Sunday, November 23, 2003, 2:57:00 AM EST
A Review of Last Week’s Gold Market
Author: Jim Sinclair
Friday was an extremely important day for gold that is worth reviewing.
As promised, I made some inquiries concerning the day’s action which was driven by a number of extraneous factors including Barrick’s complete reversal of its longstanding hedging policy.
I spoke to people on both sides of the hedging issue and was received with respect almost without exception.
Here is what we know:
1/ Mr. Munk, the Chairman of Barrick Gold, did a 180 degree reversal on hedging within a 48 hour period, telling a Reuters’ reporter that 'the commitment to hedging is gone.” He said the company had no plans to hedge over the next ten years, claiming the practice no longer created value.
2/ Since the very public lynching of Barrick’s former President, Randall Oliphant - whom they unceremoniously announced as being “fired -” Munk appears to have assumed much of his former influence within the company.
3/ Also worth noting is the fact that Mr. Oliphant served his boss loyally in financial and accounting positions and along with Mr. Munk brought gold hedging to the forefront of the gold industry.
4/ Barrick made $2 billion on its hedging positions in the bear market.
5/ When the $2 Billion was made, accounting and tax regulations allowed company’s with such profits to defer taxes payable.
6/ Barrick’s recent Annual Statement shows an account named “Future Income Taxes” as a long term liability in the amount of $488,000,000.00 which could be 25% of the profits developed in short gold spreads also called derivative hedges.
7/ Current Assets made up of Cash, Near Cash items, Accounts Receivable and Inventories are shown as $1,329,000,000.00
8/ The seriousness of these future income taxes would usually move outside Directors to demand some action if cash dropped below that level. One would assume that prudent management in Barrick would for conservative reasons consider future income taxes as a deduction from Current Assets for planning purposes.
9/ Rounded off, Current Assets of $1,330,000,000.00 less Future Income Taxes of $490,000,000.00 leaves for planning purposes a cash position of $840,000,000.00.
10/ Mr. Munk is not out of the loop when it comes to management and in fact I believe he is the management.
First Conclusion:
Therefore, I have to conclude that something happened abruptly that caused such a two day, 180 degree reversal of Mr. Munk’s well known and often stated outlook on hedging as being desirable.
What do we know concerning over-the-counter derivative hedging and derivatives themselves?:
They are unregulated.
They are non-transparent
They are not listed on any organized exchange.
They have no standards.
They are valued by computer modeling.
They are created by computer modeling.
They are not clearinghouse funded.
The financial integrity of an OTC derivative depends entirely on the balance sheet of the loser.
But the most important thing to know about derivatives is the fact there is no such thing as a short sale of a commodity free of margin requirements even if set in a non transparent, specific performance contract. Margin may be met by imbedded characteristics in a special performance arrangement called a derivative hedge by a pre-set loan line by a combination of Calls or by other exotic third or four derivatives. Regardless of how you color it, all commodities dealt in the future have margin requirements - period.
We know that Goldman Sachs and Barrick have had business relationships but we do not know for certain whom Goldman Sachs was acting for on Friday.
Second Conclusion:
It is reasonable to conclude that since derivatives have no clearinghouse funding to guarantee their performance, that an intelligent requirement for such a contract would be the condition of the balance sheet of the obligated party – in this case Barrick’s. Such a condition could be the ratio of debt to current assets.
When and why were most derivatives entered into? It became quite popular from 1990 to 2001 to seek non-recourse financing because the price of gold was declining, adding risk to new projects. In order to obtain non-recourse financing, lending institutions demanded that the project owners also sold their gold production short equal to the funds required to pay off the loan after production expenses.
That usually involved selling at least ten years of production short. The loan packages generally had the derivative imbedded in the loan agreement. It was usually a subsidiary of an international investment bank such as J. Aron & Company in London for Goldman Sachs that provided the short gold derivative when a loan was granted.
So the real price at which the derivative was originally set was in most cases at the financing of the new project. For the Bulyanhulu Mine in Tanzania, I would assume the loan and derivative would have been set sometime from January of 1999 to sometime in 2000. The sale price now is a product of the interest earned by a short seller on deferred delivery contracts in the contango arrangement. For those of you that just got lost, gold sellers are paid interest and gold buyers pay interest in deferred sales.
Now let’s look at the strange market action of gold on Friday.When you review the three minute chart of gold posted here, you will note that the rise in gold from the time of the announcement of Mr. Munk’s reversal of his previously stated position on hedging until the high was reached was one hour and six minutes. It was slow and orderly in form.
The time required when Goldman entered the market as a seller hitting every bid in sight at consecutive sales to lower levels took but 15 minutes. It was clearly not orderly.
A review of the US dollar chart with which gold has been trading in a virtually lock-step relation did nothing that would validate a violent line of selling at consecutively lower levels.
Third Conclusion:
The selling by Goldman or by Goldman’s client was intended to prevent gold from moving above $400.
What do we know about Barrick’s hedge position? Although positions can change from day to day, we can consider Barrick’s hedge position to be in the area of 16,000,000 ounces sold in one form or another.
That would mean that for every one dollar that gold moves up, the hedge on the short side would cost the hedge account $16,000,000 dollars. Every ten dollars that gold appreciates would cost the hedge book $160,000,000. Every fifty dollars that gold moves higher would cost the hedge book $800,000,000.00
Yes, technically in-situ (in the ground) reserves can rise in value even more than that but these reserves are of little use if a short term cash need arises.
What I told Mr. Oliphant when I visited him when gold was trading under $300.
First, Mr. Oliphant asked whether I had said that “major gold producers are juniors that got lucky” and if Barrick fit that model. My answer was “yes,” but I qualified it by saying “when you got lucky you also got smart and hired the people needed to make the transition from a junior trading at $0.25 to the major you are today.” That was Mr. Munk’s second significant contribution to his shareholders.
Having seen my advertising in the Mining Journal regarding my negative feelings about hedging, he then asked me what I thought about their hedging program. My answer was that at $305 Barrick had a problem and at $354.50 he had a problem. I am sorry to say that I may have been correct.
Why did I pick the price of $354.50? Well, if you have been listening to me for the last five years you will recall that my calculation of all the hedges put on in the industry by the time they were announced, adding the contango and future price over cash, indicated a breakeven of all these hedges would take place at $354.50 gold. They would have all turned negative and should have triggered risk control programs at $305 and gone under water at $354.50. It appears that dealers may have adhered to risk control program but not the producers.
Fourth Conclusion:
We can’t be sure but from a speculative standpoint if the average of the industry was Barrick’s average on its 16,000,000 ounces short at $354.50, then at $404.50 Barrick would have a debit somewhere for $800,000,000.00 with a cash position of around $840,000,000.00, considering a future Income Tax Liability. That situation in today’s world would require outside Directors to demand a change of course.
Now please be assured that I haven’t any idea whether this has occurred. However, the numbers do suggest that the derivatives are accruing some cost.
It is also logical to assume that if you can make $2,000,000,000.00 short gold in a bear market you can lose $2,000,000,000.00 short gold in a bull market. There is no free lunch in trading.
There is however one thing we do know from Mr. Munk’s statement. He has just predicted a generational bull market in gold. I wonder where he heard that. In stating his plans not to hedge for a decade, he has said that gold is going up over the next ten years.
So what can we conclude with certainty? Someone out there is terrified that gold will move above $400. This person or entity is by circumstantial evidence a client of Goldman Sachs or Goldman Sachs itself. That in all probability has to do with a trigger point in a derivative of an imbedded requirement that is financial and will be hard to meet.
My answer to Mr. Cramer
I read this weekend a missive written by a Mr. Cramer (I thought he was on Seinfeld) who recommended selling gold short because he claimed to make a living following people and companies that are always wrong.
Well, Mr. Cramer apparently doesn’t know that Barrick made $2,000,000,000 short spreading gold in the bear market. So let’s give credit where credit is due. Anyone that can make $2,000,000,000 in a bear market is damn smart - period.
Even if Barrick has a loss now, it is certainly nothing like what they made and apparently they are doing something about it.
That is an act of sanity - not the act of a fool.
Friday, November 21, 2003, 6:02:00 PM EST
Gold Market Summary
Author: Jim Sinclair
Something is Very Wrong with the Market
The effort to keep gold from going through $400 is clear and determined. No one with market experience - knowing that plus $400 gold has no more technical relevance than that of passing a round number - can accept that the supply and the way it is being handled has anything to do with normal market behavior.
I suspect that it may affect some extremely large contractual agreements written in some relationship to the price of gold as well as the option expiration this Monday.
We all know who played the market lower as it approached $400 today because they surfaced as COT on the floor of the Comex to sell their wares. It is the old crowd of normal sellers who I call the Gold Cartel of Common Interest. Yet the degree of their exasperation speaks to me not only of the expiring option but something else that remains to be defined.
I also find most confusing that Mr. Munk, Chairman emeritus and the God Father and power behind Barrick addressed a seminar in London just two days ago extolling the virtues of hedging yet surprisingly today announced 'Forthwith Barrick will no longer hedge.'
I can only conclude that there are entities in this marketplace that are completely terrified of the implications of a close at $401 for reasons we can only speculate. But their efforts to create a price and not move volume speaks of other reasons we do not know.
I am going to call in a few markers this evening so I can report to you on this unknown. There is one thing I know for certain and that is that gold is going over $400 soon (where it will stay) and that event could be Sunday night in Asia.
Significant people so deeply fear the other side of $400 that they would throw their own Mothers into the market inferno to stop it. However, do not fall for the bluff that it is government selling. It is not. This seller is a commercial entity which may be in deep financial trouble on the north side of $400.
Charts and definitive market analysis will follow after I take my wife out to dinner. If I fail at that, I will be in deeper trouble than a gold hedger - if such a thing is possible.
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