Research Capital asks: Why pick on Barrick?

In a recent report titled Why is ABX the Lightning Rod on Hedging?, Toronto-based mining analysts Barry Allan and Steven Greene of Research Capital take a timely look at the gold-hedge positions of the three leading North American gold producers: Barrick Gold (ABX-T), Placer Dome (PDG-T) and Newmont Mining (NEM-N).

First, the analysts present some raw statistics:

q Barrick has 19.2 million oz. of gold hedged at an average price of US$342 per oz. At a gold price of US$350 per oz., which is Allan and Greene’s long-term assumption, Barrick’s committed hedges total 17.9 million oz., representing 21.7% of its reserve base of 82.3 million oz. Thus, as Barrick expects to produce 5.3 million oz. gold in 2003, its committed ounces at US$350 gold account for about 3.3 years of production.

At a gold price of US$350 per oz., the gross book cost (in lost opportunity) of Barrick’s hedge book is calculated at US$174.2 million.

q Placer Dome has 17.7 million oz. gold hedged at an average of US$364 per oz. so that, at a US$350-per-oz. gold price, the hedge book produces a net gain of US$367.3 million.

Placer’s committed ounces at US$350 gold comprise 12.1 million oz., or 23.3% of its 52.1 million oz. of reserves — the highest percentage of the three — and would consume 3.6 years of Placer’s 3.4 million oz. of annual production (2003 estimate).

q Newmont has the smallest hedge book of the three, with 9.2 million oz. hedged at an average of US$323 per oz. At US$350 per oz. gold, Newmont’s committed ounces total 5.2 million oz., representing 6.3% of its industry-leading reserve base of 83.2 million oz.

At a US$350-per-oz. gold price, Newmont’s hedge book has a gross book cost of US$210.1 million — a sum worse than Barrick’s.

However, as the world’s largest gold producer, Newmont expects to mine 7.2 million oz. gold in 2003, meaning its committed ounces at US$350 per oz. gold cover only eight and a half months of production.

“It is clear that Placer’s hedge position is the most robust of the three, producing net gains [additional revenue] up to a gold price of about US$374 per oz.,” write the analysts. By comparison, Barrick’s and Newmont’s hedge books start to incur an opportunity cost [lost profits] at gold prices of US$340 and US$312 per oz., respectively.

However, when spot gold prices rise US$25 per oz., Allan and Greene calculate that Placer’s change in gross value per outstanding share is the greatest (a decline of US89 per share in the form of opportunity cost), followed closely by Barrick, at minus US87, and Newmont, a distant third with a decline of US36 per share.

The analysts conclude that it would be difficult for Barrick or Newmont to close their hedge positions before maturity without incurring a significant loss, and they expect each company will only close hedges by delivering against the contracts without re-establishing the positions.

Placer is in a unique position, Allan and Greene believe, because theoretically it could have closed its entire position at the end of the third quarter of 2002 without incurring a loss. Still, they “seriously doubt” Placer will close out its position in advance.

It is perhaps worth noting that the gross value of Placer’s hedge position at US$350 per oz. gold is actually greater than its market capitalization (115% of its market cap), compared with Barrick (73%) and Newmont (14%).

Hybrid instruments

Things get more complicated as Allan and Greene try to determine the three companies’ committed hedge positions at various gold prices. They concede that a flaw in their analysis is their treatment of convertible and contingent options and contingent forward sales. These are generally referred to as “hybrid” instruments, and often come in the form of a derivative on a derivative.

The analysts caution that a hybrid “suffers from huge amounts of optionality and is prone to significant swings in market value,” adding that optionality is “another way of saying ‘market uncertainty and exposure.'”

They state that since it is impossible to know from publicly available information how these contracts will fare at various gold prices, it was necessary to make a “harsh judgment” and assume that hybrid contracts are committed, but at unfavourable terms.

Calculating hybrid contracts as a percentage of reserves, the three companies rank thus: Barrick has no hybrids; Newmont’s 1.5 million oz. of hybrids make up 1.8% of reserves; and Placer’s 4.4 million oz. of hybrids constitute 8.5% of reserves.

They further note that hybrid contracts typically constitute most of the negative market value embedded in a hedge position. For example, 40% of Newmont’s year-end 2001 market-to-market loss on its hedge book was related to hybrids, even though they accounted for only 17% of hedged ounces.

Furthermore, Allan and Greene expect Placer’s 2002 year-end disclosure “will be consistent with Newmont’s experience, illustrating that both Newmont and Placer have a greater degree of volatility in committed ounces and average realized gold price than Barrick.”

They argue that Barrick’s hedge position is “less complex and less exposed to changing market conditions than either Placer’s or Newmont’s.” This assessment is based on the type of instrument Barrick uses (spot deferred, with limited option contracts and no hybrids) and the level of disclosure regarding the terms under which the hedge operates (effective realized prices).

In a nutshell, Barrick has the most ounces hedged and Newmont has the least; Placer Dome has obtained the best price for its hedged ounces, and Newmont, the worst; and Barrick’s hedge book is the least volatile, while Placer’s is the most.

Allan and Greene conclude by stating that “Barrick’s hedge position is less risky [contains fewer uncertainties] than its peers, [and] we fail to understand why the market is penalizing Barrick for it.”

The full text of the report is available at www.researchcapital.com. A related article, In Defense of Gold Hedging — The Case of Barrick, by British Columbia-based gold authority Martin Murenbeeld, can be found at www.murenbeeld.com.

Data from Research Capital