The Hedging Debate: The Ayes Had It
To hedge, or not to hedge, that is the question- Whether 1tis nobler in the mind to suffer the swings and traumas of outrageous volatility, or to take out protection against a sea of speculators...
Offering his own version of Shakespeare's Golden Rule, Alan Baker of Deutsche Morgan Grenfell and LBMA Chairman introduced the first LBMA Debate. The international panel discussed the Motion "This house applauds the practice of hedging by gold producers ".
The Michelangelo Hotel, Sandton was the venue for the Debate, which was followed by a cocktail reception for the guests, who came from a wide cross-section of the mining, investment and dealing fraternities. It formed part of the 20th Annual Investment Conference of Societe Generale Frankel Pollak to whom for their encouragement and help the LBMA is much indebted.
Alan introduced the speakers: Stewart Murray (Gold Fields Mineral Services) to set the scene, Kelvin Williams (Anglo American Corporation) and Guy Manuell (Normandy Mining Limited) proposing the Motion, and Graham Birch (Mercury Asset Management) and Brett Kebble (Randgold) opposing.
Alan suggested three thoughts on the concept of hedging:
- The dividing line between hedging and speculation is a thin one.
- Not to hedge is to speculate.
- It is not always necessary to hedge but sometimes it is foolish not to.
He concluded by describing why hedgers in the gold market find themselves in a unique situation: while other metals can be analysed in terms of the fundamentals of supply and demand and the external economic situation, in gold a wild card exists in the deck - the stocks held by central banks, whose intentions remain clouded in mystery. It is these stocks which provide for probably the most efficient hedging and financing facilities in the world of commodities.
Setting the scene
In painting the backdrop Stewart Murray commended the LBMA for the timing of their Debate since over the two previous years we had seen, in 1995, an unprecedented supply from producer forward sales and, in 1996, an unprecedented fluctuation in producer positions with, over the year, little net change. Claiming to be daunted by addressing such a gathering of specialists, he drew comfort from his role as the bean- counter of the international bullion market.
Murray provided a brief history of hedging: the modern version dates from the early 1980s and as the years passed expanded in both volume and types of products. Gold loans were followed by forwarding sales, which were in turn followed by options in all their wondrous flavours. These products fulfil the differing needs of all players involved. These he saw as financing new mine production;
- fixing the future price of gold not yet produced;
- interest income for lenders, i.e. mainly central banks, and
- revenue for bullion banks and dealers.
Murray then contrasted the contangos present in the gold and silver market over recent years with the almost continuous backwardation in copper and noted the considerable differences between short - and long-term gold leasing rates. He noted the difficulty producers face in deciding whether to go for fixed or floating lease rates given the side volatility of rates and the difficulty of matching the producer's preference for a long -term arrangement with the central bank lender's usual reluctance to lend much beyond one year. This potential mismatch provided the bullion bank with a vital role in intermediating between the ultimate borrower and lender and ensuring that short -term positions could be rolled over to provide the long-term cover sought by producers.
In concluding Murray described the impact of hedging on the spot physical market. The existence of some 30, 000 tons of gold in central bank reserves made gold hedging very different from that of any other metal. It was the willingness of the holders of this gold to lend their metal cheaply which had underwritten the steady increase in hedging positions over the past decade or more. As a result, he noted, some of the gold stated as being held by central banks was, in fact, hanging around the necks of ladies in the Middle East or India. GFMS estimates showed that world forward selling positions had taken off from a negligible level in 1984 to around 1,700 tonnes in each of 1995 and 1996, with Australian, North American and South African producers all prominent.
For the future, Murray found it difficult to judge whether the hedging business had reached a mature position and was therefore likely to level off. One pointer, however, was the still large proportion of central bank reserves unattached to hedging programmes. What his view was clear, was that gold hedging would remain substantial and interesting.
In proposing the Motion, Kelvin Williams set out to refute the arguments used by anti-hedgers. First, hedging was not speculation, he said, but the converse. It was a modest locking in of the return on the massive capital investment made to acquire access to reserves. For the majority of gold producers, hedging was seen as a fundamental tool - and only one among many - for managing financial and market risk.
Secondly, there were many reasons for hedging and they were often mine -specific. There was the obvious benefit of the price leverage obtained through the contango, there were the benefits of being able to manage one 's price rather than be a passive price-taker, there were revenue and budget certainty, profits and dividends could be smoothed, capital expenditure programme could be protected from interruption or abandonment owing to a fall in the gold price, the cost of capital could be lowered as banks were offered the security of a known sales price and revenue flow, and in areas like South, Africa producers could provide greater security for all stakeholders through continuity of operation.
Thirdly, Williams turned his guns on those who expressed concern about the negative effect of hedging on the gold market itself and the depressive effect on the supply/demand balance of bringing forward future physical production to current market supply. This, was a superficially sound, but mistaken argument since price movements were more often than not influenced by players other than the gold producers.
Williams went on to criticise those who thought that the natural movement of the gold market was always upwards. It may have been true once, but was no longer the case. The current market was more liquid and like most markets was two-way. Price rallies today, therefore, were more likely to be stopped out by the absence of follow-through of investor and speculator buying or by profit-taking by those speculators; physical demand very soon dried up at higher price levels, and central banks could acid to the dampening effect as short call option positions moved into the money.
Why did not the critics of hedging, therefore, also direct their fire, if their ambition was to remove a hypothetical price page 10 cap, on to the central banks, the IMF, most Middle and Far Eastern holders of gold investment instruments, floor dealers on Comex and fund managers in the developed markets? It was significant, he claimed, that when in late 1995 and early 1996 three major North American producers adopted the exact course advocated by the critics of hedging and bought back millions of ounces, it made no difference whatever to the price of gold.
Williams also asserted that the idea that investors were not enamoured of companies that hedged was mistaken. The evidence suggested otherwise: the share price of the I 0 or 12 largest hedging producers in Australia had outperformed the ASX gold index by a substantial margin.
In opposing the Motion Graham Birch set out his stall as the successor to Julian Baring who had started MAM's well -known campaign against hedging. He was, he said, happy to take up the cudgels and oppose what he called "this deplorable Motion". He firmly believed that the effect of hedging on the gold industry was like drug addition: it gradually took a firmer grip and it sapped energy. There was only one cure: cold turkey.
Closeout the speculative gold hedges today and practically every mining company could walk away with a profit. Would they do it? Sadly, he thought not. It was hard to give up when you were ahead. But, he warned, it was even harder when you were down - a position that few miners had experienced in the Golden Contango Casino.
Birch sought to dispel the view that hedging had no depressant effect on the market. He cited in evidence several analysts quoted in Alchemist No. 6 who all saw hedging as a contributory factor to market weakness. The most alarming part was that producers were selling more and more of the gold not yet produced at lower and lower prices - the action of an out-of-control gambler and creating a dangerous dealing house environment in which the "double or quits" culture appeared to be rewarded. Were there, he asked, adequate controls in place to prevent reckless trading?
Birch next criticised the complexity of so many hedging programmes, which was such, he claimed, that not even the directors of the hedging companies could understand all their ramifications. He cited one example where it was impossible for investors to understand the hedge details; they, therefore, decided it looked too risky and sold the shares, which duly plummeted.
He also criticised the producers who were happy to lock in low prices at a profit margin of, say, only $50/ oz above costs, when investors had to pay, say $100/ oz above costs for gold in the ground. That was as much fun for investors as tearing up £10 notes under a cold shower. The more gold that producers pre-priced at low levels, the surer the investor became that he was unlikely to see a return, so he sold his shares.
A further worrying portent was that to justify the economics to their bankers, producers were having to hedge further and further forward: 12-year deals were now commonplace - scary stuff, especially when one realised that most of the directors who signed the contracts today would be safely retired when they matured.
Birch next sought to counter the miner s' claim that hedging provided revenue and budget certainty. A delusion, he claimed. If the price of gold fell during construction of a project so that the mine was no longer viable, then it was no longer viable, however, much hedging was in place. In his view, if a project could not withstand a period of low prices it should remain undeveloped.
Looking to a possible ghastly vision of the future, he saw gold mining companies laying the foundations for an almighty bull market in hedged metal. Prices could rise to where the losses on hedge books became significant. Lending banks could begin to pull the plug, central banks could become nervous about lending short to bullion banks who had lent long to the mining companies. Gold interest rates could soar, institutional investors could pile into gold for the first time in a generation. What option would that leave to the management of a hedging company other than to make for the nearest window -sill?
Birch concluded by seeking to persuade producers to reverse their hedging strategies to their own advantage (the gold price would rise, or a low gold price would make them leaner and fitter, they would face less risk and would be more attractive to investors, so that the cost of capital would fall). And he suggested that investors should demand that mining companies should cat their cold turkey, take their profit while it was there and propose that all hedging programmes should mature before the Chairman's retirement date.
Next Guy Manuell spoke in support of the Motion. Whereas Kelvin Williams had sought to refute the arguments of the anti-hedgers, Manuell's aim was to put the positive arguments for hedging.
These were the familiar ones of:
- enhanced revenue and budget certainty
- revenue predictability enabling stock analysts to make more informed comment on profitability;
- additional revenue allows more exploration and faster development;
- continuation of profit s and dividends;
- otherwise, uneconomic ore can be mined or low -grade ore such as tailings can be processed;
- in the event of a fall in the gold price, revenue from hedging can meet the high cost of closing a mine or putting it on a care and maintenance basis;
- the creation of employment in corporate treasuries and bullion dealers.
Hedging, said Manuell, was not speculation, which was risk-taking. It was, on the contrary, risk-management. He concluded by waving a headline from that day's Australian Financial Review: "Normandy hedges pay off in profit rise". He rested his case.
Finally, Brett Kebble, in support of the opposing Motion, said investors bought gold shares because they sought exposure to the gold price, not to an arcane hedging policy. Producers who hedged put themselves in the hands of the bullion banks and dealers, the highly-paid bears who made the most money out of the gold industry. Randgold did not hedge and it out-performed hedged mines such as Western Areas, Freegold and Beatrix. ln Kebble's view, it was cheaper to issue equity than to engage in hedging schemes and the gold price would be higher in the absence of hedging. He concluded by echoing the Shakespearean tone with which Chairman Alan Baker had begun: "Alas, poor Barrick ..."
When the Debate was opened to the floor the first on his feet was Bill Nairn, Chairman of Western Areas. He disagreed fundamentally with Graham Birch: he knew precisely what his hedging strategy was all about. His South Deep system required $2.7billion for a 7-year project. Hedging was the way to raise that sort of money: it could not have been raised in the equity market.
John Brownrigg, MD of JCl's gold division, pointed out that Brett Kebble's Randgold had out-performed non-hedgers more than hedger s. Anglogold's Nigel Sutherland argued that gold, like any other commodity, was cyclical. A relatively small hedge kept a mine and reserves in play during bad times and enabled them to take advantage of the spikes. Guy Manuell came back with the statistical fact that since 1980 the 5-year contango had been such that maturing hedges were invariably above the spot price a clear indication of a relatively short -term hedging programme.
The Final Vote
Ultimately, after two-hours of debate and due consideration of all the arguments, the audience of about 110 voted 66-16 in favour of the Motion. The debate was lively, but never rowdy, and we are extremely grateful to our speaker s for their contributions and to our audience for their participation in a timely debate on a topical subject. There are many enbenched views on the issue and it is doubtful if any of them were changed by the arguments presented. But we at the LBMA saw value - and we hope our audience did as well - in bringing the many-faceted arguments on both sides into sharper focus in a single public forum. The fact remains, of course, that there is no one answer: the decision to hedge or not to hedge depends on a wide range of variables which are specific to companies, to areas and individual mines, to time and to a whole range of financial and gold market factors