COMMENTARY — The benefits of hedging

Mining companies of all sizes are finding that some of the risks of mining can be reduced through the smart use of hedging. Even companies that historically refused to hedge are now seriously considering doing so as they see the benefits.

Hedging requires an understanding of “derivatives,” which are financial products that “derive” their value from that of something else, such as the price of gold or a base metal. One common kind of derivative is a “forward.” This is simply a contract in which two parties agree to purchase or sell a currency, index or commodity for a fixed price at a fixed point in time.

For example, a copper mining company is always concerned about the price of copper going down. The company could enter into a “forward,” typically through a financial institution, guaranteeing the miner the ability to sell a given tonnage of its production for a set price on a specific date in the future.

The mining company will lose the opportunity of gain should the price of copper go up, but it is certain not to lose if the price drops. Effectively, the company is exchanging certainty for uncertainty, improving its ability to meet financial obligations such as capital expenditures, payroll and debt-servicing.

The “spot deferred contract” is a hybrid of the forward contract, and is very popular amongst the gold and silver miners. Like the forward, it offers a set price at a future date, but also the added luxury of deferring its maturity date to match the date when the metal becomes available for sale at the refiner.

Miners also use spot deferred to push off low-priced contracts into the future in order to take advantage of higher current spot prices. Remember, precious metal forward prices are typically higher than spot prices (US$15-20 per year in the case of gold), and can ultimately result in a very attractive price, if you roll the contract out far enough.

While forwards and futures are seen as firm obligations, they do have a less restrictive relative, namely the “option.” This gives the buyer the right, but not the obligation, to proceed with the transaction. A “call” option gives the holder the right to buy, and a “put” option gives the holder the right to sell, a specific quantity of an asset for a fixed price during a specific period. A miner would usually be interested in buying the latter.

Some mining companies have chosen to enter into option combinations, such as “collars.” These essentially offset the cost of purchased put options with revenue raised by selling call options. This creates a range of possible hedge rates.

Another kind of hedging that has been popular in recent years is the metal loan, typically gold. Simply put, gold bullion is borrowed from a bank and sold to raise money to develop or expand a mine. This is carried out because the cost of borrowing gold is much lower than the cost of conventional financing. Also, banks are comfortable offering gold loans to miners who can repay principal plus interest out of production.

Many refiners have chosen to add hedging services to their traditional metal services offered to miners and consumers. Banks are another option, by which we mean any of the majors or investment bankers that specialize in derivatives. If your needs turn out to be particularly unique, banks have strong resources to create customized strategies.

Before getting involved in derivatives, it is important to remember that they do carry risk. To help make sure that the only explosions in a mining company are at the rock face, we recommend that the top-most reaches of the company learn the risks and formulate policies for hedging strategies.

Directors would be well-advised to establish a risk management committee made up of board members and senior management. As the financial environment is constantly changing, there should be periodic independent reviews by the internal audit department or external consultants. Also, the risk management process should incorporate a concrete method of evaluation.

— Michael Smyth is a senior manager with KPMG in Toronto, and is formerly vice-president and treasurer of Lac Minerals.