Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Strategies & Market Trends : The coming US dollar crisis -- Ignore unavailable to you. Want to Upgrade?

To: ggersh who wrote (4448)	2/21/2008 2:48:29 PM
From: RockyBalboa	Read Replies (1) \| Respond to of 71475

One can imagine that they might have cash problems. The variation margin on a sold contract (at 6 or 7, as many did) is a mountain. In a similar case, some years ago Ashanti and also Cambior hedged their produce and had to be rescued of the same trouble. ....................... Timing issues: Most of the active hedgers amongst the gold mining companies hedge more than a year forward. Some hedge five or even ten years forward. This can create a timing problem because a company which has hedged a relatively "modest" amount, such as 33% of its 500,000oz annual production for the next six years would have a total hedge (1Moz) which is twice as large as any single year's production. Thus, a $50 per ounce move above the average hedge price puts a $50m loss in the hedge book. On the other hand, cash realized from 500,000oz of gold production will improve cash flow by only $25m over the next 12 months. Of course, the loss in the hedge book is somewhat illusory because so long as the gold production comes out as scheduled; the higher price will be more than compensated in increased revenues from the sale of physical gold. However, some companies have clauses in their hedging contracts, which enable their banks to seek additional collateral prior to the actual production dates. Other hedgers may have loaded up their contracts in the early years with the intention of rolling them forward into later years as the hedge contracts approach maturity. In a gently rising gold market, the "rolling forward" strategy will work. In a market with sharp upward move such as the $50 -75 spike seen in only two to three weeks, the required restructuring of maturities would have been virtually impossible to achieve, leaving a serious timing problem. Margin requirements: Few companies have a credit standing equal to that of the handful of top tier gold miners (such as Barrick Gold.) Many companies of somewhat lesser credit standing have been forced by their lenders and hedge counter parties to accept margin requirements. The way these work is that if there is a loss on the gold hedge, then some or all of that loss must be paid to the counter party in order to keep the hedge intact. In other words, the lender is not willing to simply trust the gold miner and wait months or years for the gold they have hedged to be produced. After some many years of falling gold prices, many miners may have been lulled into a feeling of complacency over the risk of leaving such margin triggers in the hands of their bankers. While most banks appear to have behaved in a responsible fashion towards their clients, there are rumors that one or two may have been "trigger happy" and asked their clients to come up with more margin money or have forced them to cover the hedges, often at very unfavorable prices. Asymmetrical hedging: Falling gold prices had also encouraged another dangerous strategy of what I call "asymmetrical hedging" by which I mean selling two or three times the volume of calls as a company buys puts. For example, an at-the-money $275 Put might be acquired by selling three out-of-the-money $300 Calls. If the price moves down, then the hedge "kicks in" immediately and cash compensation is paid for the price drop. Additionally, the first $25 of upward price move is "cost free" because the strike price was set $25 above spot. The problem arises when there is a price move of more than $25 and the company has to cope with three times as much hedge loss for every further dollar of price protection. Most press comment has not has not properly identified the very negative impact of this particular strategy. After so many years of falling prices it was far too easy to forget the risk of an upward price spike. Huge expansion of option volatility: Some of the above problems become even more dangerous when added together with an upward spike in volatility. A company, which has done asymmetrical hedging where the calls it has sold are also subject to margin requirements, is left in a highly vulnerable situation. They may be forced to buyback their calls when the cost of doing so is highest. An example would be a 3 month call which is $25 above spot might yield only $0.30 - 0.35 when it is sold at a volatility near 10%. But when the option is at the money and volatility has jumped to 30%, a three month call with a strike at $300 might cost $15.00 per ounce to buyback, which is 40-50 times the original premium received from its sale. Worst of all is the case where a miner's bank forces the company to buyback the option, realise a very substantial loss, and then the gold price drifts back down. Who is the villain in such a case, the miner or the overly cautious banker? Well, both: since the miner should have considered such "worst cases" when it was implementing its hedge program. Operational problems In general, the problems I have described above are those of liquidity and not insolvency. So long as the hedge program does not exceed future production, the gold will be produced to enable the miner to meet his hedging related obligations. But there is one type of problem feared greatly by the banks, the miners and their investors, which is why margin requirements are imposed in the first place- that is, the possibility of an Operational problem. If the gold can not actually be produced or if the cost is substantially above the forecast, then the gold production will not be sufficient to cover the hedge losses. Fortunately, the hedging book problems of 1999 do not seem to be of this type- at least at the point of writing this article.