FN Arena News – April 07 2006
Continuing from Part I
This all sounds very sensible doesn’t it? The problem is, however, that it creates a dilemma for the shareholder of the mining company. An investor with a diversified portfolio can always sell out of gold mining shares if the view is that the gold price will go down. In a way, the shareholder is really not bothered with a need for the mining company to be hedged.
But where the shareholder loses out is on the upside. The price of gold might rally (and this is why an investor would hold gold mining stock) but the value of the shares may not rally in the same proportion by virtue of the hedge – the predetermined sales price obligations of the mining company.
This then becomes a quandary for the mining company, which may need to attract equity funding in order to proceed with a mining venture. Should the answer be simply death or glory? Should mining companies just not hedge?
Some don’t, but then some have to. Hedging can be divided into that which is “discretionary” – on the decision of the mining company – and that which is “non-discretionary” – on the insistence of a third party.
That third party would be a lender of start-up capital for a particular mining project. It might be just a bank. Insistence may also come in the form of a necessity within a debt instrument of specific maturity, underwritten by an investment bank or other institution. While equity holders look to the upside, debt holders fear the downside.
The end result of all of this is you will find most gold miners have some level of hedging in place. Okay, this puts some limits on the upside, but then nothing else can go wrong, can it?
Oh yes indeed. Hedging is not the end of the risk. In fact, it creates its own risk.
In all of the hedging scenarios the common theme is that the gold miner will always ultimately produce the gold to meet the obligations. But what if it doesn’t? What if the geological surveys were off the mark, or a mine collapses, or something goes terribly wrong in the production process?
If a miner can’t come up with the gold, then it pretty much has to come up with the cash as compensation. But if the miner is not mining enough gold to sell, chances are there won’t be a lot of that cash. This is the situation currently facing Croesus Mining (CRS).
Croesus has undertaken hedging which has left it with obligations its mines cannot fill. It has been burning cash to meet gold sale shortfalls, and there is still more to come. Yet the amount of gold it is extracting is nowhere near enough. Someone’s estimates were terribly wrong. At present, trading in Croesus is suspended while the third parties see if they can keep it afloat.
Sons of Gwalia also had problems with gold production. As the end grew near, this was what the company put up as its excuse. The truth, however, was a bit more sinister.
Looking at our three hedging scenarios, borrow-and-sell, and forward-sell are straightforward concepts. Options are a bit more tricky, but the strategy presented here is what could be called a “vanilla” one. In the latter case, however, there is no end to the complexity of structured hedging deals that could be, and have been, constructed either by a counterparty, all of which have the theme of “optionality”.
Optionality (the concept whereby a right exists, but not necessarily an obligation) is a form of leverage. Let’s go back to shares for a minute to understand this.
You can buy BHP Billiton (BHP) shares now for $29.85 and pay for them. You can buy June expiry, $30 call options now for $1.78, and only pay $1.78. Provided BHP rallies by (30.00-29.85 + 1.78 =) $1.93 before June, your options will be break-even. Any upside above that is yours. No upside and you just lose $1.78, not $29.85.
Because you can sell the options before expiry, you could capture any upside to that point while still only having outlaid $1.78, but make an almost identical profit on the deal as if you have forked out for shares. But if you have X amount of money to invest, you can buy one hell of a lot more options than you could shares, and thus make one hell of a lot more money. This is called leverage.
Coming back to gold, the same applies in reverse. A gold miner could actually end up making a lot more than the upside in the gold price by virtue of option leverage provided the deal was structured accordingly and everything went to plan. In this way, hedging is no longer just hedging – it’s punting. Of course, it all relies on producing enough gold…
That’s what happened to Sons of Gwalia, and a number of other gold miners around the same time. They stopped using a hedge book as insurance, and started using it as a profit centre. And they came unstuck.
History is littered with hedgers who brought down a company – not just in gold.
The days of such highly risky, highly complex deals are over (for now). In fact, the level of gold hedging has actually halved in the last four years or so – not because the gold price has rallied, but because no one wants to touch complex, leveraged trades with a ten foot pole. Not miners anyway (hedge funds have taken over the role).
This is also resulted in a reduction of the number of hedging counterparties. The cowboys have left the ranch and only the traditional service-providers remain.
To hedge or not to hedge? That is yadayada. How are gold miners approaching this question in 2006?
Let’s have a look at Newcrest (NCM) – Australia’s leading gold company. There has been much discussion of late that Newcrest’s share price is overvalued because although the gold price is going to the moon, the company has hedge obligations dating back five years. Five years ago the gold price was (a lot) less than US$500/oz, so the differences are obvious.
Newcrest’s hedging policy is one that has come about largely from a non-discretionary perspective, such that hedging requirements formed part of its fund raising efforts for new projects begun when the gold price was at the bottom of its cycle. Five years ago, Newcrest hedged 90% of its forecast production. This was necessary to get such projects as Telfer off the ground (Or is that into it? Anyway, don’t mention Telfer).
The accompanying table (provided on Newcrest’s website) indicates the level of Newcrest’s forward obligations. As you can see, there’s some pretty low gold price numbers locked in for some large amounts. As we move into time however, Newcrest’s hedge ration drops – to 75% for 06/07, 50% for 07/08 and so on until 10/11 is looking at ratios below 30%.
www.newcrest.com.au/hedgebook.asp (see attachment below)
Newcrest does not hedge on a discretionary basis, these were obligations. That is evident in the scaling down of the ratio (as risk would subside as the mine proved successful). This is not based on a gold price view, or the rally to date.
Newcrest’s hedges are of the simple type. The company used to use more complex, option-style hedge transactions back when everyone else did, but not for punting. Management decided the return to simplicity not because the likes of Sons of Gwalia were biting the dust, but because the option-style hedges could not actually provide a known obligation in the future. Everything was dependent upon everything else.
This meant they couldn’t produce a nice simple table like the one above, nor even be able to answer investor questions about hedging obligations. It was all a bit unnerving.
Counterparties still recommend gold miners hedge some of their production – but then they would. Miners are not so convinced, but then everyone needs insurance. If hedging is treated as insurance, then everybody knows where they stand – shareholders included.
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