A case study written by Professor Ian Giddy

Gold Producers Are Split on Whether to Hedge By BERNARD SIMON New York Times January 24, 2002 An argument has raged among members of the industry for the last decade: whether to hedge against a drop in the price of their product. 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 interview. 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 said. 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 question." 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 restructured. 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 declined. 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 hedged." 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 Mining, 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."   Questions 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 fluctuations? What would be the arguments in favor of hedging? What hedging strategy do you recommend for Barrick, going forward?