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 the market.

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, to hedging.

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 investment publication. For more information please visit his website ( or contact his publisher at (800) 528-0559 or (602) 252-4477.


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