Dehedging gold – Why Barrick's in trouble
Source: SeekingAlpha
15 November 2006
Bill Cara submits: Despite some weird trading action, gold prices are likely to rise by $200 over the next four years. That's the forecast of firms like UBS, Credit Suisse, BMO and others, and it also just happens to be what the forward market is priced at.
There are many factors involved in setting prices, some in opposition, and some more popular at times than others. But at the end of the day, prices rise because demand is rising and supply is not.
In their Weekly Comment (Nov 13) on Gold, Credit Suisse states:
"Our studies indicate that gold supply in the long term is inexorably falling behind demand as the diminishing number of new reserves fails to compensate for dying mines. This has been happening for some time but, until recently, the effect has been masked by Central Bank sales and producer hedging. However, Central Bank sales will likely whither, and Banks could become net buyers of gold. This transition, together with expected increased investment demand, jewelry consumption and diminishing mine supply, will be when the supply-demand imbalance heats up the gold price. We believe this has already begun.
Some of the major drivers, which collectively support and provide upward pressure to the price of gold, are:
- U.S. economic fundamentals – the US$ underpins the gold price. There continues to be a raft of reasons and arguments from economists against the long-term health of the US$. These include: the massive and rising debt and current account deficit; looming crisis in Social Security; the rising budget deficit; and excessive household debt.
- High energy and commodity costs – these cause inflationary pressures that result in upward pressure on the gold price (because of gold's inflationary hedge characteristics). The significant increase in commodity costs means high capital sums are required to exploit mineral reserves, which is likely to deter investors as project margins are squeezed.
- Global supply and demand factors – mine supply will likely continue to decline significantly over the next 10 years. Global gold producers are depleting reserves faster than they can discover them.
- Official Sector supply (Central Banks) will likely decline significantly, particularly after 2009, and many countries could increase their gold reserves in the future (China, Russia Japan).
- De-hedging is likely to continue to draw on supply.
- Fabrication – the demand for jewelry and other areas of fabrication fairly remains strong. China's consumption is likely to increase significantly over the next 10 years.
- Investment demand is likely to continue to increase significantly through bullion-backed securities (Exchange Traded Funds ETFs) and through Comex and Tocom. ETFs are now acting as a "Peoples Central Bank," buying gold, thereby taking gold out of the system and countering Official Sector sales. The total investment in ETFs, bench-marked against Central Bank holdings, now ranks No. 11 – at 585 tonnes.
- Geopolitical turmoil – global hot spots: terrorism and political tensions cause short-term volatility, putting upward pressure on the gold price. (Middle East Iran, Iraq and North Korea).
We believe the US$ will continue to underpin the gold price. However, supply and demand factors will begin to make their presence felt to such an extent that they alone (or in combination) could trigger a quantum upward change in the gold price, enough to sustain a new gold price US$ equilibrium.
For the record, Credit Suisse has dropped their gold price forecast (made in May) for 4Q06 from $690 to $630 (which is obvious since half the quarter is now gone), and from $700 to $665 for 2007, from $725 to $700 for 2008. and from $767 to $751 for 2009. But for 2010, they kept the forecast at $800.
From where I sit, traders now ought to be looking at buying into those asset rich junior and intermediate producers and the companies holding huge as yet undeveloped resources. In a Gold Bull market, the seniors that have falling production and depleting resources will be the ones on the acquisition trail. In every case, we have seen huge premiums paid by the senior companies, and their share prices have taken major hits as and when take-over bids are made.
Of course takeover premiums are already built into the market, but on the pullbacks, that's where value will lie.
Also, the producers that have declining production, rising costs, and relatively high cash costs at present are the ones traders ought to avoid.
There are also several major producers that are rapidly trying to de-hedge, which means that as and when the gold price pulls back, they are going into the market and buying back some forward production they previously sold. That will drain future cash flow and profitability, so traders have to watch this situation as well.
Credit Suisse is reporting that goldminer producers have de-hedged 10.24 million ounces (318 tonnes) YTD, and that already is twice greater than the 131 tonnes de-hedged for the whole of 2005.
That statement tells anybody who can read that gold mining companies expect the price to ramp up from here.
The Mitsui Report, which Credit Suisse quotes, estimated 2Q06 de-hedging at 5.1 million ounces (158.6 tonnes), which is the greatest quarter of de-hedging since 4Q02; and they claim it came 3.0 million oz. from Barrick Gold Corp. (NYSE: ABX – News), 1.0 million oz. from AngloGold Ashanti Limited (NYSE: AU – News), and a sizeable amount from Newcrest Mining.
The total outstanding hedge book at the end of June was about 44.9 million oz. (1,396 tonnes), which is equal to about 55% of global mine production (all sources) for 2006.
Hedging can be a wonderful profit maker in a Gold Bear market; and it can throw off sufficient cash to help these companies on the acquisition trail (other companies or properties directly), but in a Gold Bull, just the opposite effect happens.
When this issue first became a popular discussion I spent some time trying to analyze corporate reports, and I didn't learn much. Then some of the major broker-dealers started quoting from the Mitsui Report, which gave me concern because I was always hearing Barrick was the largest hedger and I recall how Barrick's Peter Munk and Mitsui had been involved in major deals before he went into the gold business, so I discounted that material.
Moreover I kept Barrick as a Cara 100 Company despite mail from concerned readers. Was I wrong to do that? Perhaps. But I figured that the market had been pricing in the hedge book negatively anyway, and broker-dealers of high quality (UBS and others) had Buy recommendations out, so I hung in.
But now that I see how immense this hedge book still is – 12.3 million oz. (and that's after buying back 5.1 million oz. in the 2nd quarter) – I'm in a quandary. That's $7.75 billion in production already pre-sold at lower prices.
And when I look at the 12-month price performance of some of the major producers, you can pretty much split the results into the hedgers at the bottom and the non-hedgers at the top.
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