The Folly of Hedging

The rationale for hedging is faulty on several counts. The central justification was that hedging would add predictability to cash flow by dampening the influence of fluctuations in the gold price on corporate revenue.  A neutral stance on gold prices became popular among the post 1990 industry leadership.  Advocacy of gold within the mining industry has diminished to near silence.  Under the hedging regime, the principal financial metrics used to evaluate company performance became cash cost and total cost of production, not return on shareholder\'s equity or an accurate view of reserve replacement cost.  The new metrics positioned gold mining as a spread business in which the primary task of management was to execute cost control procedures once price had been locked in. In this way, the leading companies were portrayed as “growth golds,” a politically correct and inoffensive way to tout the group that did not clash with the prevailing bullish macroeconomic views underpinning the bull market in financial assets.  The thought that hedging might play an important role in depressing the gold price received little consideration.  The possibility that neutralizing a mining company\'s exposure to the gold price might undermine the valuation of its shares received even less.

Goldfields Mineral Services (GFMS) in its Gold Survey 2000 concludes that industry costs declined 5% to $197/oz and total costs to $257.  In light of the average spot price of $280, before enhancement by hedging profits, a $23 margin of 8% after all costs might imply that mining gold is a profitable, if not thriving industry these days.  GFMS portrays an industry that is driving down costs in a tough market.  There is an implication that productivity enhancements can drive costs still lower, and that therefore, the price of gold itself will follow this decline curve.  It is this sort of misguided analysis that has provided bullion dealers with their intellectual rationale for a bearish stance on the gold price.

In fact, the industry is downright sickly.  We think that the industry is gutting its productive capacity by high grading, getting behind on development, squandering financial resources by keeping marginal properties afloat, and drastically reducing exploration expenditures. What prolongs these ill-advised practices long beyond what would be tolerated in any other industry is the unique ability to fix forward selling prices to guarantee (in theory) the spread over projected cash costs.  However, there is no guarantee against unforeseen production shortfalls or cost overruns due to labor problems, faulty mine plans, unexpected cost changes, extraordinary items, changes in taxation, or issues related to sovereign risk.  Hedging limits the upside price swings that the mining industry once depended upon to offset these risk factors.  Positioning a risky, capital-intensive endeavor such as gold mining as a spread business, similar to a bank or insurance business model, is ludicrous.  In so doing, many producers, and especially the financially weaker ones, have taken on a form of hidden financial leverage due to their inability to generate capital internally or enjoy normal access to capital markets.  For them hedging was a bargain with the devil that allowed deferral of difficult operating decisions, thus prolonging a state of limbo which precluded prosperity by diminishing the single variable which could restore financial health, a much higher gold price.

The total cost figure used by GFMS is not intended to be reconciled to producer income statements as it does not include corporate SG&A, interest and financial items, exploration costs, or taxes.  If one adds these items, the cost per ounce figure would increase by $25-$30 for the typical producer, or approximately the current price for gold and the average at which it traded in 1999.  Adding in some allowance for even a feeble return on capital would boost the per ounce requirement to well over $300/oz.  The reality to which cash cost and total cost analysis are blind is that the gold industry is barely breaking even in the current market environment.  It cannot attract new capital except on a very project specific basis. Not only is the industry as a whole incapable of expansion, it is hard put to replace its reserve base.  The habitual squandering of capital enabled by hedging has long since passed the point that would guarantee a downturn in production if gold prices do not improve, and even limits a significant increase in production if gold prices rise substantially.

Few mine company executives seem to grasp the importance of the relationship between the cost of replacing reserves and hedging decisions.  In our view, that cost is well above the market price, probably in the range of $350-$360/oz on an industry wide basis. While annual reports and financial presentations of gold producers focus on cash cost per ounce, or total cost to produce, almost no company that we are aware of considers replacement cost in the context of hedging.

The following table, which contains information provided to us by a major international gold producer, shows a selection of new projects and the gold price they would require in order to generate a real return on capital of 10%.  Notable is how few new projects fit into the \"superlative\" category with cost characteristics that allow profitability within today\'s price structure.  Their total reserves of 47.8mm ounces (a figure which of course is likely to grow) replace less than the entire industry\'s annual production.  More than 80% of new mine projects, some of which are represented in this table, require a gold price on average of $333/oz, well above today\'s trading range.  These figures do not include discovery costs, either the exploration or acquisition cost of the property.  A very conservative across the board estimate would be $25/oz, resulting in a total replacement cost for new ounces approaching $360/oz.  Numerous corporate acquisitions in recent years would place this figure far higher.  A continuation or worsening of gold prices would force a contraction of mine output in due course.  In that incremental hedging would prolong a weak gold price environment, the industry would be hastening its demise.  The preponderance of price realizations generated by the industry hedge books are well below $360/oz.

Economics of New Mine Projects