The Hedging Advantage
Why Barrick's Gold Hedging Program Delivers Record Results
Much like fine wine, the benefits of gold hedging just keep getting better with age for Barrick Gold Corporation.
In 1997, the company's hedging programme celebrated its 10th anniversary of exceeding the spot price by delivering its best results ever. For the year, the programme generated a premium of $88 per ounce or $269 million of additional revenue and $200 million of added earnings. More recent results have continued the pattern. During the first quarter of 1998, Barrick 's hedging programme generated $79 million in additional revenue as the company realized an average price of $400 an ounce, compared with an average spot price of $295.
With over 10 million ounces of gold hedged at $400 per ounce, Barrick has created a $4-billion position. This hedging asset makes a great contribution to Barrick's ongoing financial strength. Yet it is not reflected in our balance sheet nor is it fully appreciated by the markets.
In this brief article, I would like to elaborate on what benefits hedging has historically provided for Barrick, why the Barr ick programme delivers unrivalled results, and why Barrick's hedging provides for protection on the downside and allows us to take advantage of the upside.
A Hedging Pioneer
Barrick Gold's hedging strategy to maximise revenue and minimise gold price risk through gold price hedging is one of the principles on which the company was founded.
Barrick largely pioneered the hedging process in the gold in dust r y. When the programme began, it involved simple forward sales. Since then, it has become much more sophisticated, providing better returns and greater flexibility. Over the past decade, hedging has contributed a total of $765 million in additional revenue and $580 million in earnings to the company. Thus, hedging provided an average premium of $46 per ounce, for every ounce sold, over the entire 10-year period.
Barrick's Unique Approach:
Barrick's programme, which is the subject of a case study at Harvard Business School, continues to earn exceptional returns for several reasons.
First, Barrick hedges consistently. While we can select the timing of gold sales, we add to our hedge position on a regular, disciplined basis.
The second reason is that we enjoy the most favourable terms for our hedge contracts. We now have the ability to roll our contracts forward for up to 15 years. These terms recognise the exceptional size and quality of our reserve base, and of our balance sheet, which hedging helped to build.
The third reason is that we manage the proceeds from the original spot sale very actively. At 5% net interest, $4 billion hedging asset earns us $200 million a year in interest income. At 31 December 1997, the mark-to-market gain was $800 million, representing the amount of money Barrick would receive if we purchased gold on the spot market and delivered against our 10-million-ounce hedge position. We manage our hedge asset as carefully as our mines.
We have developed strategies for maximising the returns on our hedge asset. We have managed to lower the cost of the borrowed gold and improve the yield from the money on deposit. The average yield in the money market these days for the term of our hedges is 5.5%. By choosing the investment vehicles ourselves, we are currently earning about 7.5% interest instead. Each 1% improvement in our interest rate earns us an extra $40 million a year.
Barrick Hedging - Past, Present and Future
The Past 10 Years
- Consistently exceeded spot gold prices
- Realized price on average yielded a $46 premium over spot price
- $765 million in additional revenue.
- 10 million ounces hedged at $400 per ounce
- There years' production hedged
- Mark-to market gain - $800 million (valued today if we closed out contracts)
- Our 10 million ounces hedged at $400 creates a $4 billion asset (which generates $200 million per year in interest income)
- Actively manage the asset to maximise interest income
Barrick will continue to earn a superior return over others because:
- We hedge consistently
- We have longer and more flexible contract terms.
- We actively manage the hedge asset to maximise interest income.
How hedging contract works
To earn a higher future price under a forward contract, gold is borrowed from central banks through one of Barrick's gold trading banks and sold at the prevailing market price. These proceeds are placed on deposit to earn interest. The interest (or contango) that Barrick receives on its contract in the future is the difference between the interest earned on the proceeds and the interest paid on the borrowed gold. The interest paid to borrow the gold is normally less than 2% per year. The higher forward price is achieved since the US dollar interest rate is applied to the invested funds is higher than the interest rate changed in the borrowed gold.
Barrick's Spot Deferred Contract.
Barrick uses a version of the forward contract for its hedging called the spot deferred contract. A forward contract is a commitment to deliver a specific quantity of gold, on a specific date, at an agreed price to a purchaser. A spot deferred contract is similar but the ultimate delivery date and corresponding forward price for a spot deferred contract are not fixed.
The flexibility of spot deferred contract meant s that when the spot price is higher than the hedge price, Barrick is able to sell its production are spot, roll the contract forward. When the hedge price is higher, the company delivers its production against the contract. This Barrick is able to realize the higher of the two prices for its gold.
With the 10 million ounces we have hedged at present and our ability to achieve forward prices on new hedge contracts, even if gold were to remain at current levels indefinitely, we could actually realize more than $350 an ounce on our entire SO-million-ounce reserve base.
When we look at the impact of our hedge programme historically, it is no exaggeration to say that it has allowed us to be the kind of company we want to be.
First, we are financially strong. Our balance sheet remains the strongest in the business. Indeed, Barrick has the only A credit rating in the gold industry. At 31 March, our cash position was $439 million, almost the same as our long term debt. With the dependable stream of hedged cash flow behind us, Barrick can afford major projects, and we can choose our own timing.
Second, we maximise revenue and minimise gold price risk on each ounce produced.
Third, we have financial flexibility. We know our realized price going forward - and not just for the three years of current contracts. Should we choose, we could blend various contracts to extend this hedge benefit out through the life of our reserves, or we can participate in gold price improvement.
If the gold price rises through Barrick's hedge price in excess of $400, the company will sell its gold at the higher spot price and keep the contract for a future date when the gold price may not be so attractive. The contracts will rise in value the longer they are outstanding.
Since the hedging programme is structured to allow the company to take advantage of rising gold prices, Barrick's shares have traditionally moved up over time, showing a strong correlation to movement in the gold price. Thus, Barrick shares are likely to appreciate consistently with a rising gold market and, at the same time, offer downside protection through its unique hedging programme.
Looking at the future, hedging remains an ongoing, core activity of this company. We do not know where the spot price will be, but we do know that by earning a 5% premium for three years, Barrick ounces will realize, on average, at least the spot price plus 15%.
Hedging works with other elements of our prudent financial approach to benefit the Company and its shareholders. Through hedging, we increase the price we receive for our gold. At the same time, Barrick is focusing on cost containment and increasing production from low-cost mines. Low costs, plus high realized prices, are a powerful combination, and it results in very powerful ounces. One Barrick ounce earns four times as much as our peer group's earnings. This margin will become even greater, as our operating costs decline. And, since Barrick's reserve life is almost 50% longer than our peer group, we not only generate four times as much money per ounce, but we do so for a much longer period of time.
(Note: Currency throughout the article is expressed in US dollars)
Using the above example, Barrick will earn contango of 5.5% in each of the next three years, resulting in a forward price in 2000 of $400 per ounce. The $340 spot deferred contract increases in value to the $400 forward price.
If in 2000, the spot price of gold rises through Barrick's hedge price of $400 per ounce to $420, Barrick would take advantage of the flexibility of the spot deferred contract by selling its products at the $420 spot price and rolling the $400 contract forward for an additional year. The hedge price would rise because the interest compounds to achieve a new forward price of $422.
The following year, Barrick would deliver against the spot deferred contract at $422, if the spot price remained at $420. If the spot price was higher than $422, Barrick has the flexibility under the terms of its spot deferred contracts to continue to roll the contract forward for up to 10 years and sell its production at the spot price.