Risky Business (some thoughts on Barrick's hedge programme)

Dr Martin Murenbeeld recently published a study in which he discusses the practice of hedging future gold production in general and Barrick Gold's hedge programme in particular. The study is titled "In Defense of Gold Hedging - The Case of Barrick" and anyone interested in reading it can do so by going to http://www.mips1.net/MGGold.nsf/UNID/TWOD-5DV2QD and downloading the document in pdf format.

As the title of the study suggests, Dr Murenbeeld's conclusion is that the benefits of the gold hedging undertaken by Barrick outweigh the costs. We would argue, however, that the jury is still out on whether Barrick's hedging will benefit its shareholders in the long-term. It certainly benefited them while gold was in a bear market, but the following chart showing the ratio of the Barrick Gold (ABX) stock price and the Amex Gold BUGS Index (HUI) shows that they certainly haven't benefited since gold began its bull market (we date the start of the gold bull market at October/November 2000 when the US$ reached a long-term peak against both the Swiss Franc and the euro and when most gold stocks made long-term bottoms). The line on the chart rises when ABX is out-performing the HUI.

Drawing conclusions about the merits of an aggressive gold-hedging programme by looking at Barrick's performance over the past 15 years, which is what Dr Murenbeeld does, makes as much sense as drawing conclusions on the benefits of owning tech stocks by looking at the NASDAQ's performance between 1995 and the first quarter of 2000. The total picture can only be seen after the cycle is complete. Hedging became extremely popular during the 1980s and 1990s because the gold price was in a long-term downtrend. So far we've only seen the first stage of the ensuing up-trend and the evidence to date indicates that the shareholders of gold mining companies with large hedge books are going to fare quite poorly, at least on a relative basis. 

Although Dr Murenbeeld has attempted to show Barrick's hedge programme in a positive light, he briefly touches on two risks associated with the programme that, we think, are substantial. In fact, having read Dr Murenbeeld's study we would now be even less inclined to buy ABX than we already were (and that is really saying something). Before we discuss these risks, it is important to understand that almost all of Barrick's forward sales fall into the "spot deferred" category, which means that Barrick has the option of rolling forward the contracts rather than delivering into them. If, for example, Barrick's hedge programme calls for 3M ounces of gold to be delivered at a price of $340 in 2003 and the spot gold price at the time of delivery is $400, Barrick can choose to roll those contracts forward and sell the gold into the spot market. In this way they supposedly have the best of both worlds - they have the downside protection of a hedge book but have not limited their upside in the short-term. These "spot deferred" contracts can be rolled forward for up to 15 years.

One of the risks mentioned by Dr Murenbeeld - one that he quickly dismisses as not being important - is included at the bottom of page 16 of the study. Apparently, Barrick will not be able to defer delivery into its forward-sales contracts if "the counterparties are unable to acquire bullion in the open market or any organised exchange or to fund any such acquisition". In other words, if Barrick's counterparties (the bullion banks) are unable, for any reason, to borrow the gold needed to facilitate the forward sales contracts, the contracts cannot be rolled forward. So, if central banks decide to stop or cut back on their gold lending, Barrick will probably not have the option of rolling forward its contracts. This (central banks stopping or substantially curtailing their gold lending), in our opinion, is something that has a very high probability of happening within the next two years. In particular, as the US Dollar's bear market becomes more widely recognised the central banks or Europe will become less inclined to part with their gold.

The other risk worth noting is discussed on page 19 of Dr Murenbeeld's study. If Barrick decides to defer delivery on a particular contract, and assuming that Barrick's counterparties are able to borrow enough gold to enable the deferral to proceed in the first place (a big assumption), then the contract is re-priced based on the interest rates at the time of deferral. The risk is, if the gold interest rate (lease rate) happens to be higher than the US$ interest rate at that time then the re-priced forward-sales contract will have an exercise price that is less than both the previous contract price and the current spot price. 

Forward prices for gold have, over the past 9 years, always been higher than the spot price because gold interest rates have always been lower than US$ interest rates. On this basis Dr Murenbeeld concludes "it is therefore safe to assume that the contango [the US$ interest rate minus the gold interest rate] will be positive on re-pricing dates". This, in our view, is a very dangerous assumption. If this gold bull market picks up steam and the major central banks figure out that lending their gold for a piddling 1-2% per year return is what we Australians would call a 'mugs game', then even if gold is available to borrow it might only be available at a much higher interest rate.

The real problem for ABX shareholders is that an accelerating up-trend in the gold price - something that should be welcomed by a company in the business of mining gold - will probably create the conditions under which Barrick's hedges cannot be rolled forward. As such, the 'spot deferred' concept is likely to break down just when it is most needed, that is, when the spot gold price has risen well above the exercise price on the forward sales contracts. 

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