Gold Producers Are Split on Whether to Hedge
By BERNARD SIMONJanuary 24,
An argument has raged among members of the
industry for the last decade: whether to hedge against a drop in the price of
Newmont, based in Denver, is firmly in the antihedging camp. The company
believes hedging is a bet against an icon, dampening the profits of mines and
making gold stocks less attractive.
As part of its pitch to Normandy shareholders and other investors, Newmont
pledged to eliminate forward sales and other financial instruments through which
commodity producers typically try to protect themselves.
"We're trying to provide our investors with maximum flow-through to the gold
price," said Bruce D. Hansen, Newmont's chief financial officer, in a recent
A Newmont fact sheet, promoting its $2.3 billion bid for the Australia- based
Normandy and Normandy's biggest shareholder, Franco-Nevada Mining of Canada,
said that the combination would offer investors "a clear choice, premised on a
belief in gold's intrinsic, long-term value."
Such sentiments, echoed by gold bugs on Internet chat sites, are a
none-too-subtle dig at Newmont's archrival, Barrick Gold of Toronto, as well as
its foe in the Normandy bidding war, AngloGold
of South Africa, and other producers that have used hedging extensively in
recent years to lock in returns well above prevailing market prices.
The Barrick camp sees Newmont's antihedging pitch as an attempt to distract
investors' attention from Newmont's shortcomings, including higher production
costs and a heavier debt burden.
Barrick, with its strong balance sheet and low production costs, is the
world's most highly valued gold stock. According to Randall Oliphant, Barrick's
chief executive, hedging increased his company's revenue by about $2 billion
over the last decade, even as the spot gold price stagnated.
For much of that time, the price of gold has been $250 to $350 an ounce.
Mines have closed, and combinations have become the order of the day in an
effort to lower costs. Given that, Barrick and its supporters say, they would be
foolish to dump their cautious approach.
Producers of other commodities, from copper to oil, also use financial
instruments to insulate themselves against volatile markets. But nowhere does
this activity stir as much emotion as in the gold industry.
"People who buy Phelps Dodge
don't think copper is going to the moon," said Philip Klapwijk, managing
director of Gold Fields Mineral Services, a London-based research group. But
gold investors expect "a magnificent return when gold goes to $400 an ounce" and
are disappointed when hedging has locked them into a lower price, Mr. Klapwijk
For much of the last decade, though, hedging has made a lot of sense. Barrick
has pocketed returns higher than the prevailing market price for 55 consecutive
quarters. In the third quarter of 2001, it realized an average price of $340 an
ounce, compared with the prevailing spot price of $274. Gold now trades at about
$279In one common hedging strategy, commercial banks, on behalf of producers,
sell gold borrowed from central banks to lock in the current price and then
invest the proceeds in government securities.
The banks that set up the deals tend to be enthusiastic about hedging.
Drummond Gill, managing director of ScotiaMocatta, the Bank of Nova Scotia's
metals trading arm, said hedging removes the risk of volatile markets, leaving
only the "operational risk" of running a mine.
But according to Mr. Klapwijk: "The judicious use of hedging has been shown
to be profitable in the past. Whether it will be so in the future is another
Hedging began in earnest in the late 1980's, but serious doubts surfaced in
1999 when a sudden jump in the gold price, from $254 to $326 an ounce in less
than a month, caught two miners, Cambior Inc.
of Canada and Ashanti Goldfields of Ghana, with very wrong bets through hedging
contracts. Both companies were plunged into financial crisis, and have since
More recently, sliding interest rates have made hedging less profitable for
the central banks that lend their bullion for forward sales. According to Mr.
Gill of ScotiaMocatta, the banks' lease rates for borrowed bullion are down to
1.1 percent, from 4.5 percent in mid-1999.
In addition, the one-year contango, or the difference between spot prices and
forward prices, has narrowed to $3 an ounce, from $15 a few years ago.
There is also a growing chorus of criticism that forward sales help keep the
gold price in the doldrums.
Hedging activity has indeed fallen off. Gold Fields estimates that producers
hedged 100 fewer metric tons last year than in 2000, when hedging activity also
Mr. Oliphant strongly defends Barrick's strategy. "The arguments have largely
been the same for the past 10 or 15 years," he said, but "companies with the
most consistent track records have generally been those that have been
Yet, even at Barrick, the antihedging arguments appear to have gained some
ground. When the gold price climbed in 1999, Barrick bought call options so that
it could profit from a further rise. With its recent acquisition of Homestake
the share of Barrick's reserves committed to hedge contracts has dropped to 20
percent from 26 percent. And when Barrick publishes its 2001 earnings next month
it is expected to say that it has stretched its hedge arrangements over a longer
period, thereby lowering the proportion of current production that is insulated
from movements in the gold price.
Mr. Oliphant declined to give details for now. But he confirmed that with a
lower capital spending budget and more cash on hand "we can afford to have more
near-term participation in the price of gold."
In your view, why would investors prefer to invest in the shares of a gold mining
company that does not hedge away the risk of gold price
- What would be the arguments in favor of hedging?
What hedging strategy do you recommend for Barrick, going forward?