Feature Stories | Apr 07 2006
In 1854, Peter Lalor led a miners’ rebellion at the Eureka Stockade. Miners brandished a Southern Cross flag which has become the symbol of worker solidarity in Australia ever since.
In 1984 a mining company, founded by Lalor descendents Peter and Chris, produced its first gold. They called the company Sons of Gwalia. In 2004 it was the third biggest gold miner in the country, just before it collapsed. This time it was the shareholders who revolted.
There were production problems at Gwalia leading up to its demise, but the bottom line was not about production, it was about hedging. Gwalia had fallen into the trap of treating its hedge book as a means of making a profit, rather than a means of preventing a loss.
What, then, is gold hedging all about?
If you want to be a widget maker you design a widget, open a factory, and produce and sell widgets. As long as there’s a market for widgets it’s a pretty straightforward business.
If you want to be a gold miner it’s not quite so simple. You have to explore, survey, take samples, test samples and then hope the early signs of flickering glow in the dust prove to be, over time, a substantial lode. You then have to raise funds, open a mine and start digging, processing and hopefully, selling gold.
The price of a widget will largely be determined by the world’s immediate need for widgets. The price of gold is a function of currency movements, inflation, wars, terrorism, cataclysm and even, we mustn’t forget, a subjective desire for jewellery. The gold price through history has run in long cycles. These cycles determine whether in fact gold mining might be a profitable business. At any given time, a miner is at the mercy of the gold price, and a lot of money has been spent to get to that point.
And it takes a good deal of time. Once it becomes apparent just what price per ounce of gold its recovery from a particular mine will average out at, it may well be that the gold price has fallen below that level. Or if not, it may fall below that level at some time in the future. Mines may have lives of many years, so if a miner wants to be able to capitalise on a mine for a length of time, it helps if he can be confident what price that gold will fetch in the future.
In order to secure that confidence, a gold mining company can elect to hedge. Hedging is a means of guaranteeing a price for that product out to time. It means miners can sleep at night.
To simplify matters, let’s say there are three main forms of hedging: gold borrowing, forward sales, and options. We’ll take them one at a time.
The price of gold will always be higher in the future than it is now. This sounds counter-intuitive, because gold prices not only rise but they fall. What this statement actually means is that if you want to arrange now to buy gold at some time in the future, the price will always be more than it is now.
It is still possible that when you receive that gold, for which you paid a higher price, the "now" price (spot price) is lower than it was at the time you made the arrangement. All you are doing is paying a premium for making that arrangement in the future.
This is known as the "forward curve". When a forward curve rises into time it is said to be in "contango". Other than in very, very exceptional circumstances, the price of gold is always in contango.
Aside from that which is used for jewellery, most of the world’s gold is held in stockpiles by central banks. This is used to provide collateral value to a country’s currency which is otherwise effectively a paper IOU. Gold is the global currency that transcends all others. But it is easier to transfer US dollars than it is to move gold bullion, so the US dollar is the world’s business currency.
Like any other currency, the price of gold must increase into the future at something approximating a discount rate (some average of global interest rates which in turn have components for inflation – that is why gold is known as a hedge against inflation). As most of it is stockpiled, it is always there, unlike say, copper. So there is no risk of an immediate shortage which might push the spot price above the future price.
Because there are always stockpiles, gold can also be borrowed.
The first simple form of hedging is to borrow gold from a central bank. The cost of borrowing is very low (usually less than 1%) because there’s simply a lot of it sitting around doing nothing. A mining company can borrow gold and immediately sell it at the spot price. In so doing, it has secured today’s price for gold that it has yet to produce.
The company then invests those funds in the money market, earning an interest rate that ensures its net interest (net of borrowing cost) is positive. The company goes about producing gold, and then gives that gold to the lender to pay back the loan. It has also earned a bit of cash along the way.
If the price of spot gold falls during the production period, the company doesn’t care – it need only give the lender gold. Thus it is hedged against adverse movements in the gold price.
The second form of hedging is the forward sale. Rather than fiddling around with borrowing gold, a mining company simply sells gold into the future. Because of the contango, the miner will always receive a higher price than the spot price. A miner may sell gold forward a whole five years. Who buys it? Usually an investment bank or similar gold trader, who will then go on and trade with others and generally try to profit from the forward purchase. But that’s the buyer’s problem. The mining company can just go about its business of producing gold happily knowing that the sale price is locked in. Come the time, the gold is finally handed over.
In each of these cases the greatest benefit to the miner is that if the gold price falls during the life of the mining operation, it doesn’t matter because the sale price is locked in at a level the company is happy with. Margins are known, new projects can be considered, workers will always be paid.
The flipside is, however, that if the gold price rallies above the level of the sale price at the time the deal matures, then the mining company has missed out on potentially extraordinary profits. This is what a miner has to weigh up. And this is also where thought must be given to an actual view on the future gold price. Is it worth the risk to go in unhedged, take all the glory, but risk bankruptcy if things go the other way?
The third simple gold hedge is a means of alleviating this problem to some extent. A mining company can buy gold "put" options.
A gold put option is the right, but not the obligation, to sell gold at a predetermined price at a predetermined time in the future. The "seller" of the put option is obliged to buy gold at that price if the mining company decides to "exercise" that option. The price can be chosen by the mining company now, and would usually be set at some break-even or disaster saving level below where the spot price is now. The idea is that if the gold price collapses, the company has a form of insurance.
This form of hedge leaves the upside in price available to the miner. Sort of a have your cake and eat it too. However, for this right the miner must pay a premium.
In order to offset the cost of that premium, it is common for a mining company to simultaneously sell "call" options at a price level above the spot price. This would oblige the company to sell gold at the higher price were it to be surpassed at the maturity of the contract – even if the spot price had reached much higher levels.
This is a means of "funding" the insurance premium of the put option by giving up some of the potential upside, such that the whole transaction may establish obligations, but with no net cost to the miner.
All three cases are about being able to establish a level of security of revenue for the mining company so it can go about its business without undue risk. Hedging is a form of risk management.
Continued Part II