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The Folly of Hedging
by John Hathaway

Among the factors depressing the gold price in recent years, forward selling and other hedging activities have been prominent. Producer hedging has added as much as two years' of future production since year end 1996 to normal mine supply. By accelerating future supply, the gold mining industry has exacerbated its woes. In trying to protect against the downside, hedgers have magnified it. Perhaps in recognition of self-damage caused by their activity, many leading hedgers indicated earlier this year that hedge books would not be increased in 2000. While these announcements represent a significant improvement in gold market fundamentals, few renounced hedging as a matter of principle. In most cases, room has been left to initiate new hedges at higher prices. The anti-hedging stance appears to be a temporary experiment rather than a permanent change in direction.

usagoldThe rationale for hedging is faulty on several counts. The central justification was that hedging would add predictability to cash flow by dampening the influence of fluctuations in the gold price on corporate revenue. A neutral stance on gold prices became popular among the post 1990 industry leadership. Advocacy of gold within the mining industry has diminished to near silence. Under the hedging regime, the principal financial metrics used to evaluate company performance became cash cost and total cost of production, not return on shareholder's equity or an accurate view of reserve replacement cost. The new metrics positioned gold mining as a spread business in which the primary task of management was to execute cost control procedures once price had been locked in. In this way, the leading companies were portrayed as "growth golds," a politically correct and inoffensive way to tout the group that did not clash with the prevailing bullish macroeconomic views underpinning the bull market in financial assets. The thought that hedging might play an important role in depressing the gold price received little consideration. The possibility that neutralizing a mining company's exposure to the gold price might undermine the valuation of its shares received even less.

Goldfields Mineral Services (GFMS) in its Gold Survey 2000 concludes that industry costs declined 5% to $197/oz and total costs to $257. In light of the average spot price of $280, before enhancement by hedging profits, a $23 margin of 8% after all costs might imply that mining gold is a profitable, if not thriving industry these days. GFMS portrays an industry that is driving down costs in a tough market. There is an implication that productivity enhancements can drive costs still lower, and that therefore, the price of gold itself will follow this decline curve. It is this sort of misguided analysis that has provided bullion dealers with their intellectual rationale for a bearish stance on the gold price.

In fact, the industry is downright sickly. We think that the industry is gutting its productive capacity by high grading, getting behind on development, squandering financial resources by keeping marginal properties afloat, and drastically reducing exploration expenditures. What prolongs these ill-advised practices long beyond what would be tolerated in any other industry is the unique ability to fix forward selling prices to guarantee (in theory) the spread over projected cash costs. However, there is no guarantee against unforeseen production shortfalls or cost overruns due to labor problems, faulty mine plans, unexpected cost changes, extraordinary items, changes in taxation, or issues related to sovereign risk. Hedging limits the upside price swings that the mining industry once depended upon to offset these risk factors. Positioning a risky, capital-intensive endeavor such as gold mining as a spread business, similar to a bank or insurance business model, is ludicrous. In so doing, many producers, and especially the financially weaker ones, have taken on a form of hidden financial leverage due to their inability to generate capital internally or enjoy normal access to capital markets. For them hedging was a bargain with the devil that allowed deferral of difficult operating decisions, thus prolonging a state of limbo which precluded prosperity by diminishing the single variable which could restore financial health, a much higher gold price.

The total cost figure used by GFMS is not intended to be reconciled to producer income statements as it does not include corporate SG&A, interest and financial items, exploration costs, or taxes. If one adds these items, the cost per ounce figure would increase by $25-$30 for the typical producer, or approximately the current price for gold and the average at which it traded in 1999. Adding in some allowance for even a feeble return on capital would boost the per ounce requirement to well over $300/oz. The reality to which cash cost and total cost analysis are blind is that the gold industry is barely breaking even in the current market environment. It cannot attract new capital except on a very project specific basis. Not only is the industry as a whole incapable of expansion, it is hard put to replace its reserve base. The habitual squandering of capital enabled by hedging has long since passed the point that would guarantee a downturn in production if gold prices do not improve, and even limits a significant increase in production if gold prices rise substantially.

Few mine company executives seem to grasp the importance of the relationship between the cost of replacing reserves and hedging decisions. In our view, that cost is well above the market price, probably in the range of $350-$360/oz on an industry wide basis. While annual reports and financial presentations of gold producers focus on cash cost per ounce, or total cost to produce, almost no company that we are aware of considers replacement cost in the context of hedging.

The following table, which contains information provided to us by a major international gold producer, shows a selection of new projects and the gold price they would require in order to generate a real return on capital of 10%. Notable is how few new projects fit into the "superlative" category with cost characteristics that allow profitability within today's price structure. Their total reserves of 47.8mm ounces (a figure which of course is likely to grow) replace less than the entire industry's annual production. More than 80% of new mine projects, some of which are represented in this table, require a gold price on average of $333/oz, well above today's trading range. These figures do not include discovery costs, either the exploration or acquisition cost of the property. A very conservative across the board estimate would be $25/oz, resulting in a total replacement cost for new ounces approaching $360/oz. Numerous corporate acquisitions in recent years would place this figure far higher. A continuation or worsening of gold prices would force a contraction of mine output in due course. In that incremental hedging would prolong a weak gold price environment, the industry would be hastening its demise. The preponderance of price realizations generated by the industry hedge books are well below $360/oz.

Economics of New Mine Projects

   (mm oz)  Required
Gold Price
 Red Lake (Goldcorp)  2.4  $168
 Pieriena (Barrick)  5.6  205
 Bulunhulu (Barrick)  7.8  227
 Wallaby  2.6  242
 El Penon (Meridian)  2.2  235
 Perama Hill  1.2  236
 Pascua (Barrick)  19.0  288
 Geita (Anglogold)  5.3  276
 Francisco Gold  1.7  277
Average & Totals  47.8  $255
 Fort Know (Kinross)  2.4  $265
 South Deeps (Placer Dome)  27.4  303
 Getchell (Placer)  5.3  290
 Ridgeway  2.5  295
 Crown Jewel (Hemlo)  1.4  310
 Yamfo (Normandy)  5.9  333
 Wandoo (Normandy)  6.9  338
 Las Christinas (Placer)  8.0  347
 Phoenix  2.8  384
 Pueblo Viejo  9.5  445
 Average & Totals  72.5  $333

The traditional function of management in the mining industry has been to find reserves and produce them at the lowest possible cost. Investors in gold mining shares have sought upside potential tied to gold prices. For managers to hedge away future upside destroys the option value of the shares. The option value relates to the potential upside appreciation of a company's proven and probable gold reserves. Hedging has undermined one of the traditional advantages of gold mining equities, a very low cost of capital based on this option characteristic.

Hedging has transformed gold mining shares from perpetual options on the gold price to prosaic, every day industrial equities trading against the shop worn metrics of enterprise value to cash flow and p/e ratios. Before hedging, gold share valuations were routinely the highest in the basic materials sector, the only sliver of the "old economy" with a chance to sell at dot.com valuations. In addition, the well-publicized problems of Ashanti and Cambior confused investors, discouraging interest in the entire sector.

Gold share valuations have seldom been lower. According to BMO Nesbitt Bums research, the average net asset value premium for the senior and intermediate producers is currently 54% versus 130% at September 1999 just before hedge book problems became widely publicized. This decline in valuation has coincided with a series of rallies taking the gold price higher by 15% to 35%.

Forward selling in its most benign form simply locks in today's price plus an interest rate factor based on the yield curve. By encumbering the potential realization on reserve ounces, it ratchets down return possibilities from future cash flows to inappropriate bond market yields. In its most pernicious form, hedging extends the life of inefficient properties, encourages uneconomic investments, and protects otherwise vulnerable management jobs. In the instances of Ashanti and Cambior, it is clear that cash generated from hedge book transactions was being used to keep the companies afloat.

What is to be gained by selling output at prices that lock in returns inadequate to replace depleted reserves? To justify this activity, managers refer to the revenue added or premium to the spot price of gold through hedging. However, these revenue "enhancements" consist of short selling profits, successful and self-fulfilling bets against the gold price, plus the interest earned on the proceeds of the short sale. The "premium" is no more than a spot sale enhanced by an interest factor based on a spread between money market yields and the gold lease rate. In one sense, producers that hedge are performing a role analogous to that of the lender in a short sale transaction in that the return for doing so is limited to an unexciting spread between short term interest rates. The important difference is that they have no power, in most cases, to reclaim their asset should it become more valuable. In a sharply rising market there will be no boasting of revenue enhancements from hedge books.

Gold mining is risky. The commodity is scarce, hard to find and challenging to produce. Upside possibilities for return on investment are linked to price volatility. Why remove this all-important variable? If typical new mine economics require a gold price of $360/oz to generate a modest return, selling forward at anything less is in essence a liquidation of capital. Yet, the average hedge transaction for the last three years has been at spot prices below this figure.

It is disappointing that the industry has become almost silent on the advocacy of gold for monetary uses. While initiatives to open and liberalize markets as well as sponsorship of web sites to lower retail jewelry prices are worthwhile, the industry must do whatever it can to reverse gold's marginalization as an alternative to financial assets. The potential valuation of gold as money far exceeds the possibilities available through expanding the jewelry market. The marginalization of gold is favored by bullion dealers and multinational commercial banks that use it as a low cost method of funding via derivatives (see JP Morgan to the Rescue?).  These institutions make far more money trading paper gold derivatives than the mining industry can earn at today's depressed prices. They would be unable to do so if gold prices traded substantially higher, obviously something they do not want to happen.  Hedging provides order flow to these institutions that enables the derivatives trade which in turn keeps the gold price in check, absent a surge in investment demand.

Who is smarter than the market? The hedger presumes to be. Where would the gold price sit without hedging or the prospect of it? It is safe to say that it would be substantially higher. Notwithstanding the financial market's disaffection with tangible assets, the supply of gold for sale would have been considerably less, perhaps by a factor of 50% during recent years. Not only would bullion dealers have lacked the order flow to sell gold short; the mining industry would have been more likely to shut down inefficient properties.

A secular low was put into place in August 1999. Bear market tactics are no longer called for. Hyperactive hedging strategies implemented by those who do not understand or do not choose to believe the bullish case will only cost shareholders money. A key challenge for the industry is to avoid the temptation to outsmart the market. Hedgers: tear up your sell order tickets and throw out your bullion dealers' phone numbers. The only investment attraction your industry has going for it is the possibility of sharply higher gold prices. Don't stand ready to cap future rallies by betting against a bullish trend.

by John Hathaway / Tocqueville Asset Management L.P.
May, 2000

The information contained herein has been obtained from sources believed reliable, but is not necessarily complete and cannot be guaranteed. Tocqueville Asset Management L.P. and Tocqueville Finance S.A., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. Affiliates of Tocqueville Asset Management L.P. and Tocqueville Finance S.A. may, in the last three years, have been manager or co-manager in a public offering of securities of issuers discussed in this publication.
Copyright © 2000 by John Hathaway and Tocqueville Asset Management L.P. All Rights Reserved.

Reprinted by USAGOLD with permission of John Hathaway. No further reproduction without permission.

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