Hedging or Speculation?

The explosive reaction of the Gold market to a sudden policy shift by the European Central Bankers has brought to limelight the "hedging" activities of the Gold producers. "Ashanti" and "Cambior" have announced that they are in deep trouble. There may be many others.

A lot has been written on the "hedging" activities of the Gold producers. Some have labeled them as "glorified hedge funds". People who invested in gold-mining stocks did so with the sole purpose of benefiting form Gold's price rise. Should the price of Gold rise further, many of the Gold producers would have to answer a lot of questions. It is also possible (likely) that GATA (gold anti-trust association) or any other association or individuals would want to take up the matter to court.

While I commend the efforts of all individuals and associations in exposing the Gold market manipulations, I urge all of them to use the phrase "speculating activities of the Gold producers" instead of "hedging activities of the Gold producers". I am not saying this merely because it sounds music to the Gold bugs. I have the following reasons:

1. 1. The dictionary meaning of "hedge" is

• a means of protection or defense
• to protect oneself from losing or failing by a counter balancing action
• to protect against risks from price fluctuations
• to protect oneself financially as by buying or selling commodity futures as a protection against loss due to price fluctuation

1. 2. The dictionary meaning of "Speculate" is

• to assume a business risk in hope of gain, especially to buy or sell in expectation of profiting from market fluctuations.

1. 3. The Gold producers claim (and the press believes) that by their Gold market actions (selling futures or buying puts and writing calls or selling leased Gold for cash) they have assured for themselves a certain price of Gold for their future production. Should the price go down they would have locked in a decent profit and if the price of Gold goes up they would deliver their future gold production. Some of them, like Barrick Gold, claim that they can benefit from short term spikes in Gold price by deferring its forward contracts for as long as 15 years.

To almost everyone this sounds like a flawless claim. It isn't for the following reasons:

1. The Gold producers own "yet-to-be-mined Gold reserves" against which they sell "readily marketable Gold". There is a world of a difference between what they own and what they are selling. Based upon the market capitalization of big mining companies and their proven + probable gold reserves we get a figure of $ 50 - $70 per oz. Of yet-to-be-mined Gold reserves. After incurring a "Cash Cost" of more than $ 200 per oz the mines convert this yet-to-be-mined Gold into "readily marketable Gold". Hedging is like-to-like basis. Something worth $50 /oz is not like-to-like to something $300 /oz.
2. If a Gold producer sells 5 years future production then he is "speculating" that his "Cash Cost" would remain at the present levels or go down. While it may be possible to make reasonable projections for the "Cash Cost" during the next 3 to 6 months, it is very difficult to project too deep into the future. In the medium term there could be hundreds of reasons resulting in "Cash Cost" going up much beyond the expectations of the management of these producers. For example a) the Government of the country where the mine is located may decide that the minimum wages for the miners need to be doubled or even quadrupled (Minimum wages in some countries where the mines are located may be only $50- $100 per month). b) The lease rates may shoot up to unreasonable levels, say 30 % + per annum. c) There may be Y2K related failures of the mining equipment. d) Political risks e) Natural disasters f) Very weak US$ g) Hyperinflation in the country of the mine h) Hyperinflation in the US etc.
3. To emphasize the above point I wish to state that what may be reasonable in a 1 month time frame may be absurd in a 5 year time frame. Like it may be reasonable to assume that there will be no earthquake in my town in the next two weeks, it may be unreasonable to assume that there will be no earthquake in my town during the next five years. Therefore, if I am constructing a temporary site office good for 3 weeks then I will not include the possibility of an earthquake in my design but if I am constructing a bridge then I will. Similarly a mine can not predict, with reasonable accuracy, the "Cash Cost" after two years. For this reason, only a short-term forward sale can qualify as a "hedge".
4. Another example: if I own "sea water" should I sell "drinking water" without full assurance of what desalination is going to cost me? If I know what desalination will cost today then should I assume that desalination cost would remain the same five years into the future? If owning "sea-water" and selling "drinking water" is not hedging then selling "readily marketable Gold" and owning "yet-to-be-mined Gold" is also not hedging.
5. If the actions of the producers in the Gold market have to qualify as "hedging" then they must be assured of the same profits whether the price goes up or down. This isn't the case. If the "Cash Costs" go up to (say) $500 per oz then a mine with 10 mln oz forward sale @ $350 per oz will lose $ 1.5 bln in Cash and that may wipe out its entire capital.
6. If a Gold jeweler sells Gold in the futures market in quantities more or less equal to the stock in his shop then that qualifies as hedging. Should the need arise, he is in a position to deliver the stocks in his shop and settle his commitment. Gold producers need a lot of value addition before they can deliver Gold.
7. Hedging is not merely fixing a price for your future production. It is supposed to eliminate the risks associated with future price fluctuation. If price fixing for future production protects against downward price move and could threaten the existence of the producer if the price moves up then it is certainly not "hedging". It is "speculation".

If I have been able to convince you and if you own stocks of highly speculative mining companies then you must give a thought to the following:

1. Did the constitution of the mining company (the articles and memorandum of Association) permit the management to speculate in the Gold market?
2. Did you invest in the Gold mining company because you felt (and wanted) that the Gold price would go much higher? If yes, has the management betrayed you?
3. As shareholders, were you made aware of the severe risks involved in the actions of the management?
4. Was the decision to sell forward forced upon the management of your company by the Bankers? If so, did the Bankers warn the management of the risks?

If you agree with the above then prepare yourselves to ask tough questions from the management of the companies you have invested in.

Sunil Madhok

[email protected]

United Arab Emirates

19 October 1999