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Apr 2002 - Mercury Asset Mgmt

It appears that Mercury was right after all

Julian Baring’s Mercury Asset Management (swallowed by Merrill’s) were the chief proponent of trying to stop gold companies from hedging or forward selling their gold production on the basis that such activities dampened or held back the gold price. We can recall on more than one occasion seeing Mercury and trying to defend the actions of Australian gold producers.

The gold industry has had a love/hate relationship with gold hedging or forward selling ever since they have dabbled in it. Loving it when they receive gold prices more than the spot price and hating it when either they receive less or face margin calls and losses on options.

Gold hedging mainly arose out of the demise of gold loans in the market collapse of October 1987 when banks found that there was a risk in lending gold to companies in that they may not get their gold back if the company collapses and defaults on its loan. There were a number of defaults and we noticed gold loans became less favourable, and instead hedging or forward selling increased.

A simple gold hedge (or forward sale) involves a bullion trading bank receiving an order for say 10,000oz from a gold company, borrowing that 10,000oz in gold from a Central bank, and paying that Central Bank an interest rate called the “lease rate”. Lease rates vary according to a number of different market parameters and according to the time over which the gold is borrowed. The bullion bank then sells the 10,000oz in gold at spot say currently A$558/oz (US$290/oz at about an A$ exchange rate of US$0.52) and deposits the money received into a local bank.

The gold company receives the difference in interest rates from the local interest rate less the lease rate, which is called the “contango”. So that if the difference in interest rates (or the contango) is 5% per year, and the gold company produces 10,000oz in one years’ time, the gold company can then effectively sell 10,000oz of the gold that it produces at A$586/oz (A$558/oz x 1.05) regardless of what gold is trading at the time. While an almost A$30/oz increase may not appear to be that much, in 5 years’ time at 5% per year it can become 10,000oz sold at A$712/oz (or if exchange rates are still at US$0.52, an equivalent gold price of US$370/oz).

It can be seen that there are three key parameters, namely the base price, the contango (or interest rate difference) and the length of time the hedge is taken out over.

Australian gold companies found that hedging did not appear to affect their share prices. We can recall that the share price chart of GMK could be overlaid on top of that of Homestake Australia (they each owned about 50% of KCGM), and yet GMK was 100% hedged (or had forward sold all its gold production for a number of years) and Homestake Australia was 100% unhedged (or had not sold any of its gold forward), with the result that GMK was far more profitable than Homestake Australia.

Sons of Gwalia was also effectively 100% hedged (and usually received gold prices in the vicinity of A$650/oz or so, which was well above spot levels), but yet its share price used to fluctuate with the US$/oz gold price. It appeared that Australian investors did not understand hedging and valued gold stocks in US$/oz and then made a 10c to 30c adjustment according to whether a stock was hedged or not.

Australian companies were able to defend their hedging by using it to cover mining costs or ensure that a project could be financed. Other gold companies in the world cited similar reasons, and when the gold prices were received, the gold company that received a higher gold price because it had hedged was more profitable than the company that did not hedge.

The non-hedgers used to argue that companies should not hedge because they were dampening or holding back the gold price and if their mines were not profitable at lower gold prices, then they should close the unprofitable ones which should result in higher gold prices for the rest of the industry. Many years ago in South Africa we can recall that the then major gold companies wanted to close the Barlow Rand gold mines (which have become the Durban Deep, ERPM and Harmony of today) for the good of the gold industry and result in higher gold prices, but obviously that did not happen. Instead natural attrition has closed some of the mines while others have debatedly continued on.

The logic of holding back or dampening the gold price was valid. Apart from the net new hedging per year adding to annual gold supply, there have been many times in the past when the gold price was rising and approaching a critical chart point that the rumours would flash on the news screens that the Australian gold companies were hedging again and it would usually stop the gold price rise “in its tracks”.

However, it was not all simply “money for jam”, there are pitfalls in hedging such as using options and buying and selling puts and calls, of which the industry found out what a call really means. The industry used a practice of buying puts (to protect the downside, for which you have to pay for the right to make a seller buy your gold at a specific price in the future), and using the selling of calls (for which you can receive money for the right to sell your gold at a specific price in the future) to pay for the cost of the puts.

That was all very well, until the gold price rose to say US$300/oz beyond the level of the put at say at US$260/oz and the call at say US$280/oz, such that the gold company would not exercise the put (or sell gold at a lower price than it was trading at), but suddenly found that it was being called to deliver its gold at a lower price than spot and could face margin call rights. Call rights have varying rates, which almost caused Ashanti to implode (or explode) when it used rocket-fuel options and the gold price soared as the company scrambled to buy gold to deliver into its options. That episode effectively ended the use of call options by gold companies.

Gradually gold companies started to reduce their reliance on hedging. Some small companies that may not want to hedge often find they do not have a choice if they want to borrow money from a bank as usually the bank insists on hedging being undertaken (to protect its loan, although the producer often results in receiving a lower gold price) as part of the loan.

Some of the majors have made sweeping statements and most of the South African golds have reduced their hedging to close to zero (apart from what they have inherited in takeovers). The South Africans were never really keen having been burnt historically usually by the falling Rand or by the fact that their Reserve Bank initially prevented them from selling more than 2 to 3 years’ ahead. However, it is the gradual takeover and consolidation of the major Australian gold companies that has had the greatest impact, particularly with announcements earlier this year of reductions in the hedge books.

That reduction or close out of the Australian hedge books appears to have been the main catalyst to increase the gold price to its current levels of US$290/oz or so, consequently, it appears that Mercury was right after all !

This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, who has a Proper Authority with State One Equities. This e-mail address is being protected from spambots. You need JavaScript enabled to view it The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents

  • Written by: Keith Goode
  • Monday, 01 April 2002