Gold mines – to hedge or not to hedge

In very simple terms, the first step in selling forward is to approach a bullion bank with the intention of selling say a million ounces of gold forward. The bullion bank then finds a central bank willing to lease the approximately 30 tons of gold – typically at a very low rate of about 0,5% p.a. – on the premise that in due course of time the leased gold will be returned and the lease cancelled. This gold is then sold into the market and the proceeds are made available to the gold mine, less commissions for the bullion bank and so on.

Now this money is not placed under the mattress, but invested by or on behalf of the mine and earns a return substantially higher than the cost of the funds, which therefore in effect represents a much higher price for the gold than the current market price at the time of the transaction. Which is fine for both the mine and the bullion bank.

The only real risk for the mine is that the gold price would rise substantially. If the price of gold rises well beyond the price at which the gold is effectively valued in the hands of the short sellers – the mine and the bullion bank – the bank will want some ‘insurance’ in case, and for whatever reason, the gold is not delivered in time and has to be purchased in the market at a higher price. Readers may remember that 30 months ago the Ashanti gold mine in Ghana, and some other mines, were in trouble when gold spiked from about 5 to 0 in response to the announcement of the Washington Accord by the European central banks. It was called upon to pay margin of over 0 million and was only saved by massive restructuring of its position – very expensive to Ashanti shareholders – and the fact that the gold price retreated quickly again.

Of course, while the gold price retreated from over 0 in February 1996 down to near 0 in 1999, mines that had sold forward were smiling, as they were producing gold that had been sold at effectively a much higher price. But the gold price has been rising now for just on a year. It is following a distinct rising channel and is currently settled near the top of the channel, which lies at about 8. On previous occasions when the price had reached the top of the channel, it retreated very rapidly – largely under influence of new supply of gold as gold mines used the spike in the gold price to accelerate their forward selling.

Now the gold price is more resilient and this may well be because at least some gold mines are viewing the one year long bull channel with some suspicion. One does not want to sell more gold forward if the price is going to rise – stockholders may well be rather nasty to management if they sell all the gold production gold of the next two years or so at say 0 and two months from now the spot price is 0 and rising.

With prospects of a higher gold price investors are also likely to favour mines that are unhedged or lightly hedged over mines that have sold more than two year’s production into the forward market – particularly if this was done not so long ago when gold was well below 0, which means any further rise in the gold price from current levels will not benefit such mines to the same degree as those that are unhedged.

Consider the results of three different mostly or completely unhedged gold mines against AngloGold who not so long ago was said to have sold forward 50% of their production for five years (and is now busy reducing their forward book – which could be a factor in the new resilience of the gold price.)

During the most recent bull trend in the price of gold shares, since August/September of last year to Friday’s close, AngloGold’s price improved by about 93% which in just more than 6 months is rather good going. But not nearly in the same league as Goldfields and Harmony with about 240% and 250% respectively. They, again, are left well behind by Durban Deep; its price went from 700cps late in August last year to 4260cps on Friday 12th April for a gain of a touch more than 500%.

It should be noted, however, that as the rand price of gold improved, marginal producers should also show better price gains than lower cost producers – a fact that also favours the three lightly or unhedged mines over AngloGold, and the more so now that Harmony sits with the marginal Free State mines that used to be in the AngloGold stable. Perhaps it was a wise decision by Goldfields not to follow the leader!