Hedge edge may spark mad scramble
Wall Street banks' gold derivatives in danger zone
By Thom Calandra, CBS.MarketWatch.com
Last Update: 10:22 AM ET June 7, 2002
SAN FRANCISCO (CBS.MW) - As gold's polar opposite, Nasdaq, gets
blasted, bullion investors expect miners' risky hedge books to further
boost the metal.
By some estimates, gold
mining companies are
hedging, or selling forward,
about 4,000 tons of gold.
Some analysts say it's far
more. As gold prices
continue to rise in the face
of a weak stock market and
a declining dollar, most of
the world's largest hedgers
are looking for ways to
reduce the hedge risk from
their books.
Earlier this week, South
Africa's AngloGold Ltd., the
second largest gold miner
as measured by production,
indicated it would continue
to slim its hedge book. The
company took 105 tons of
gold off its forward-sale
program in the six months
ended March 31.
Other highly hedged
companies, including
Canada's Barrick Gold
(ABX: news, chart, profile),
say they will keep slimming
their use of derivatives and
the bullion leasing market
to hedge gold production. In
bad times, when gold prices
were below $300, such
practices created extra
revenue for gold companies.
Hedged instruments
harvested a higher gold
price than was available in
the spot market for bullion.
Yet critics of the practice
long have pointed out how
hedging by gold miners
battered the gold price,
mostly by encouraging the
lending of central banks'
gold reserves to investment
banks, which then design
hedge programs.
Essentially, hedging of any
type is a short-sale against
the price of gold. Now that
gold is flirting with $330 an ounce in the spot market, gold's most outspoken
investors see the hedge-rush adding speed to the gold rush.
"I see $340 and $360 an ounce as the danger zone for banks, that is where
hedging and the hedge book problems start to have an impact," said Ian
McAvity, editor of Toronto newsletter Deliberations on World Markets and a
director of gold and silver closed-end fund Central Fund of Canada (CEF: news,
chart, profile). "I expect to see a $25 up day for gold one day, largely due to
someone getting skewered by their hedge book, either the bank that extended it
or the mining company."
A rapidly rising gold price is the worst enemy of
hedged miners and the banks that designed their
derivative strategies. A powerful gold rally could force
some miners, or the banks behind the hedge books,
to engage in a mad scramble to locate gold and
deliver it to the original lenders.
McAvity points to the largest investment banks,
among them JP Morgan Chase (JPM: news, chart,
profile), as facing the most risk from the continuing
gold rally. Gold's spot price is up about 20 percent since Jan. 2. Figures from
the Office of the Comptroller of the Currency show JP Morgan Chase having the
largest exposure to gold derivatives among U.S. banks and trusts, as of Dec. 31.
JP Morgan Chase held $41.04 billion of gold derivatives of all maturities as of
Dec. 31, according to the Comptroller of the Currency. The total amount of gold
derivatives for U.S. commercial banks and trusts last year was $63.3 billion.
McAvity sees the declining dollar and the move away
from Nasdaq and other expensive company shares
as positives for the gold price. The euro is zeroing in
on 95 cents vs. the dollar for the first time since
January 2001. The dollar has lost about 7 percent
against the currencies of its major trading partners
thus far this year.
"The financial asset mania of 1982 to 2000 is now
giving way to a return to tangibles, and a precious
metals trend that should run for many years," McAvity says.
The gold fund manager most outspoken about the evils of hedging, John
Hathaway, sees fiscal distress for many parties as gold prices rally. Hathaway's
Tocqueville Gold Fund has gained 81 percent since Jan. 2, holding largely
unhedged mining companies such as Gold Fields Ltd. (GFI: news, chart, profile)
and Harmony Mining (HGMCY: news, chart, profile), both from South Africa.
"There is a huge outcry against hedging among investors," says Hathaway.
"Mine company managements have received a loud message from the
investment world to cover their hedge books, and all but the most obtuse will be
doing so."
Hathaway sees gold mining companies issuing new
shares to buy physical gold that they use to
ameliorate, or cover their forward sales of bullion.
"Durban Deep (DROOY: news, chart, profile) was the
first to do it, and I believe there will be other, bigger
players," he said. Durban is a South African
company whose shares have gained 290 percent
since Jan. 2.
Hathaway estimates each $10 rise in the gold price
"means the collective bullion dealers have extended another $1.4 billion to the
gold mining industry, based on a 4,000 tonne position."
Hathaway warns, "A $50 move, which is certainly in the cards, would be $7
billion. What does this mean? It means a serious squeeze on the bullion
dealers, not the mining companies for the most part. Central bankers who have
lent the gold to JP Morgan, Morgan Stanley (MWD: news, chart, profile),
Goldman Sachs (GS: news, chart, profile) and others would not be happy with
this situation."
What can the bullion dealers do about it? "Not a whole lot, other than buying
gold to cover their short, which is what they are starting to do," says Hathaway
from his Tocqueville (TGLDX: news, chart, profile) offices in New York City.
"Most mining companies, especially the big ones, have margin-free trading
agreements with their various dealers. This means they do not have to advance
cash when the gold price rises. It is too late for the bullion dealers to go back to
the mining companies to change the deal, so they have no choice."
Hathaway sees Wall Street clean-up crews at work,
frantic in their efforts to erase the gold derivatives.
"There are all kinds of crazy, exotic deals made in
the past that will come to light -- exploding puts,
knock-in calls, etc., which had high fees originally
but are now viewed as toxic waste by the dealers
who sold them."
The fund manager points out that actual gold
supplies do not move around as freely as those who
need to cover their hedging strategies would like. "Physical gold is illiquid
relative to short covering demand. This will take gold a lot higher, unless the
central banks step in, which I expect them to do when the gold market gets
really disorderly, like gapping $10-$20 a day or more." |
