MINING & OPINION – COMMENTARY — Gold hedging here to stay

Although hedging by gold mining companies has had a relatively short history, it has reached a position of great significance, and not just to producers. Nowadays, any potential investor, any dealer in gold bullion and even central bankers need to have a clear understanding of what the hedging industry has to offer and how it affects the gold market.

Hedging products are financial instruments that have been developed by the banking and dealing community. There are three categories of hedging instruments.

The first is the gold loan. A producer, in effect, uses the collateral of the mineral reserves it owns to borrow gold, usually from a central bank or other counter-party. The gold is sold to generate dollars to finance a new project or pay down other debt. At the end of the loan, the producer must pay back the original loan plus the interest accumulated. This brings us to a most important term — the gold leasing rate, which is simply the annual rate of interest applicable to such a loan. The higher the leasing rate, the less attractive the gold loan will be to a producer. In general, the leasing rates have been well below the cost of borrowing money. Metal sold represents an additional supply to the market, often called accelerated supply. When the loan is substantially repaid, the transaction represents demand in that gold that is produced does not come on to the market but instead goes back into the bank vault.

The gold leasing rate is also an important factor in the second of our three types of hedging product: the forward sale. Here, a producer wants to fix the price of gold it will deliver in the future, so it arranges a deal with a bank, which, for a fee, guarantees the price to be paid on delivery. The forward premium is essentially the difference between the interbank cost of borrowing dollars and the gold leasing rate. The greater the difference between the leasing rate and dollar interest rates, the better it is for the producer. Because the counterparty actually finances the forward price offered to the producer by borrowing and immediately selling gold, this product has a market impact similar to that of the gold loan.

Our third category is the option. To use the classic phrase, this gives the holder the right, but not the obligation, either to take delivery of the gold or to deliver it at a previously determined price. For this right, the holder of the option must pay a premium. Options come in two forms, the put and the call. Options also have an impact on the market because counterparties keep their exposure to price movements neutral by either borrowing or selling gold or by buying and lending it. For instance, if a counter-party bank has sold put options to a producer and the market price then falls, the bank can expect to be taking delivery of some gold when the producer exercises his right to sell. The bank will therefore maintain an overall neutral position by selling a corresponding quantity of gold.

To understand how hedging has been affected by low prices over the past year or two, we need to know how producers make use of hedging. Financing new production is probably still the major use for hedging, essentially replacing the gold loan as a means of financing new or expanded production at low cost. Hedging can also be used to replace conventional debt or equity, or for fixing the price of gold that has not yet been produced by mines.

Although some refuse to accept the fact that hedging results in borrowed gold being sold, there is really no doubt that this is what happens. Gold Fields Mineral Surveys, for instance, calculates that in 1997 about 18 million oz. gold were sold in this way, as a result of hedging. In the first half of 1998, it estimated that a much more modest 3 million oz. were sold.

The way the price of gold is perceived is one of the main factors influencing producers’ tactical decisions to increase, reduce or re-structure their hedge positions. The bullion price plays an absolutely central role in determining the scale and type of hedging associated with operations right at the project finance stage.

The low gold price has made it much more difficult for mining companies to attract equity finance for projects. Also, it is pretty obvious that sponsors are going to need to use a relatively high proportion of debt to get their new operations going. But in this environment, lenders are also much more wary of lending gold to the private sector. Above all, they need to be confident that the project’s cash flow will be able to repay the debt. One of the ways of doing this is by hedging a proportion of the first few years’ output — and the lower the price, the higher the amount of production that needs to be hedged.

However, although the companies that have used hedging facilities wisely have undoubtedly benefited from the practice, hedging may continue to deter investment in physical bullion, owing to the perception that it will ultimately cap any substantial rally. But hedging is not going to go away. It will remain very much a part of the gold industry in coming years.

— The preceding is from a speech by the author, president of Washington, D.C.-based The Gold Institute, at the Northwest Mining Association’s annual general meeting in December 1998.