EDITORIAL PAGE — Reducing risk through hedging

Mining is a risky business.

Sometimes the risk takes the form of an operational surprise. In other instances, it may be an exciting drill hole that turns up empty. Still other risks include volatile metal prices, environmental issues, labor disputes and changing political winds.

And although the general news media discuss frequently the percentage point changes in the bond and equity markets, the fact is that metals prices show much more wild swings. Indeed, they have been known to move 50% or 100% within a year, as in the copper market.

What can miners of precious and base metals do to cope with, and possibly avoid, some of these unavoidable risks?

One option is hedging, which is accomplished through the use of financial instruments and which is aimed at covering a company’s metal positions and minimizing downside potential. In this way, hedging can be used as an “insurance policy.”

It is important to realize that hedging can be used by almost any size of producer. In evaluating a company’s ability to get involved in this market, financial institutions consider its financial statements and reserves, not necessarily its size. Quality, in other words, is more important than quantity.

Extensive hedging markets exist for most key metals, including gold, silver, copper, aluminum, nickel, lead, tin and zinc.

Traditionally, producers of metals have avoided hedging, under the assumption that shareholders would disapprove. As well, if the market timing for hedging turned out to be wrong, management would never hear the end of it.

But hedging has become more popular in recent years, as mining companies have found that what really drives up share prices is perception of future profits, which is a reflection of a growing reserve base and resource potential.

Fifteen years ago, one could count on one hand the number of mining companies that hedged. But during the doldrums of 1992, according to Scotia McLeod’s “Gold Hedge Outlook,” 25 out of 52 North American gold miners engaged in the practice. And despite the more optimistic gold price environment that has prevailed since that time, 31 gold producers are known now to be hedging.

Consider the price of gold in April, when it was trading in the US$390-per-oz. range. Hedging forward offered a US$26-per-year pickup over spot prices; that is, US$416 for April, 1996, and US$442 for April, 1997. For Canadian miners requiring Canadian dollars, hedging is even more attractive; with spot gold at $535, a 1-year hedge offered $580 and a 2-year hedge, $620.

That is pretty attractive pricing, and a producer that can count on this pricing has an advantage over a producer who typically budgets based on today’s price or less.

What kinds of benefits do “hedgers” seek?

Hedging can mean bigger budgets. It adds certainty to the amount of revenue expected, so that companies no longer need to budget in a “cushion” to allow for prices falling to lower-than-expected levels. Management can plan better, and parcel out with confidence more money for exploration, research and development, and business development. The more “irons in the fire,” the more likely is success. As a result, the stock becomes more attractive.

Hedging provides strength to take advantage of opportunity. When the inevitable downturns in metal prices come, conservatively financed miners are able to pick off the overextended miners. It is at these times that any mining company can buy reserves quite cheaply, but only if it has deep pockets.

In summary, hedging is a strategy which can, if properly managed, add value and certainty to a company and endow it with more resources, in the hope that its shareholders’ dreams come true.

The author is a senior manager of the “treasury risk management practice” of KPMG, Toronto. He is a former treasurer of Lac Minerals.