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Attack On The Gold Hedgers
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The gold mining industry has been reducing its hedge position
steadily for the past couple of years and is clearly getting
more aggressive in bringing down the total hedge position.
The build-up of hedges was a major reason for the collapse
of the gold price that began in 1997. The reversal of that
process has been the biggest contributor to the gain in the
metal price over the past couple of years.
Beginning in the mid-1990’s, gold mining companies began
to lock-in the plus-$400 gold price by selling production
forward. That process, which was intended to protect against
a falling gold price, actually created downward pressure as
forward sales accelerated when the gold price began slipping.
By some estimates, as much as five years of future production
was pre-sold into the gold market.
Those forward sales are much more than financial transactions,
as physical gold is delivered into the retail market. The
hedging intermediaries borrow gold, usually from the central
banks, and then sell that borrowed gold into the physical
market. That borrowed gold finds its way into jewellery display
cases, alongside newly mined gold. Many central banks supplemented
or replaced their gold sales programs with leasing programs
that provided a steady supply of gold to the intermediaries.
As the gold mining industry pumped more gold into the market,
the over-supply of metal pushed down the price. As the price
began falling, the process turned into a self-fulfilling prophecy
as more and more companies got into the hedging process.
Initially, the hedgers and the central bankers all looked
brilliant as they were able to boast higher selling prices
than the prevailing market prices. Over time, more and more
investors woke up to the fact that the industry was fighting
against itself in the hedging process.
Most of the gold producers are now giving at least lip service
to their desire to cut the total hedge position. Barrick,
which long trumpeted its financial brilliance in the hedging
arena, recently fired its CEO, Randal Oliphant. As the chief
financial officer, he put together the hedging strategy for
which he was rewarded with the CEO mantle. Barrick has been
less aggressive than most majors at actually reducing its
hedge position, and that is reflected in the share price.
The company just announced a plan to raise $1 billion of new
debt, part of which will be used to buy its shares in the
market in order to help prop up the share price.
Newmont, in sharp contrast to Barrick, has declared open
war on the hedge bankers. Newmont was less hedged than most
majors before it merged last year with Franco-Nevada and Normandy.
Like other Australian producers, Normandy had fallen under
the spell of the local bankers and carried an onerous hedge
position.
Newmont CEO Pierre Lassonde, part of the duo that built Franco-Nevada,
called the bluff of Goldman-Sachs when the banker demanded
a $46 million payment under a hedge contract when the gold
price rose earlier this year. Lassonde offered 50 cents on
the dollar to settle the hedging deals. Goldman-Sachs insisted
on full payment, but Lassonde held his ground and put an Australian
subsidiary company called Yandal into bankruptcy. In a forced
liquidation, the holdout bankers are expected to receive only
40 cents on the dollar. The three mines owned by Yandal produce
about 145,000 ounces per year.
We are not likely to see a rush of companies suddenly challenging
their hedge counter-parties to showdowns. The Yandal deal
represents an unusual situation in that a major company held
off-side hedges in a neatly packaged subsidiary company with
no recourse to the parent. Newmont could walk from Yandal
with little impact on the overall organization. The major
is now buying back the mines at a fire-sale price, free from
the hedge obligations.
Even if this scenario is not repeated, the implications of
a tussle between the world’s largest gold producer and
one of the leaders of the hedging movement are far-reaching.
At the very least, the relationship between these two companies
must have suffered. More importantly, future hedge deals will
be structured with a lot more care and attention to the longer
term, from the perspective of both sides.
The most important thing arising out of this deal is further
confirmation that the hedging business itself is fading. It
will never go away completely, as normal short term commodity
contracts are an important aspect of every resource business.
But, the long term hedges that robbed shareholders of the
upside in the gold market will hopefully soon be worked out
of the system.
The steady unwinding of gold hedges is a very important aspect
in the bullish outlook for the gold market.
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