Producer hedging and the gold price
November 28 2003
Last week I looked for a correlation
between net investment demand for gold and the price of gold, but
couldn't find any. Some may say that's because net investment demand,
as calculated by Gold Fields Mineral Services, is really just the
arithmetic difference between two sets of collected data, i.e. a
small difference between two large numbers. I don't think that's
why there is no correlation.
I believe that gold is money, and that is why commodity
style analysis has such an abysmal track record. Before we get to
a monetary analysis though, I want to convince you that looking
at gold as if it were just another commodity really does not work.
The argument goes that hedging caused the gold price to decline
because it increased supply when borrowed gold was sold into the
spot market. De-hedging (the closing-out of a hedgebook), on the
other hand, is currently thought to be strengthening the gold price
because it either decreases supply, when the mining companies deliver
production to repay gold loans instead of selling it, or because
the mining companies pay their loans off with gold purchased in
If we look at the net amount of gold involved in hedging,
forward sales and loans, and the GDP-weighted average gold price
(GDP-weighted index of 35 currencies, representing in excess of
75% of the world's economy, introduced last week) it is evident
that the price of gold is not dependent, or even materially sensitive,
Note that the average net amount of hedging, forward
sales and loans from 1990 to 1999 was in excess of two hundred and
forty tonnes a year. Yet, in spite of that, the average gold price
increased from three hundred and eighty to five hundred against
the index of GDP-weighted currencies. If hedging was deleterious
to the gold price, how come the gold price around the world increased,
on average, by more than thirty-one percent?
If we look at the average worldwide gold price, instead
of just the US Dollar gold price, we can see that hedging did not
cause the gold price to decline, because there was no decline in
the gold price. If there is any correlation between hedging, forward
sales, loans, and the gold price, then the former merely add a small
element of volatility to the latter.
It is interesting to note that net hedging, forward
sales and loans, which typically add supply to the gold market,
turned into quite a bit of demand from 2001 onwards, as many gold
producers began scrambling to close out under-water hedgebooks.
This increased demand, as with net investment demand and Central
Bank sales, which will be covered next week, is a reaction to the
increasing gold price, not the cause of it.
The reversal of hedging as the US Dollar gold price
increased since 2001 is a reflection of the fact that many gold
hedges are denominated in US Dollars. Also, the decline in US interest
rates and the increase in gold lease rates have taken the profit
margin out of US Dollar hedging. So while hedging itself did not
contribute to the decline in the gold price during the 90s, the
increase in the US Dollar gold price since 2001 has put the brakes
on Dollar-based hedging.
Gold mining companies can, and most likely do, still
hedge their production in terms of Rands and Australian Dollars,
or any other currency for that matter. That can take the form of
currency hedges, or gold hedges denominated in other currencies,
but the majority of hedging that occurred during the 90s was Dollar-denominated,
which is why it ceased when the bull market in the Dollar ended.
There is speculation among a number of sophisticated
gold analysts that the process of de-hedging, by virtue of reducing
mine supply to the market, or because gold mining companies are
closing hedge books with purchased gold, is contributing to the
current increase in the gold price. If all the hedging that took
place during the 90s did not cause a decline in the gold price,
why then will partial de-hedging cause an increase in the gold price?
These same analysts also point out that when the process
of de-hedging comes to an end it would cause a decline, or at least
a retraction of the gold price, as demand eases and supply increases.
This, too, is fallacious.
The decline in the gold price from 1996 to 2000 was
a result of the increase in the US Dollar exchange rate, and not
fundamentally driven by changes in the physical gold market, as
I will demonstrate in due course. This is more than semantics: it
has major implications for gold investors since what may intuitively
seem like a good idea, may, in fact, not be.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
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