Issue 2
The Gold Hedging Revolution and the Silver Mystery
Gengold's hedging programme for its Beatrix mine's number three shaft represents nothing less than a revolution for gold hedging, in our opinion. The Gengold move signals a complete change in the strategic thinking of the South African mining house. Past hedging strategies were very limited and were carried out by head office. The price protection afforded by these programmes was doled out to a few of the group's mines. But for the most part the mining houses simply counted on the steady decline in the value of the rand to give them price protection. Now we detect a most welcome change in thinking. The houses seem to be looking at the financial needs of each and every one of their mines and are looking at custom-made programmes for each one. Many of these programmes will, we think, forgo some of the 14 per cent contango the South Africans enjoy to pay for call options which will allow the mines to participate in a good part of any reasonable price rallies. This will please the bulls and should keep all the shareholders happy.
So, at some point in the next 12 to 18 months the market should be faced with as much as 500 to even 750 tonnes of extra hedging sales. This should not be as bearish as it seems, in our opinion, because we expect these "new" hedgers to be very sophisticated and generally adroit in doing the business. But the sales should certainly act as a further cap to the gold price. And all that extra borrowing of gold from central banks to lend to the market to facilitate these new forward sales should ensure that lease rates stay high or even rise further.
How are the Australians and North Americans going to react to higher lease rates? How will it influence their hedging strategies, particularly as they are unlikely to be able to extend the term of their hedges much beyond the five and 10 years that they currently have? Some observers think the answer lies in even more sophisticated option programmes. We are not an expert on options and as such have no strong opinion.
However, our gut feeling is that the new hedging revolution will probably result in an even more stable and narrow trading range than we currently have. We could be looking at, say, a $10 an ounce annual trading range instead of $20 now. If we are correct in this view, then gold consumption should go on rising happily against the background of a nice stable price. This in turn would be good news for the gold miners. But not much fun for the bullion dealers.
What is happening in silver and who is doing it? What objectives do the mystery players have? Do they want to drive prices much higher? Or do they simply want to make a good living out of trading the London and New York markets? Unfortunately, we don't know the answers to any of those questions but, as a minerals economist, we do have some comments to make about the fundamentals of silver.
Once spot prices get much over $5.50 an ounce for long periods of time, Indian demand starts to fall away sharply. Indian demand is very price sensitive. The rupee fell recently by around 11 per cent to a record low against the US dollar. Indian bullion market sources noted at the time that this de facto devaluation will have the effect of cutting silver (and gold) imports into India by between 10 to 15 per cent over the next 12 months. Indian imports of silver in the last few years have been running at around 2,500 tonnes plus annually. That is equivalent to around 17 to 19 per cent of annual supplies. Losing 10 to 15 per cent of such a big chunk of demand will not make for a sustainable bull market, in our opinion.
At $6.00 an ounce and above scrap supplies could start to rise rapidly. Scrap, on the basis of the recent World Silver Survey 1995 publication done by Gold Fields Minerals Services, accounted for 4,121 tonnes or 22 per cent of total supply of 18,637 tonnes last year. The London silver price averaged $5.32 an ounce in 1994. If you added another 12 to 15 per cent to the average annual price, it is not unreasonable, we think, to expect a bit more scrap to come out.
At $6.00 and over an awful lot of primary and by-product producers must start to actively think about selling forward and locking in these wonderfully high prices. No less than 86 per cent of all silver mine supply comes as a by-product from the mining of lead, zinc, copper and gold. Well over half the by-product output has a cost of production of $2.00 an ounce or less. So,
assuming a by-product producer sells at $6.00 an ounce, he is locking in a 200 per cent profit over his cost of production.
Prices at $6.00 plus should concentrate the minds of the Treasury departments everywhere. But there are still far too many silver producers out there, whether primary or by-product, who do not hedge. Perhaps a price spike to $6.00 plus will accelerate their desire to hedge their silver output. GFMS notes in its World Silver Survey 1995 that, whereas around 50 per cent of total western world gold output is sold forward annually, in silver's case "it represents only 8 per cent. But if the evolution of gold hedging is anything to go by, the forward selling of silver could become more widespread."
Incidentally, silver production from by-product operations has risen this year by around 680 tonnes and should rise by another 448 tonnes next year. In 1997, we should see a massive 1,182 tonne jump (mainly from new lead-zinc operations in Australia). So, there is potentially a lot more metal to sell forward.
With silver prices at $7.00 and over, we would expect to see India turn a net exporter. We could even see some silver come out of China.
The bulls, of course, argue that this price rise reflects solid fundamentals and that the supply deficits of past years have finally caught up with the market. We disagree. GFMS's figures show a cumulative net supply deficit of 12,714 tonnes over the five-year period 1990-1994. This is equal to 92 per cent of 1994's total mine output. On the face of it, a very bullish factor. But all of this deficit has been easily met from drawing down stocks in Europe and America. GFMS did not attempt to quantify total stocks held in Europe and North America but did comment that "while stocks on both sides of the Atlantic can still meet any market shortfall for some time to come, they are being whittled away year by year". The bulls focus on the "whittled away" bit of the text while we focus on the "for some time to come" bit.
We think that Andy Smith, Union Bank of Switzerland's precious metals analyst, really makes the most pertinent observation there is about silver stocks. In a recent paper on the market he noted that it was not strictly true to say that silver stocks were "being whittled away, year by year" given silver's indestructibility. "Rather," he said, "stocks are undergoing a huge location swap; from Middle America (selling back its coins) and European dealer stocks (down over 9,000 tonnes since 1990) to India (11,000 tonnes offtake since 1990). With metal loco Punjab wrists and ankles, borrowing costs in London rise."
Ted Arnold is a Metals Specialist at Merrill Lynch Futures Research in Merrill Lynch, London.