Commentary — The mystery of hedge pricing

Future metal hedging prices offered by investment bankers to miners are not dreamt up out of thin air. Precious metal hedge pricing is actually fairly straightforward and based on some sound principles.

To start with, precious metal miners are in the fortunate position of being able to borrow gold and silver quite cheaply, and have been doing so for many years. These loans are available because the world’s central banks are now trying to earn income on otherwise idle bullion inventories, and they perceive a relatively low credit risk associated with bullion loans to high-quality investment banks and producers.

When the banker borrows the gold, sells it for U.S. dollars and invests the proceeds, the key areas of risk are covered for the bank.

Essentially precious metal forward pricing is based on (1) the spot price and (2) the difference between the cost of borrowing the gold and the income from investing the proceeds in the form of U.S. dollars. For instance, gold is usually lent at about 1% per year by central banks — a low level, but one that would more than meet the central banker’s costs of storage. Let’s take a simple example: a banker can borrow gold for one year from a central bank, sell it today for US$385 per oz., and invest the proceeds (in U.S. dollars) at 6%. At the end of the year, the banker has the $385 plus a net return of 5% (6% minus 1%), equating to $404.25 per oz. Investment bankers call this 5% pick-up “contango.” Targeting a profit for his efforts, the banker would agree to buy gold from a producer a year from now at $400 per oz., repay the central bank loan, and assure himself of a profit of $4.25 per oz. — all at minimal risk.

As metal borrowing sources seem to be restricted to the precious metals sector, the hedging methodology does not carry over to base metals. Base metal pricing is oriented more around supply and demand.

At times of attractive spot levels, such as today, future hedge prices are found steadily declining. Market participants anticipate a flood of new metal coming on-stream, forcing future prices lower.

Likewise, during times of poor spot levels, as in 1992-1993, future prices were found to be rising. Market participants anticipated a slackening in supply, therefore forcing future prices higher. In copper markets, for example, the 3-year forward price for copper has had a difficult time deviating from US$1 per lb. to US$1.05 per lb. This has occurred despite the fact that spot prices have almost doubled, to US$1.35 from US$.75 per lb.

The less restrictive instrument relative to the forward/spot-deferred/future contract is the option contract, which is gaining rapidly in popularity. The option provides just that: the option to sell gold at the contract price, or not to sell — whatever the buyer chooses, but with an up-front cost. For a copper miner, a fair, up-front option premium on a put option (the right to sell copper) is based on a complex formula that incorporates perceived volatility of the future copper price, and maturity on the option contract. When volatility or time goes up, the up-front premium cost goes up. Therefore, during times of volatile prices, one can usually associate the cost of option protection as being expensive.

Survey data support the trend to hedging among today’s miners. A recent Scotia McLeod hedging survey among gold miners showed that, in 1992, 46% of miners actively hedged via forwards, spot deferreds or options. In 1995, only three years later, 66% of miners are found to be actively hedging. And of that 66%, almost half can be classified as “smaller” mining companies (fewer than 100,000 oz. of production per year). These statistics should make it clear that hedging activities are not restricted to large, well-capitalized firms.

— Michael Smyth is a senior manager in the Treasury Risk Management Practice of KPMG in Toronto. Formerly, he was vice-president and treasurer of Lac Minerals.