Trends in Risk Management for Gold Producers
The storm of extreme gold market conditions that struck in September 1999 caught many producers and bullion banks unprepared. As the storm abated, the next twelve months were spent either fighting or cutting back hedge positions, toxic or otherwise. Eighteen months later the Gold Survey 2001 published by Gold Fields mineral Services Ltd. (GFMS), points out that despite produce buy backs and withdrawal from hedging during much of 2000, overall the current size of hedge books is almost the same as it was at the end of 1999. What the raw numbers do not reflect is the corporate and portfolio changes that have been put in place over the period.
Both producers who had hedged against adverse gold price movements and those who had not realised that they were achieving disappointing financial results and share price performance. In addition, specific lessons were drawn from companies which had sailed close to the wind and were almost overturned by the extreme market conditions in the fourth quarter or 1999.
Since poor conditions seem set to continue, many have taken further precautions, but we cannot say that all gold producers are well prepared for more market turbulence.
Emphasis on Good Corporate Governance
In our business in South Africa and elsewhere, we have noted a greater awareness amongst a wide range of companies of the principles of good corporate governance, which in general are being applied. This is more than a cosmetic exercise - we can see it in the workings of company audit and risk management committees and in the appointment of more independent directors with sufficient ex1Jertise to critically review the treasury division on an ongoing basis (usually reporting to the risk management committee).
In the past, there were instances where the treasury was a law unto itself or where treasurers acted outside a loosely agreed mandate. We increasingly now see that treasurers and boards simply do not feel comfortable without a properly defined treasury mandate. The mandate is approved by the board and usually sets out in general terms the role and objectives of the treasury division. This trend is more than just a reaction to bad practice - it demonstrates that the task of risk management is a corporate-level responsibility.
We have detected much less emphasis for the treasury to be a profit centre - instead, the focus has shifted to more efficient cash flow management and control of" market risks. More restrictive treasury and hedging policies have been implemented. Boards of companies have become wary of proprietary or incentivised trading activity. A by-product of this trend is that it has become more difficult for companies to remunerate and retain good people.
Companies have by and large consolidated the exposures of wholly owned mines, driven by both the efficiencies of a combined book and the higher credit charge imposed by banks on individual mines.
Producers today are more risk-averse, resulting in a significant fall in the volume of exotic products and complex structures transacted. This is not simply because gold producers are rejecting them out of some irrational fear, but rather that they now try to evaluate proposals better and are more aware of the risk/reward ratio. Producers do not want to enter into very complex transactions where they cannot easily price the products themselves or obtain independent pricing, and where spreads are wide and there is insufficient liquidity if they wish to restructure at some stage.
Despite the general risk aversion, only a few companies have tried to analyse the role risk management should play - within organisations - in great depth. Few have decisively opted for pure risk mitigation or for a more strategic risk-taking strategic role. And there are instances where risk mitigation and profit motivations have been combined(and sometimes confused) incorporate hedging programmes or where decisions have been influenced by more subjective market-oriented considerations and objective risk management criteria were put to one side. There are still occasions when strategic (risk-taking ) positions are put on and treasuries do not have a robust framework of stop-loss and Value-At -Risk limits to manage them.
Of course, gold producers cannot control the international price of gold. The disappointing results of last year's hedging standoff have led many companies to take a less emotive view of hedging. More companies are now guided by their strategic financial and operational parameters and the specific objectives of key corporate stakeholders. The public statements that several companies made last year claiming that they would not add to their hedge books do not preclude them from doing so now. Indeed Placer Dome has reviewed its strategy for 2001 and Rex McLennan, Executive Vice - President and CFO, recently announced: "Our forward sales program remains an integral component of our financial strategy".
The GFMS Gold Survey 2001 estimates that net producer outstanding positions did contract slightly in 2000 [graph-fig. 42 GFMS]. At Standard Risk and Treasury Management (SRTMS) we believe that the drop in hedging during the first three-quarters of 2000 was not the start of a trend, and that producers will hedge when they feel it is necessary.
Since the beginning of this year, the majority of large gold hedge transactions have been driven by project debt financing. Given the current low gold price and cost/difficulties in raising funds from equity or bond markets, we anticipate that this trend will continue for less robust companies.
Not enough companies have an accurate estimation of the true cost of transaction spreads and embedded credit and administration charges. The gold contango is generally argued to make hedging economic, but longer-dated transactions involve greater costs and these are not transparent to less-sophisticated risk managers.
Producers want to be able to participate if the gold price rallies: they still feel the need to give investors some blue sky. Jamie Sokalsky, Senior Vice President and CFO of Barrick stated in February this year, "We offer investors a minimum floor price for the gold we produce, with the flexibility to participate in rising gold prices".
There needs to be a direct relationship between the company's market risk strategy, its broader financial strategy and the overall corporate strategy. Too often this is not in place and we see treasuries struggling to get Board approval in time to take advantage of market conditions.
Producers are keen to address the concerns of shareholders and potential investors. They have to contend with negative and contrary perceptions ranging from the view that commodities are high risk to the view that gold hedging destroys value. Companies need to communicate better to investors the connection between their market risk management strategy and other aspects of the financial/corporate strategy. Financial disclosure alone cannot do this.
Only a few producers have been able to transform their market risk management capability into a core value proposition to investors.
Overall, we see a better correlation between the level of protection and production risk. Spot deferred contracts can help producers to manage this risk. However, the events of 1999 demonstrated the exposure many companies had to margin calls by bullion banks. Consequently, several producers have moved with unimagined lines or participate level of commitments (that make mark to markets volatile).
In the past more attention was given to US dollar gold price exposures and not enough was given to interest rate and currency risks. With the low US dollar gold price and volatile foreign exchange markets, we have seen some producers - predominately involving Australian dollar and South African rand - place a much greater focus on local currency risk.
The US accounting standard on derivatives, FAS133, has led to a more disciplined execution of hedge transactions to make their bona fide hedge status apparent. Because of their profit-making intent., strategic positions are taken directly to the profit and loss account on a mark-tomarket basis. FAS133 has also contributed to a more critical approach towards exotics even among producers who do not report on a US basis. It has in addition affected the decision to transact and the amounts and instruments used. But there is still some confusion about the practical application of the new accounting standard and there is no consistent or concerted industry response as yet.
A large number of African mining companies have now outsourced all or part of their treasury function - a number of these form an important part of SRTMS's client base.
Does outsourcing mark the start of a trend - or is it just a regional phenomenon? These gold producers have decided that the treasury operation is not a core competency and are motivated both by the ability to reduce and manage costs better and the need- to access world-class systems and expertise. There is an acute skills shortage its South Africa, and this has affected the mining industry. However, the problems of retaining staff and properly resourcing the treasury and risk-management areas affect the industry globally - all the more so when revenues are under pressure and market risks continue to be high. In a recent non -industry-specific article; Timothy Smith of the Amega Group says that "outsourcing the finance or accounting function is the fastest growing outsourcing trend". This trend is now evident in the gold sector, and we are of the opinion that it will become more commonplace.
Technology - No Single Solution
We have not seen a trend towards the adoption of any single technology. provider for gold treasury risk measurement. There is a wide range of tools on the market and a few adequate- in-house systems as well. Despite this, we note that producers continue to experience costly time delays with modifications to new systems and that the implcmentatio1i of systems and that the inputting of new or exotic products continue, to be problematic. But the real problem is that even. the most sophisticated risk calculation tool is just a box - and consequently useless without the human expertise needed for interpretation. The true value comes from the understanding of inputs and the interpretation of OL1tvuts.
In today's markets, the obsolescence factor for risk calculation tools and methodology is high but the searing events of 1999-2000 taught gold producers that it is critical to be well resourced in terms of technology and expertise. The banks are the leaders in this area but the mark-to market reports and other data they issue to clients are insufficient to enable proactive risk management. Producers do need their own accurate data or access to an independent reliable source focused on their requirements.
A number of dot.com companies have tried to sell Internet risk measurement tools to the commodities sector, but we have seen little take-up by large-or medium-sized gold producers. Companies are reluctant to download sensitive financial transaction details or to trust the accuracy of the analysis.
Across the market, there has also been a realisation that conventional reports need to be analysed in greater depth. Some key limitations are:
- The overall portfolio mark to market does not reflect offsetting positions with different bank counterparties - and this can be critically misleading.
- Models can significantly over - or underestimate the close-out cost of transactions, particularly when markets are volatile
- Rates inputs to modelling tools are critical to the correct pricing and analysis of sensitivities and are not easily obtained for longer maturities
- Sensitivity analysis must matrix all the financial inputs against each other
- The availability of scenario analysis ("what if") tools and technical' and financial expertise are critical when looking at the structuring of a hedge portfolio
- The sensitivity of a portfolio in different time buckets (and not just as a whole) to market movements has long been overlooked but can be critical when analysing a portfolio and the approach to possible restructures.
Producers have had to review, the liquidity and term characteristics of -the gold market as these appear to have changed. Recent movements and volatility in currency interest rates and gold lease rates have highlighted the need for sophisticated risk-measurement tools that quantify the sensitivity of complex portfolios, and the complementary value, that human expertise brings.
In this article, we have identified trends in the way gold producers manage exposures to financial market risks. The opinions expressed are our own, made from our observations from our involvement with gold producers around the world. While no one single or major trend has emerged, in general, we have definitely seen a significant change in the approach to risk management and in the quality of its execution. There is now a greater awareness of what risk management entails and greater importance attached to it, resulting in a number of improvements.