Selling Low and Buying High: Hedging by the Gold Miners
Hedging is a controversial topic, probably as controversial as any I have written about. Nevertheless, I want to share my thoughts and hopefully add something new to the topic.
It is general knowledge that the gold miners had adopted hedging during the long years when the gold price was moving sideways to downwards, culminating in the low of 2001. Most investors also know that in the years of the current bull market, the miners bought back those hedges at great expense. Barrick alone squandered about $6B of shareholder equity to find its way back from its adventure in hedging. Other miners also paid a heavy penalty. No wonder this is a controversial topic.
Today—with the gold price falling without a bottom seemingly in sight—the discussion of hedging is once again on the table. Analysts, if not the miners, are considering it. A quote from this Kitco article by Debbie Carlson captures the thinking about hedging.
“Equity holders like the upside they get from the gold price, but at the same time they don’t want the company to be out of business.” —Robin Bhar, metals analyst at Societe Generale
In one sentence are included three different ideas that should be considered separately. I allude to the first one in the title of my article. There is now a real fear that the price could keep falling and falling. Carlson quotes Barclays, “Fresh non-project related hedging would be a clear bearish signal.”
With all due respect to Barclays, this is the smart money / dumb money analysis to which I referred in my article about the COMEX gold inventories. Do the miners necessarily know where the gold price will go next? If so, then why did many sell low and buy high in the last cycle? Do we presume that whomever is buying their forward production does not know?
Second, the fact is that every business must earn a spread in its primary operation. It must sell its outputs for more than its costs including capital, labor, and other inputs. The gold miners buy diesel, tires, tooling, machine parts, plus they pay wages, and they service their debt. They sell gold (and often other metals). Sales of metal must be greater than total expenses, or else they cannot continue to operate.
Third, many investors buy mining shares as a way to speculate on the gold price. Miners, it is widely believed, have gearing or leverage to the gold price. Their share price has certainly fallen much more than the gold price since 2011. Investing in a commodity producer as a way to speculate on the price of the commodity is not unique to gold and silver mining, but it seems to take on greater intensity. This could be because the case for vastly higher gold prices is so clear, whereas even with oil the picture is muddied by chronically falling demand since 2007.
These first and third items are two sides of the same question: how much gold price exposure should the miner have? The second item gets to the core issue: the miner must survive for the long run, even in a protracted downturn in the price such as now. Its business model must be robust to all market conditions.
Before I give my opinion, I want to address one other issue raised in Carlson’s article. It will make a good segue. Societe Generale is bearish on the gold price, and part of the reason is that they expect miners to hedge, and their hedging will put a cap on the price.
I think this can be easily dismissed. Let’s look at the concept of the stocks to flows ratio. Stocks are inventories. Flows in this case is annual mine production. Inventories divided by mine production for gold is around 80 years. Another way of saying this is that every year, total mine output is well under 2% of existing stockpiles. For ordinary commodities, the ratio is measured in months. This is extraordinary. It means that people are willing to accumulate gold without any particular limit, unlike ham sandwiches, crude oil, houses, or iPads.
In wheat, for example, if the harvest is a few percent above estimates, there is a glut and the price goes down. This discourages farmers from planting wheat, and encourages anyone who needs cheap starch to choose wheat over corn or rice. The glut is eventually worked off and the price recovers.
For gold, on the other hand, there is no such thing as a glut. For thousands of years, the market has stood ready to absorb whatever quantity of gold that may be delivered. This is one way to understand why gold is money.
To clarify, I am not claiming that Big Scary Sales, such as the UK’s sale of half its gold under Gordon Brown, can’t cause a temporary dip. Speculators front-run it of course, getting out of the way and buying after the sale is done. Such moves are short-lived and in any case, central banks cannot change the long-term trend. I am stating that the value of gold does not vary inversely with the quantity of gold, as is assumed for ordinary commodities by the “law of supply and demand.”
Even if the miners hedged by selling 100% of their annual output forward, they would add but a small and temporary amount to the gold stocks. And of course they would not sell all of their production, but only a part of it. Hedging will not affect the price of gold.
Let’s look at the world from the perspective of the gold miner. They and their investors do not keep their books in gold. They do not operate for gains in gold. They borrow in dollars and pay their expenses in dollars. The difference between their dollar revenues and their dollar expenses is what decides if they continue operations or close their doors.
Regardless of the philosophical discussion of whether the dollar is money, or a sinking fiat currency, whether gold is money, or a risky commodity, to the gold miner there is no practical debate. The miner operates in dollars and the gold price is volatile. Prudence would suggest that miners take all necessary steps to ensure their viability. In my own experience as CEO, I have found that if I took care to make sure I could survive the downside then all surprises would be pleasant ones.
The miners should hedge.
Hedging should not be done in bipolar fashion. It should not be turned on abruptly, when the gold market is nearing a capitulation low, and turned off at great expense, when the price is relentlessly rising to new highs every day. Proper hedging is not all-or-nothing, but positions that are changed by degrees in response to the mining company’s cash flow needs, the gold price, and other factors (e.g. the gold basis).
The market reality today is probably that investors do not want gold miners to operate purely to make a spread between their input costs and the sales price of the gold. Investors want gearing to the gold price, when it’s rising. The investors are, after all, the owners of the company. Mining management can violate the expectations of investors at their own peril.
There are two conceptually separate components to the gold mining enterprise. One part is producing and selling enough gold to earn enough on the spread to sustain its own existence, and to generate a sufficient operating profit. The other part exists to provide investors with an enhanced return based on exposure to the gold price.
I say conceptually separate, because a single hedging strategy must accommodate both areas. By the term hedging here, I do not refer to merely forward sales, but a dynamic trading program designed to squeeze the maximum dollar return out of the miner’s gold production and gold position, in rising and falling markets.
In Part II, I will discuss how to use hedging to enhance the upside and reduce the downside. The idea is closer to a hedge fund supported by a gold producing operation, than to simple forward sales (at the wrong times).
In Part III, I will explore another direction. There is no reason why a gold mining company couldn’t keep its books in gold, raise its capital in gold, and run its operation for a return in gold. Indeed, of all companies, the gold miner is one of the few who has a proper gold income (though it, like everything else today, is papered over in a veneer of dollars).