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Golden Rules For Mining Company Gold Hedging


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July 26, 2000

Golden Rules For Mining Company Gold Hedging



This short paper, written by Michael Hampton a specialist derivatives trader and adviser, was written towards the end of 1999 when companies such as Ashanti and Cambior had been caught on the wrong foot on their hedging programmes and virtually decimated. It is now being resurrected in the light of the number of Australian junior producers announcing hefty losses on their mark- to- market positions in recent quarterly results.


The aim of the paper is to help companies use gold...


/see: http://www.minesite.co.uk/nc/cnd/minews/si....html?tx_ttnews[pS]=962406000&tx_ttnews[pL]=2678399&tx_ttnews[arc]=1&cHash=9a58b1b74a

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Date : 27 July 2000


Golden Rules For Mining Company Gold Hedging


This short paper, written towards the end of 1999 when companies such as Ashanti and Cambior had been caught on the wrong foot on their hedging programmes and virtually decimated. It is now being resurrected in the light of the number of Australian junior producers announcing hefty losses on their mark- to- market positions in recent quarterly results.


The aim of the paper is to help companies use gold derivatives.hedging in an effective and intelligent way. . Since it was written opinion has moved against hedging in a number of influential quarters, but it will not go away as long as banks demand it as part of development, or other, funding packages. Moreover there are many advantages hedging can bring. If used properly, as with power tools, they can do a job more cheaply, easily, and efficiently than more traditional methods of assuring a company's finances. And again, like power tools; if used wrongly, derivatives can make a serious mess of things.


What went wrong?


The writer has no special inside knowledge of the detailed hedge positions of any of these Australian companies so these comments should not be taken as relating to the situation of any specific mining company. However, press articles and comments from some of the companies do provide a reasonably clear idea of what has generally gone wrong with the gold hedging programs. Specific problems that have been mentioned include:


Timing issues:


Most of the active hedgers amongst the gold mining companies hedge more than a year forward. Some hedge five or even ten years forward. This can create a timing problem because a company which has hedged a relatively "modest" amount, such as 33% of its 500,000oz annual production for the next six years would have a total hedge (1Moz) which is twice as large as any single year's production. Thus, a $50 per ounce move above the average hedge price puts a $50m loss in the hedge book. On the other hand, cash realized from 500,000oz of gold production will improve cash flow by only $25m over the next 12 months. Of course, the loss in the hedge book is somewhat illusory because so long as the gold production comes out as scheduled; the higher price will be more than compensated in increased revenues from the sale of physical gold. However, some companies have clauses in their hedging contracts, which enable their banks to seek additional collateral prior to the actual production dates. Other hedgers may have loaded up their contracts in the early years with the intention of rolling them forward into later years as the hedge contracts approach maturity. In a gently rising gold market, the "rolling forward" strategy will work. In a market with sharp upward move such as the $50 -75 spike seen in only two to three weeks, the required restructuring of maturities would have been virtually impossible to achieve, leaving a serious timing problem.


Margin requirements:


Few companies have a credit standing equal to that of the handful of top tier gold miners (such as Barrick Gold.) Many companies of somewhat lesser credit standing have been forced by their lenders and hedge counter parties to accept margin requirements. The way these work is that if there is a loss on the gold hedge, then some or all of that loss must be paid to the counter party in order to keep the hedge intact. In other words, the lender is not willing to simply trust the gold miner and wait months or years for the gold they have hedged to be produced. After some many years of falling gold prices, many miners may have been lulled into a feeling of complacency over the risk of leaving such margin triggers in the hands of their bankers. While most banks appear to have behaved in a responsible fashion towards their clients, there are rumors that one or two may have been "trigger happy" and asked their clients to come up with more margin money or have forced them to cover the hedges, often at very unfavorable prices.


Asymmetrical hedging:


Falling gold prices had also encouraged another dangerous strategy of what I call "asymmetrical hedging" by which I mean selling two or three times the volume of calls as a company buys puts. For example, an at-the-money $275 Put might be acquired by selling three out-of-the-money $300 Calls. If the price moves down, then the hedge "kicks in" immediately and cash compensation is paid for the price drop. Additionally, the first $25 of upward price move is "cost free" because the strike price was set $25 above spot. The problem arises when there is a price move of more than $25 and the company has to cope with three times as much hedge loss for every further dollar of price protection. Most press comment has not has not properly identified the very negative impact of this particular strategy. After so many years of falling prices it was far too easy to forget the risk of an upward price spike.


Huge expansion of option volatility:


Some of the above problems become even more dangerous when added together with an upward spike in volatility. A company, which has done asymmetrical hedging where the calls it has sold are also subject to margin requirements, is left in a highly vulnerable situation. They may be forced to buyback their calls when the cost of doing so is highest. An example would be a 3 month call which is $25 above spot might yield only $0.30 - 0.35 when it is sold at a volatility near 10%. But when the option is at the money and volatility has jumped to 30%, a three month call with a strike at $300 might cost $15.00 per ounce to buyback, which is 40-50 times the original premium received from its sale. Worst of all is the case where a miner's bank forces the company to buyback the option, realise a very substantial loss, and then the gold price drifts back down. Who is the villain in such a case, the miner or the overly cautious banker? Well, both: since the miner should have considered such "worst cases" when it was implementing its hedge program.


Operational problems


In general, the problems I have described above are those of liquidity and not insolvency. So long as the hedge program does not exceed future production, the gold will be produced to enable the miner to meet his hedging related obligations. But there is one type of problem feared greatly by the banks, the miners and their investors, which is why margin requirements are imposed in the first place- that is, the possibility of an Operational problem. If the gold can not actually be produced or if the cost is substantially above the forecast, then the gold production will not be sufficient to cover the hedge losses. Fortunately, the hedging book problems of 1999 do not seem to be of this type- at least at the point of writing this article.


The "Golden Rules"


In my experience of over ten years in assisting commodity producers in developing their hedge programs, I have developed several hedging rules, which follow:


The Direction of a hedging transaction should be normally the opposite of the overall underlying exposure of the company. In other words, a gold miner shouldn't be adding to its underlying "long" position from mining gold by buying gold calls or forwards. If shareholders want a pure financial play on gold, they can buy it themselves in the futures market. However, this should not rule out the adjustment of the hedges over time.


The Size of a hedge should normally relate to the underlying strategic position being protected and the creditworthiness of the company. Many mining companies attract investors because they represent both a mining business and an "upward" directional bet on the price of gold. If a company sells all of its "upside" by selling forwards and calls, there will be no more upside for investors. Hedging against the downside by purchasing puts is a somewhat different matter. Protection against a fall in the gold price can help assure a company's future by securing a minimum amount of cash flow to pay debt and cover overhead costs. Going beyond this "core" level of downside protection may be a sound strategic decision at times because it may help secure a competitive advantage (so that one company's cash flow is stronger in a weak market than its competitors.) However, a company of middle credit standing must be very careful about the "margin triggers" that it leaves in the hands of its bankers. A hedge that is theoretically satisfactory in the long run is of little use if the hedging company cannot withstand the monthly losses while it waits for the hedge to move back in its favor.


The Risk/Reward should make sense. If combinations of options are used, there should probably be a ratio of exposures which, if prices move the "wrong" way remains somewhere near symmetrical exposure on both the put and call sides of the trade. Otherwise, when the market moves against the hedge (as it is likely to do someday) the ultimate loss in the hedge book may be magnified to an extent that it can endanger the company's viability.


There should be a clear Understanding of the hedging book at senior levels so that the company can measure, monitor and anticipate the extent of its exposure on hedges over a wide range of scenarios (and explain the results to the board if necessary.) The net exposure within the hedge book should be capable of being evaluated within minutes, not days.


There should be a clear Hedging Policy. For example, "trading around a hedge" (ie taking profits and modifying hedge positions) can be a good tactic so long as the amount and size of trading is not excessive and fits the policies and strategies agreed by the corporation's senior management. Many firms in many industries have got into trouble by failing to think through their overall hedging policy.

There should be close Supervision from senior levels of the corporation to make sure that corporate hedging policy is being followed, and that those responsible for risk management have the ability to understand and manage the overall risk management program.

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