As a thinking person and an MBA in finance, you can surely understand the obvious implications of the analysis below from Reg Howe. The key factor is that much like Enron, Barrick has created a large off balance sheet portfolio of assets that are only seen and understood by them. They apparently disclose almost nothing of how they structure the spot deffereds and how they chose to determine the "price" that they are carried on the off balance sheet books. The amazing radomness of the "schedule" of when they will come due points out that they are managing the years in which they are recorded and using computer modeling to "assume" what "value" they will have on the schedule. There is no ryhme nor pattern to the drastically changing numbers. What exactly is going on here is not clear because the shareholders do not have access to the exact wording of the contracts nor clear explanations on why the amounts and prices change so dramatically. The fact that someone like yourself is not curious about the nature of how they derive these schedules is curious in and of it self. Why are you not interested in what happened that made them make the dramatic shift from having intedendent money managers manage the assets and now have decided to leave the balances with the very banks who they have the contracts with. Maybe the only people aside from Barrick management that actually can see the full impact of the hedge portfolio are the counterparty banks and they are demanding that the cash balances be placed with them. I don't know this but it is highly suspicious in the post Enron/Arthur Anderson world that the banks are now holding the money. Don't you agree?
These contracts, as we know from careful exegesis of other portions of the text in question, do not in fact establish “selling prices;” rather, the “selling prices” are merely projections of the future values of existing cash balances using various assumptions on interest rates. Recall the description of how forward pricing works in the excerpt from the 1997 annual report: “When Barrick delivers its gold, which is used to repay the central bank, it receives the net proceeds from the sale: the original spot price, plus accumulated income earned, minus the cost to borrow the gold” [emphasis supplied]. The sale referred to is the short sale entered into to fund the forward, not the final sale on delivery. All Goldco gets when it closes out a particular spot deferred is the original short sale proceeds plus interest.
So a critical component of the “selling price” is the assumed rate of interest on the proceeds of the short sale. This explains the statement in the 2001 annual report:
Contrary to most businesses, we are adversely affected by lower interest rates rather than higher rates. In higher interest rate environments, we earn higher premiums for our spot deferred sales program because the forward price is primarily a function of US interest rates, as well as higher interest income on our cash balances [emphasis supplied].
Making such a big bet on interest rates involves risk. The cost of funds could spike up, the return on investment could go down; either swing could dramatically affect the size of the amount available on delivery. Barrick’s solution: derivatives.
The Company maintains an interest rate risk-management strategy that uses derivative instruments to mitigate significant unplanned fluctuations in earnings or cash flows that arise from volatility in interest rates.
But what about the rollover option in the spot deferreds? How does a decision to defer delivery affect pricing assumptions? What other costs are incurred in the exercise of this flexibility? Take a hypothetical example. Assume on a day when spot is $250, Goldco enters a contract to deliver 1 ounce on June 30, 2002. But when June 30 rolls around, spot is actually $400, so Goldco does the rational thing and elects to put off delivery for a year, selling its ounce instead into the spot market. Assume one year later spot has fallen to $200, so Goldco elects to deliver into the contract and book a gain. Who bears the loss of the “profit” that the bullion bank/central bank would have enjoyed if it had received its gold on the due date? It could have turned around and sold in the spot market then for $400, but now it’s stuck at $200. Can these contracts be so cleverly drawn that in every scenario, it’s heads Barrick wins, tails the banks lose? Or does each deferral trigger yet another actual or synthetic short sale by the bullion bank to lock in the profit deferred? Does this explain the phenomenal growth in J.P. Morgan’s derivatives position? If so, what is the corresponding adjustment to Hedgebook’s accounts? Or does each deferral just trigger some sort of payment or obligation which need not be disclosed, as it takes place beyond the cyber-membrane?
Grid and Bare It. That spot deferred “prices” are mere projections, changed as circumstances warrant, is demonstrated by the futility of attempting to track them across reporting periods. The following tables show the “selling prices” for gold under spot deferred contracts as presented in Barrick’s annual reports for the last three years and the first quarter of 2002:
2002, First Quarter:
Scheduled delivery 2002 2003 2004 2005 2006+ Total
Ounces (thousands) 2,100 2,600 2,800 1,500 9,000 18,000
Avg. price ($/oz/) 365 340 340 335 342 344
2001:
Scheduled delivery 2002 2003 2004 2005 2006+ Total
Ounces (thousands) 2,800 2,600 2,800 1,400 8,600 18,200
Avg. price ($/oz.) 365 340 340 340 344 $345
2000:
Scheduled delivery 2001 2002 2003 2004 2005 2006 2007+ Total
Ounces (thousands) 3,800 3,800 2,100 1,600 700 600 2,300 14,900
Avg. price ($/oz.) 340 340 362 364 355 357 360 350
1999:
Scheduled delivery 2000 2001 2002 2003 2004 2005 2006+ Total
Ounces (thousands) 3,700 3,700 1,800 900 900 500 2,100 13,600
Avg. price ($/oz.) 360 360 360 360 360 361 366 361
Try tracking the scheduled amount for delivery in 2002, just for fun (shown in bold in the tables). It starts out life in our series back in 1999 at 1,800,000 ounces, sporting an average price of $360. In 2000, the very next year, some committee or other apparently decided that it would be better for reporting purposes to beef it up to a whopping 3,800,000 ounces, but felt the need to chop the “price” by $20, taking it down to $340. Cooler heads prevailed in 2001, however, and the amount was reduced to 2,800,000 ounces, but what’s this -- the “price” was increased to $365, higher even than 1999’s version. One quarter later, at least the “price” stays the same, but the amount mysteriously declines to 2,100,000 ounces.
Notice a pattern here? Neither do we. These tables breathe new life into the tired term “random.” While we’re on the subject, we wonder precisely what an investor is supposed to make of this information. Whence are the “schedules” derived? Why are they changed so often? Of what utility is a “schedule” which varies as to amount and price so radically period over period?
Is this price derivation and schedule disparity thing a big deal? We don’t know, but the false rigor bothers us.
2. Why are they so much better than the prices everybody else gets?
It is also troubling that no other hedger comes close to matching these results. Fifty, eighty, hundred dollar premiums over spot, year after year? How do you get that at a passbook savings rate, even allowing for the magic of compounding?
Granted, Barrick has an A rated balance sheet, unique in the industry. But is that enough to explain such a huge difference? The financial markets are ferociously competitive, and a great idea has a proprietary shelf life of about a minute. How is it possible that over a 14-year period, swarms of aggressive young investment bankers have not taken this concept and applied it to everyone in the phone book, thereby causing a convergence of results?
Once again, the answer may be found in a synthesis of disparate portions of the annual reports. The MD&A section of the 2001 annual report informs us that Barrick gooses returns in three ways: First, it has until recently (see Holding the Maginot Line, below) put a slug of Hedgebook under the management of gunslingers, we mean, fund managers.
To improve returns, we have diversified [Hedgebook] by investing approximately $1 billion or 17 per cent of the overall Program into an off-balance sheet fixed-income portfolio of corporate securities with a number of top fund managers, with changes in fair value being reflected in the income statement and on the balance sheet.
Second, it takes directional risk on funding rates:
We have locked in gold borrowing costs on approximately two-thirds of the overall Program while maintaining floating lease rates on the balance to maximize the forward premium earned.
Finally, it adds apple juice to orange juice, tossing in premium from the sale of other derivatives:
Third, we sell gold call options to generate additional revenue. The calls are written at prices at which we would be comfortable adding to our forward sales program if we are exercised. We have the ability to convert the call options exercised, at our discretion, including related premium income, into spot deferred contracts, which accrue contango (US$ Interest Rate - Gold Lease Rate) the new delivery date. The call options and the premiums from expired options are recorded on the balance sheet and the fair value adjusted through earnings.
So is this the answer? They take the bread & butter Hedgebook projections, add in the juice from various derivatives, extend or shorten the schedule as needed, divide by some number of ounces which they have sold under this rubric or intend to sell or might sell or could sell unless conditions change, and presto! A super high price-per-ounce calculation, and sure-fire $X-greater-than-spot bragging rights for the annual report. But when the numerator is such a hodgepodge of unlike income categories, and the denominator appears to be a moving target, of what value is the information? What are we to make of this?
We don’t know, we don’t get it, and it bothers us that we have to work so hard to try to figure it out.
The Dance of the Ashanti
Goldbugs are paranoid by nature, and we get especially cranky when we’re in the dark on the kinds of basic questions posed above. Our anxieties, as they relate to the prospect of ending up somehow with Barrick paper in a bid for Gold Fields, center on one hellish scenario: a collapse like that of Ashanti Goldfields Ltd. (NYSE:ASL) in the wake of the Washington Agreement in September 1999.
Confession time: we were long Ashanti. Not by much, but still, we’ll never forget the awful sight of hedgebooks blowing up, and the acrid smell of burnt toast wafting out of our portfolio. All because the price of gold rose. (And they wonder why we’re paranoid.)
Now, there are a number of obvious differences between the hapless Ashanti and the swashbuckling Barrick. To begin with, Barrick is not the typical prey of the derivatives sharks described in Frank Partnoy’s FIASCO. Randall Oliphant is a financial maven, not a miner, and Hedgebook is a financial business, not a mine; if anything, it would seem Barrick consistently eats the bankers’ lunch.
Add to this the important differences in the reported terms of the forward contracts themselves. Ashanti’s book, we learned after the fact, consisted of an assortment of amusing little delicacies cooked up by those merry chefs at Goldman Sachs. See, e.g., L. Barber & G. O'Connor, “How Goldman Sachs Helped Ruin and then Dismember Ashanti Gold,” Financial Times (London), Dec. 2, 1999, reprinted at groups.yahoo.com. It featured treats like Margin Call Marengo and Death by Chocolate Delivery Requirements.
Not so our spot deferreds, according to Company pronouncements. Barrick’s SVP and CFO, Jamie Sokalsky, put it thus in a letter to the editor published in the November 23, 2001, edition of Canada’s The Globe and Mail:
Critics cite a few high-profile cases of companies running into trouble with their hedging programs when the gold price rose. Barrick’s program is different in kind and quality. For one thing, we have no margin calls to worry about. But the most important difference is that if the gold price rises, Barrick has the unique flexibility to defer its contracts for up to 15 years.
To give an example, if the price of gold shot up to nearly $600 tomorrow and stayed there for 15 years, we would realize every cent of that increase.
Now that’s a striking assertion. Let’s think about its implications for a moment. According to the 2001 annual report, Goldco has proven & probable reserves of about 82 million ounces, and produces at the rate of about 6 million ounces per year. If, in Mr. Sokalsky’s hypothetical, Barrick were to sell all its output in the spot market for all 15 years rather than close out the accounts, at the end of that period it would be out of gold in the ground but the obligation to deliver under those spot deferreds would remain. So unless Barrick succeeded in adding another 80 million ounces of reserves over that 15 year period (how much do new reserves cost in a $600 gold environment, we wonder, and just how plentiful are they?), Mr. Sokalsky’s counterparties would be left holding a rather large empty bag. Now they may not be as smart as the Barrick guys, but it strains credulity that they would just stand by and watch their position disappear altogether. Assuming a normal commercial relationship, at some point they will turn the screws, contract niceties or no. |
