Trends in Global Hedging Activity
In the near panic that ensued after the announcement of the planned Bank of England gold sales, producer hedging activity soared as the price tumbled. A number of mines were subsequently caught unprepared for the sharp rally caused by the joint central bank announcement in September. Last year was a very volatile one for producer hedging, but nonetheless, several broad patterns have developed.
For the last 10 years, we have published a quarterly survey of gold producer hedge positions in the Americas. Having recently expanded this to include companies based in Africa and Australia, we present here the highlights of our initial global survey. The survey includes 51 companies based in the Americas, 9 African companies, and 22 Australian companies. We estimate this covers between 85-90% of gold production from these regions.
Over the last 15 years, hedging by gold producers has grown from a fringe activity by a small minority of companies to a widely used strategy to assure cash flow by locking in future gold prices. In an environment of flat to declining gold prices, it is one which has worked well for most users, although in a sharp rally such as that of last October, producers who hedge can, as Ashanti and Cambior found out, experience signit1cant difficulties. An indication of hedging's importance in the bullion markets is the attention which the announcements of producer hedging restraints commanded in February. These announcements moved the price above $300/oz, albeit only on a short-term basis.
Hedging by the Miners - A Significant Component of Supply
Aggregate hedge positions, including the "in-the-money" books for the three main regions where gold producers are domiciled.
There is continuing discussion in the bullion markets as to the overall amow1ts of gold borrowed from central banks to support producer hedging, fabrication and other activities. Forward sales and spot deferred do represent borrowed gold on a one-for-one basis, presumably mostly from central banks, and this totalled 2,224 tonnes as of 31 Dec. 1999. As our survey does not cover total worldwide production, we think this number could be increased by about 20% to present a truly global picture. Options further enlarge this total, but some of them offset each other and we are reluctant to estimate the average delta hedge.
Another way of attempting to determine the magnitude of overall hedging levels (although not, as noted, borrowed gold) is to look at the in-the-money totals. For the three regions, these total 3,041 tonnes. We think this could be increased to perhaps 3,600-3,800 tonnes to include the production not covered by our survey. Although in-themoney totals in our hedge survey are not an accurate guide to the amount of gold borrowed by producers, we tend to use changes to them as directional indicators. In between the forwards and inthe-money numbers is the Gold Fields Mineral Services (GFMS) estimate of cumulative hedging levels of 2,700 tonnes at year end 1998 plus the preliminary number for 1999 of 445 tonnes, for a total of 3,145 tonnes. Looking at hedging from the supply side, (i.e., central bank lending), GFMS estimates that official sector bullion lending was 4,300 tonnes for all purposes (2,700 tonnes - hedging; balance, fabrication, official sector and other) at year-end 1998, to which one can presumably add 400-500 tonnes for 1999.
There are important variations between the size and nature of hedge books in different regions. For example, due to the 13.6 million ow1ce Barrick Gold book, spot deferred sales dominate hedging in the Americas, whereas in Australia, hedging has become much more option/ derivative oriented in recent years. Although it is not apparent in the summary numbers we show, Australian hedge books are very complex and contain a range of exotic derivative products (such as puts and calls with knock-in and knock -out features, convertible puts and convertible and contingent forwards). Almost without exception, Australian producers are users or forward markets and are generally much more heavily sold forward than their counterparts in either Africa or the Americas.
The Double-Edged Sword
The test of $250/oz in the third quarter or 1999 was precipitated by the unexpected announcement in May of UK treasury auction plans and subsequently the first auction on July 6. In the panic which ensued, producers contributed materially to the nearly uncontrolled fall in price in the third quarter, believing that since gold had not held at $270 or $260 it might not hold at $250 and could, in fact, go significantly lower. The flurry of producer hedging which followed almost made this a self-fulfilling prophecy, as is illustrated in Table 2 above showing aggregate hedging for the Americas.
Forward sale s and spot deferred jumped from an aggregate level of rough.ly 20.0 million ounces leading up to mid-year 1999 to nearly 24.0 million ounces at June 30. By the time of our September survey, this had reached 30.4 million ounces. If a number of changes made by producers during October and November were added, the actual peak level of hedging would be somewhat higher still. Similarly, the "in-the-money" portion of the book. jumped from 26.3 million ounces in March 1999 to 28.8 million ounces in June and to a peak of 34.6 million ounces in September, before falling back to 31.2 million ounces in December.
Hedging activity in Africa and Australia showed a similar increase. Not only did senior producers who sell forward augment their positions, but those who had traditionally avoided hedging (i.e. ., Newmont, Battle Mountain) began building position s. What is surprising is that with all the additional hedging, gold did not, in fact, dip below $250/oz.
We used to say that producer who hedged locked in higher prices and those that didn't were forced to accept the subsequent lower market prices resulting from increased supply. Normally, that would be a two edged sword within the industry, but in hindsight, last summer's large hedging increases collectively looks more like falling on the sword!
Similar Prices, but Volumes Vary by Region
The differing patterns of hedging in the three regions is apparent in Table 3 opposite which shows the distribution of hedge books over time and anticipated realised prices.
The higher level of Australia n hedging stands out. On average these companies are over 100% hedged for the year ended June 30, 2000, and are significantly more than 50% hedged in each of the following three years. For 2004 and beyond, they have on average 21 months of production hedged. Expected realised price are similar for all three regions, with the exception of the average African reused price for 2000, which is significantly lower' than the others at $316/oz.
Australian Hedging Dominance Continues
The growth of hedging and Australian dominance is shown in Table 4 opposite detailing months of production hedged.
Although hedging in the Americas has grown during the 1990s as production by companies domiciled there has increased, the changes are relatively modest compared to Africa and Australia.
African producers were last to embrace hedging, but now have a book similar in size to the Americas, covering some 19.3 months of production. There is still a large dichotomy between those companies which are heavy users of the forward markets, including AngloGold and Ashanti, and others such as Harmony (which is completely unhedged and philosophically opposed to this strategy) and Gold Fields, which has only minimal hedging in place.
A similar dichotomy exists in North America along the 49th parallel separating Canada and the United States. Canadian based producers Placer Dome and Barr ick Gold are big hedgers, whereas US-based Newmont and Homestake have very modest hedge positions. In Australia, all miners hedge. The average producer in Australia has more than four years or production sold forward, and some companies, such as Sons of Gwalia, have more than I00% of their reserves (but a more palatable 50% of resources) hedged.
There are several broad patterns developing related to producer hedging. Provided gold does not break down significantly below $275/oz, we think producer hedging restraint, coupled with the criticism from investors on hedging, will see overall hedging levels reduced by several hundred tonnes by year-end 2000 (this direction was already apparent in Q4/99), thus returning closer to the levels of early 1999.
However, if gold breaks through technical support levels and falls toward $250/oz, we can envision a fresh round of hedging which will exacerbate the situation and could drive us well below this psychological barrier. Prices below $250 would eventually lead to a significant contraction in mine production, although hedging would delay the inevitable. Also, the South African rand would most likely weaken sufficiently so that less of this industry would disappear. There is a general tendency to longer-term hedging in North America, which historically has hedged on shorter terms than either Africa or Australia. We hope the industry collectively acts prudently if we test for lows below $280 - and resists the temptation to contribute to supply through additional hedging.
After the much-publicised problems of Ashanti, which faced margin calls, and Cambior, which in the absence of contractual obligations could not roll calls sold into Forwards, we think there has been and will continue to be a transition from exotic hedging instruments to more plain vanilla products. Also, the oneput-two-call strategy will find a few takers. We also expect that more rigorous stress testing of books will be the order of the day. One of the few benefits of last October's hedge crisis, however, is that the amount of detail provided on hedge books has grown dramatically. This new transparency has provided investors with valuable insight into the producers' financial condition.
Ted Reeve and Susan Muir have covered the North American gold equity sector since 1981 at several Toronto-bases brokerage firms. Mr Reeve has a PhD in geology and a Master’s in Business Administration from the University of Toronto. Ms Muir has a Bachelor of Arts in Journalism from Concordia University. In 1994 they joined Scotia Capital, Inc, the full serve investment dealer arm of the Bank of Nova Scotia, which also owns Scotia Mocatta, a global leader in metals trading, brokerage and finance. For 10 years, Mr Reeve and Ms Muir have collaborated on a survey of producer hedging which is published in their quarterly report entitled "Gold and Silver Hedge Outlook". This has recently been expanded to a global product.