I am enclosing the entire article for your myopic analysis. I believe the article addresses possible consequences of the notional value of a derivative, particularly when the net worth provisions of an instrumental are violated.
The markets perceive barrick's risk as some observers have, however,you apparently view barrick position thru your panglosian logic.
BARRICK GOLD'S PLIGHT
By Dr. Richard S. Appel
December 04, 2003
www.financialinsights.org
For well over a decade Barrick Gold Corp. has been recognized as being either the world’s largest gold producer or a top contender for the title. To a large degree this was due to their ability to change with the times. To this end, they were the first major gold miner to hedge much of their future production as early as the late 1980's. They continued utilizing this strategy until a recent series of announcements emanated from their management. They stated that Barrick would no longer hedge their future production, and that they would eventually reduce their hedge book to zero.
A number of years ago Barrick recognized that gold was in a Bear Market. Given their belief that the price of gold would decline over time, they were faced with a painful future. If their costs remained constant or increased, and the receipts from the sale of their product was anticipated to continually fall, they would be hard pressed to maintain profitability let alone survive. In their effort to find a way to generate income in this environment, they began to hedge their future gold output. This, so that at minimum they would guarantee the price of much of their gold output, and their future stream of income.
Barrick not only pioneered the hedging concept among gold producers but also refined and benefited most from these activities. The primary hedging methods that they used were forward gold sales, gold leasing, and selling gold calls. Forward sales are contracts in which Barrick committed to deliver a set amount of gold at a fixed price for a term which was often 10 years. Fortuitously, due to Barrick’s “A” credit rating they were allowed to roll over the contracts if they desired and could liquidate them with only a few days notice. Additionally, due to the fact that they were making delivery at some future date they locked in a premium to the current market price. This was determined when the contracts were written. Thus, even if gold fell in price they had an assured buyer at higher prices.
With gold leasing they would lease (borrow) gold from a bullion bank at a set annual interest rate that was often below 1%. They would then sell gold on the open market and invest the proceeds from the sale in higher interest rate bearing instruments. They profited by pocketing the difference between the interest rate that they paid and the higher one, which they received. While they were obligated to repay the borrowed gold at some later date they had the ability to do that from their future production. With selling gold calls, they would profit by keeping much or all of the premiums which they received from writing the calls, when gold declined. Falling gold prices made the calls worth less than their origination price. In each of these or other methods that Barrick utilized, a declining gold price would either generate a profit for them or would allow them to sell their gold production at higher levels than the prevailing market rates. This allowed Barrick to generate a massive, cumulative $2.3 billion profit, while the other gold producers struggled for their survival. In fact, it allowed them to prosper and grow as they had sufficient cash flow to acquire either important projects or other gold mining companies.
This year, Barrick anticipates mining about 5.5 million ounces of gold at a total production cost of approximately $285 per ounce. In addition to their producing mines in seven countries, they are developing four additional ones that will begin gold production between 2005 and 2008. They have gold reserves of 87 million ounces, earned $193 million in 2002, and have over $1 billion of cash and equivalents. So why do I believe that they may be in financial difficulty?
About two weeks ago Peter Monk, Barrick’s chairman, announced that Barrick would no longer hedge their gold production. In fact, during the past year and a half they already reduced their hedge position from its peak at about 24 million ounces to its present 16.1 million ounce level. Monk’s statement was followed last week when their new CEO, Greg Wilkins, confirmed their non-hedging policy, and a few days ago when Jamie Sokalsky, their CFO, appeared on the Financial News Network. What is amazing to me is the timing of this revelation and the reason behind making it public in such a blatant fashion. They appear to be utilizing the financial press as an advertising forum! Are they doing this to promote their stock or are they frightened of something, or both?
Despite the magnitude and scope of Barrick’s operation, their hedging practices while greatly benefiting them when gold was in a Bear Market, are now acting like an anchor in a howling gold Bull Market storm. For each dollar that gold rises in price, Barrick now suffers a loss of $16 million. One dollar for each of the16 million ounces of gold that remain hedged. Therefore, every $10 rise in gold translates into $160 million dollars in additional losses! It is true that they also benefit by about $55 million, with each $10 gold rise due to their 5.5 million ounces of production. However, they show a net loss of over $10 million for each dollar increase in gold.
Further to Barrick’s advantage, their 19 counter parties have agreed to a number of extremely beneficial terms. Their gold deferred agreements allow Barrick to roll over most of their hedges; there are no discretionary “right to break” provisions, and no credit downgrade clauses. Additionally, Barrick is not subject to margin calls regardless of the gold price. In what appears to be such an enviable condition with their $1 billion of cash and equivalents and enormous gold reserves and production, why should Barrick be concerned, if indeed they are? Yet, their sudden ubiquitous visibility makes me wonder.
When I delved into Barrick’s most recent financial statement I may have found the answer. Their hedge book is already saddled with $1.213 billion of accumulated unrealized losses due to the rising gold price. This figure is from their September 30, 2003 quarterly report, and is based upon a gold price of $385. With gold presently trading at $403 this figure is now about $1240 billion. Next, according to their report there is an onerous provision in all of their master trading agreements that their growing unrealized hedging losses are causing to seriously pressure them. It is that, “Barrick must maintain a minimum consolidated net worth of at least $US2 billion-currently it is US$3.4 billion” (remember, this assumes only a $1.213 billion unrealized loss). If Barrick violates this ever-present clause they may be forced to either somehow repay the gold that they owe or to suffer other consequences.
By Barrick’s own account on September 30, their consolidated net worth was US$3.4 billion. As of December 4, it has likely been reduced to approach $3.12 billion, by their unrealized hedge losses alone. Further, if gold continues to rise in price, and to Barrick’s detriment enters a period of sharp price appreciation, Barrick may find itself with its back against the proverbial “wall”. In this event, they may witness their approximate $1.12 billion cushion ($3.12 billion less the $2 billion minimum requirement) quickly evaporate and may come face to face with their counter-parties who may demand the immediate repayment of their gold. I believe that this is the likely reason for the recent frequent statements emanating from the company. They are afraid that their hedge book might explode in their faces! Even their 87 million ounces of gold in the ground won’t satisfy their bankers! Barrick won’t be capable of producing this gold fast enough as their bankers may demand immediate, physical gold!
Barrick was a master in devising schemes in which to survive and even profit from gold’s long, tortuous Bear Market. However, they failed to recognize the emergence of the great secular gold Bull Market that today exists. While their stature rose during the earlier Bear Market, they may now succumb to the changing tide. Ironically, a rising price in the item that they produce and should be expected to greatly benefit them, may lead to their downfall!
I believe that Barrick’s recent great presence in the financial media forebodes their attempt to generate a higher share price and to secure sufficient financing to allow them to maintain an adequate “consolidated net worth”. This, in order to repel their debtors. Further, if they do not succeed, and gold preempts them and sharply rises, I wonder if the likes of Newmont Mining may acquire the spoils of Barrick’s failure. I hope for the sake of their shareholders that they are aggressively reducing their hedges and can avoid such a catastrophe. |
