and extreme leverage -- an insult to sewage.
Those derivative tangles could include, in a strange twist of fate, a few hedged gold companies. The gold sector is among the North American stock market's biggest gainers this year.
John C. Doody, editor of the numbers-crunching Gold Stock Analyst newsletter, figures Barrick Gold (ABX: news, chart, profile) 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 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 million 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 top executives assured Wall Street analysts, who asked several questions about the company's gold-hedging, that they were monitoring the situation. Yet some observers are not convinced.
"The sensitivity of the derivative portfolio now stands at about $21 million 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. Barrick's chief financial officer, Jamie Sokalsky, said Monday the hedge position is "unmargined, with up to 15 year lines of credit."
Sokalsky said the perception that Barrick is afraid of a rising gold price is "nonsense." Sokalsky said more than three-quarters of the company's gold reserves, those still in the ground, are not subject to forward sales or spot-deferred sales of the metal. "We are quite delighted if the price of gold rises," he said.
In derivatives, 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.
Sokalsky acknowledged that for each dollar move in the price of gold, the company's unrealized mark to market value moves up or down by about $20 million. But he said the company's written call contracts are structured so that they roll into higher spot-deferred contracts if gold moves higher.
"It is akin to if you buy a Treasury bond, a five-year treasury bond, that bond is going to be worth more or less at any one time, but if you are planning to hold it the entire five years, the fluctuations don't matter. Given that we don't have any margining relationships, there is no problem that transpires," the chief financial officer said.
Sokalsky added that Barrick has "the total ability to turn (written) call options into spot deferred contracts. We use that as a starting point to move into a spot forward contract. We would love to get struck at these options because it would mean we were delivering at even higher prices. If we had a $350 call option, we would be starting a new spot-deferred contract at $350." The spot-deferred market uses the lending of bullion and other means to achieve forward-sales of the metal at prices that are higher than the spot market.
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: news, chart, profile), 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, some hedged sellers of gold might find themselves delivering the metal at prices below the spot price of gold. Other distortions of the gold market are possible in a sharp 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. Any whiff that Barrick had stepped into the ring looking for 23 million ounces would set the market ablaze."
Large gold producer Anglogold (AU: news, chart, profile) 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: news, chart, profile) 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."
Thom Calandra's StockWatch appears each trading day.
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