What risks are there to Barrick’s hedging program if the gold price rises substantially?
Since Barrick has the flexibility to deliver gold under its hedging agreements on any date during the term of its agreements up until the Termination Date, we can achieve the higher of spot prices or hedge prices well into the future. The long lines allow current contracts to increase to $500 to $600 over the existing terms of the contracts assuming historically typical long-term contango rates of 4%. Over the past 30 years, the average annual price of gold has never exceeded $600/oz.
Eventually, if we continually defer delivery under our hedge contracts to sell production at higher spot prices in a consistently rising price environment - and in the unlikely event that we did not add new reserves - we could reach a point in the future when we would have to deliver the final few years of gold production against our contracts instead of into the spot market. If this were to occur, and assuming normal market conditions, Barrick would deliver its last few years of gold production, years in the future, at gold prices that, while possibly below then current spot prices, would be above our cost of production (thereby still generating significant cash flow and profits). Up to that point in the future, we would have generated significantly higher earnings and cash flow by selling all our production at the higher spot price.
In our judgement, this outcome is far more attractive than the immediate downside cash flow risk an un-hedged producer faces if the gold price were to weaken and drop back down to, say, $250/oz.
What kind of financial covenants are in your gold hedging contracts?
Like virtually all financial contracts, our hedging arrangements require us to comply with certain financial covenants. These covenants include:
(a) maintaining a minimum consolidated net worth of up to $2.0 billion (our consolidated net worth as at June 30, 2002 was over $3.3 billion); and
(b) maintaining a maximum long term debt to consolidated net worth ratio below 1.5:1 (the ratio as at June 30, 2002 was under 0.25:1).
Where and how often does Barrick disclose the mark-to-market value, or fair value, of its gold hedge program?
Barrick discloses in its quarterly and annual financial statements the mark-to-market value of its gold hedge position. As at June 30, 2002, for example, the fair value of our total gold sales position was negative $261 million.
As discussed in the notes to Barrick's financial statements, applicable accounting rules do not require changes in the mark-to-market value of Barrick's gold forward sales positions to be recorded on Barrick's income statement or balance sheet. Barrick does, however, make use of other derivative instruments (including interest rate and foreign exchange hedges) where mark-to-market changes do impact the financial statements.
What is the significance of mark-to-market gains and losses in the value of the hedge position?
Mark-to-market gains and losses represent unrealized changes in the fair value of existing contracts. For example, if we had a contract to sell gold at $365 an ounce and the spot price of gold was $400 an ounce, then the mark-to-market value of the contract is approximately negative $35 per ounce. This is a purely "paper loss" rather than a cash flow loss. The mark-to-market value of negative $35 per ounce has absolutely no impact on the contract, which remains intact at $365 per ounce.
The fact remains that Barrick would realize a profit by selling its gold at the $365 contract price, since our cost of production is below $200 an ounce. After all, these are sales contracts under which Barrick physically delivers the gold production, as opposed to speculative financial trading. The mark-to-market value of our hedging program has no impact on our: 1) earnings and cash flow or 2) debt covenants.
Unlike the situation facing a few gold producers some years ago, Barrick's trading agreements contain no requirements to post margin to collateralize any negative mark-to-market value of its hedge position.
What types of events could entitle Barrick's counterparties to require early close out of its hedge positions?
Immediate Close Out
Our master trading agreements permit counterparties to require Barrick to immediately close out all transactions upon the occurrence of customary events of default by Barrick (insolvency, breaches of covenants, material defaults under credit facilities, etc.).
Close Out at Next Price Reset Date
Our master trading agreements also provide for early close out of certain transactions in the event of a material negative change in Barrick's ability to produce gold for delivery under our hedging agreements or lack of a gold market. A close out in these circumstances can only be required on the next price reset date of an outstanding contract.
For example, if we have a 10-year master trading agreement, and a forward sale contract under the agreement has a price determined for delivery in 2007, then the counterparty may require we deliver gold in 2007 under that contract, but again, only if there has been a material negative change in Barrick's ability to produce gold, and only on the price reset date (2007 in this example). In other words, the effect of such a material change would be to provide counterparties with the ability to limit Barrick's flexibility to choose the date for delivering gold under its contracts beyond the current fixed price date.
A significant increase in the price of gold would not constitute a material negative change entitling a counterparty to restrict our flexibility to determine delivery dates. In fact, a rising gold price enhances Barrick’s ability to produce gold and satisfy its contracts. A rise in the gold price directly also increases our profitability since Barrick's unhedged production can be sold at the higher spot price. A sustained gold price rise would also increase our production base as uneconomic resources at low gold prices become economic reserves at higher prices.
A material, permanent, and unforeseen decline in production such that Barrick is unable to produce enough gold from our reserves to deliver against all hedge contracts could result in the possibility of early termination of contracts as they reach repricing dates. Management views the likelihood of such an event as remote. Furthermore, Barrick manages this risk by spreading out repricing dates over many years to ensure there is sufficient production available to deliver gold on price reset dates. This risk is further mitigated by the fact that Barrick produces gold from a portfolio of mines around the world.
What would happen to your gold hedges in the event of a substantial reduction in the amount of gold available to be borrowed by your counterparties from central banks?
Barrick does not borrow gold from anyone. We have no gold loans, and our spot deferred contracts do not involve the borrowing of gold by Barrick. Our spot deferred contracts are simply contracts to sell gold at some point in the future. Our counterparties may borrow gold to mitigate their exposures on these contracts, but this borrowed gold is their own obligation and in no way can this obligation be passed on to Barrick. Also, please refer to the discussion below regarding disruptions in international gold markets.
Are there risks for Barrick associated with gold lease rates or the cost of borrowing gold?
While it is the bullion bank that borrows gold rather than Barrick, the bullion banks do charge gold lease costs (part of contango) on our forward sales, and these gold lease costs are related to what the bullion banks themselves pay to borrow gold. Put another way, Barrick does not borrow gold, but may pay lease costs in line with what it costs the bullion banks to borrow gold.
Spike in Lease Rates
Importantly, Barrick's hedging contracts provide for fixed gold lease rates over specified periods of time during which gold liquidity and pricing risk is borne by the counterparties and not by Barrick. For example, if we fix a gold lease rate for three years, then Barrick is not exposed to either gold liquidity or fluctuating gold lease costs under that contract for the full three years.
A short-term sudden spike in gold lease rates would not have a material impact on Barrick because we do not have significant short-term gold lease rate exposure. However, not all of our gold sales have the gold lease costs fixed to the final expected delivery date. For these contracts, an increase in gold borrowing costs will result in reduced contangos (US$ interest rates less gold lease rates) and therefore a smaller forward premium (assuming normal market conditions). However, because of the large amount of Central Bank gold available to be lent (relative to demand), gold lending rates tend to be low and any spikes short-lived.
Gold Liquidity
In the unlikely event the gold leasing market becomes completely illiquid (i.e., no parties lending gold on any major exchange), and if there are no alternatives to borrow or lend gold, our counterparties are required to notify us. If their inability to access the market is continuing on the scheduled delivery date for a contract, the counterparty could require that contract to be settled on that date. In other words, the effect of such a market disruption could be to prevent Barrick from exercising its right to defer delivery to a later date.
For example, if we have a ten-year master trading agreement with the gold lease rate for a spot deferred contract entered into under the agreement fixed to year five, then Barrick cannot be affected by increasing lease rates or gold liquidity, regardless of market conditions, until year five. If, in year five, Barrick wishes to exercise its right to schedule an alternative future delivery date, but the counterparty can demonstrate that gold is unavailable anywhere in the market for purposes of establishing an offsetting hedge, then the counterparty can deny Barrick’s right to schedule an alternative future delivery date. In such a case, Barrick would be required to deliver gold at the contract price on the existing delivery date.
Management of Gold Liquidity
While Barrick believes that the likelihood of these circumstances arising is remote, it mitigates against the unlikely risk of severe and prolonged (multi-year) gold availability shortages by locking in longer-term lease rates and spreading out the scheduled delivery dates over many years so that, if necessary, we expect to have the production available to deliver gold on the scheduled dates.
In what circumstances can your counterparties require you to deposit margin?
None. Our agreements do not give our counterparties the right to request that margin be provided as collateral for our obligations, regardless of the gold price or the mark-to-market value of the hedging program.
What exposure does Barrick have in the event of a bankruptcy of one of its bullion bank counterparties?
Barrick’s gold hedge contracts are contracts to sell gold production at a certain price in the future to a bullion bank. In the event the bullion bank is bankrupt (or for any reason is unable to purchase this gold), then Barrick will 1) sell this production into the spot market at the spot price of gold and 2) terminate the (now defaulted) sales contract with the bullion bank and seek compensation for any losses caused by the bullion bank's default. Any claim for compensation would be based on the positive difference, if any, between what Barrick would have received had the bullion bank purchased gold at the contract price and what Barrick actually received selling gold at spot
If the spot price of gold realized by Barrick is below the contract price the bullion bank had agreed to pay, then Barrick could bring a claim for this difference. If the bullion bank is insolvent, Barrick's claim would rank equally with other unsecured creditors, and there would be no assurance that the full amount of the claim would be paid.
If the spot price of gold is higher than the contract price, the bullion bank (or its trustee in bankruptcy) would likely complete the gold purchase under the contract since the transaction is in-the-money for the bullion bank.
Gold sales contracts between each Barrick entity engaged in hedging transactions and each bullion bank with which it trades are all governed by a single master trading agreement. Our master trading agreements provide that all transactions "net" together upon default. In other words, an insolvent bullion bank cannot "cherry pick" by requiring Barrick to deliver under contracts that are in-the-money for the bullion bank while forcing Barrick to make an unsecured claim in bankruptcy for contracts that are in-the-money for Barrick. Under the master trading agreements, all transactions would be combined to arrive at a net amount owing by one party to the other. Where the net amount is owing by the bullion bank, Barrick would have an unsecured claim in bankruptcy, and there would be no assurance that Barrick would be able to recover the amount owing.
Barrick does not have cash deposited with bullion banks as part of our gold hedges, nor have we in any way lent gold to any counterparty
Barrick has a credit exposure to a bullion bank only when application of a master agreement's netting provisions would result in an amount owing by the bullion bank upon its default under the agreement. Such exposure would only occur when spot prices at the time of default are lower than the contract prices the counterparty has agreed to pay. Even then, our exposure would be generally limited to the loss of profits we would have realized under the contract. If a bullion bank defaults under a master trading agreement, Barrick would still receive the spot price for production it would have delivered under its in-the-money contracts. When current spot gold prices are higher than our contracted prices, Barrick has no credit exposure to its bullion banks.
Barrick carefully manages its exposure to the creditworthiness of its counterparties. First, we contract with bullion banks whose credit ratings are generally "AA" or better. Second, we limit our exposure to any one bullion bank by spreading out our hedge contracts with over 20 different counterparties. As at June 30, 2002, for example, no bullion bank was a party to hedge contracts representing more than approximately 10% of the number of gold ounces subject to hedge contracts as of that date. Please refer to note 16 "G" of our 2001 financial statements for further information.
What is Barrick’s downside gold price scenario?
Barrick’s downside is if the price of gold declines. While we have approximately 25% of our reserves hedged, approximately 75% of our reserves remain unhedged and exposed to gold price variability.
Conversely, a rise in the gold price (which will result in a negative impact to the mark-to-market value of our hedge program) has a very positive effect on Barrick, as the value of our 75% unhedged reserves rises significantly.
In addition, a higher gold price will make more of Barrick's resources economic so that an even greater percentage of our reserves would be fully exposed to the higher price.
Can management guarantee that, in the long run, Barrick's hedging program will result in greater profits than if its production were entirely unhedged?
No. Barrick's hedging program is the product of management's current best business judgment with the objective of maximizing the return on the company's assets and also shareholder value. As described above, however, there are possible scenarios in which Barrick may be obligated to sell at a hedge price lower than the prevailing spot price. While management considers these scenarios unlikely to occur, they cannot be ruled out entirely.
Are there other risks Barrick is exposed to under its hedging program?
Please see Note 16 to our 2001 financial statements for a discussion of some additional risks and how we manage them. |
