PDAC 2017: What’s wrong with hedging?

Barrick Gold (TSX: ABX; NYSE: ABX) pioneered gold hedging more than two decades ago, but the company endured sharp criticism when the strategy became a liability, and management eventually closed out its fixed-price hedge book at a significant cost in 2009.

The pros and cons of hedging remain the subject of debate to this day, and the topic came up during a discussion at the recent Prospectors & Developers Association of Canada convention in Toronto, when a participant asked a panel of bankers whether they thought the practice was a useful tool for the industry. 

Egizio Bianchini of BMO Capital Markets — who prefaced his remarks by pointing out that BMO has the smallest commodity desk of all the banks represented on the panel, making him “the least conflicted” to answer the question — responded with an emphatic yes.

“It’s absolutely insane to me why a developer without any cash flow doesn’t hedge,” he said. “It’s just logical. I would love to see all development companies hedge.”

“You want to make this industry investible? Especially the junior industry? Give me some predictability,” he said. “And if you want to give me some upside, go out and drill more reserves and give me the optionality of having more reserves.”

Bianchini, vice-chair and co-head of BMO’s global metals and mining group, also said hedging was appropriate for producers.

“In terms of producers, again, you want to make it investible? Go hedge. If you have a US$4-billion project, even if you share it, it’s still US$2 billion each. Go and hedge it. There’s nothing wrong with it.

“Is this industry a prudent steward of capital? It should be. It ought to be. It better be. So hedging at the right time is part of it.”

One of the reasons why hedging fell out of favour, he adds, was pressure from shareholders.

“Part of the problem mining companies got into was that they listened to their shareholders,” Bianchini said. “We have an inherent disconnect between most shareholders — and it’s not their fault. They are paid quarterly, they are paid annually. It takes eight, nine, 10, 11, 12 years to build a mine … there are always going to be investors who say: ‘Don’t hedge, it gives away the upside.’ But there are different ways to get optionality … when you’re building a mine and you’re putting yourself out there, there’s nothing wrong with hedging.”

In his own industry, he added, banks hedge their loans. “When we have to do a transaction, and we have to lend money to someone, we’ll hedge it with an FX trade. Why shouldn’t companies do that?”

The banker also noted that “when Barrick got into trouble it was in a deflationary environment and they didn’t cover it at the right time, and they had a $4.5-billion mark-to-market that they didn’t cover.

“We’re in an inflationary environment. It doesn’t make a lot of sense in the long run to hedge, but if you’re building a mine, why not?”

Panelist Rick McCreary of TD Securities noted that hedging is a debate that every executive with board oversight has at some point, and quoted a retired mining analyst he knows who likes to say that “Investors don’t own mining stocks — they rent them.”

Shareholders “can sell at any moment, and can get in and out of the stock, so as a manager of a business you want to listen to your shareholders and ensure they’re happy, but you also have to have a viable business that’s going to go forward, and that is the challenge that they’re often faced with, decisions like hedging. Hedging is prudent for the viability of the business.”

Hedging can be appropriate when you’re building a project, and you want to ensure that the cash flow will be there when you have to start paying back your debt, McCreary said.

“This year there were probably seven or eight companies that did a little bit of what I would loosely call hedging, but it wasn’t so much forward sales, it was just put and calls … we all watched it with curiosity, because the equity investors were telling the issuers, ‘Don’t hedge, we want the upside, we want the full participation.’ But the chief financial officers were facing situations where they needed to manage their balance sheets, so they did it, and the analyst commentary and market reaction were quite positive. But it wasn’t in the vein of the way Barrick used to handle it, and roll the hedges forward, it was more in the traditional use of hedging, which is prudent balance-sheet management.”

Over the last year, a handful of companies — including Centerra Gold (TSX: CG), B2Gold (TSX: BTO; NYSE-MKT: BTG), New Gold (TSX: NGD; NYSE: NGD) and Alacer Gold (TSX: ASR) — have announced some variation of hedging.

In January, Centerra Gold said it had hedged part of its expected 2017 copper production from its Mount Milligan mine in northern British Columbia “to increase its cash flow certainty” this year. It entered into fixed price forward sales contracts for 24.9 million lb. of Mount Milligan’s expected 2017 copper production at an average US$2.69 per lb., which represents 51% of the mine’s expected copper production this year, net of copper streaming arrangements with Royal Gold (TSX: RGL; NASDAQ: RGLD), and is based on the midpoint for 2017 production guidance, the company said. Centerra noted that its current policy is not to hedge more than 75% of its copper production, net of copper-streaming arrangements.

The company also said it had entered into zero-cost dollars for 8.3 million lb. copper, with settlement dates during February to December 2017 at a minimum price of US$2.25 per lb. copper, and a maximum price of US$3.21 per lb. copper. Management said, however, that it has no plans to hedge any of Mount Milligan’s unstreamed gold production.

New Gold, which is developing its Rainy River project in northwestern Ontario, said in October that it had entered into more gold price option contracts through mid-2017 “to increase cash flow certainty from its four producing mines.” The gold price option contracts cover 120,000 oz. of first-half 2017 production, “providing a guaranteed floor price of $1,300 per oz., while providing continued exposure to increases in the gold price up to $1,400 per ounce.”

In June 2016, Alacer Gold, which owns an 80% stake in the Copler gold mine in Turkey, said it was pursuing a hedging program for part of its oxide gold production “as part of its de-risking efforts.” The company had sold 160,000 oz. of forward gold contracts at US$1,273 per oz. from July 2016 to September 2018. It noted that hedging part of the oxide production was “a prudent strategy that secures the gold price during the construction of the sulphide project,” and that revenue from gold production during the period would be used to build the sulphide plant.

Finally, in March 2016, B2Gold announced that it had entered into prepaid sales contracts to help fund construction of its Fekola gold project in Mali. The company agreed to deliver 43,100 oz. gold in each of 2017 and 2018, for total cash prepaid amounts of US$100 million. The company said the ounces to be delivered were based on an average forward price of US$1,248 per oz. gold, and that the ounces to be delivered represent 7% and 5% of forecast consolidated gold production in 2017 and 2018.

The company said at the time that it expected to enter into more prepaid sales arrangements totalling US$20 million.

One company that has used new hedging since 2013 is OceanaGold (TSX: OGC; ASX: OGC).

The company has used hedging at its Reefton and Macraes mines under a series of zero-cost collars (bought put options, which were financed with the sale of call options).

“Our purpose for implementing these hedging programs was primarily as a financial de-risking mechanism to ensure that our higher-cost operations remained cash-flow positive during the downturn in the gold price,” the company’s director of investor relations Sam Pazuki says.

“We were investing large sums of capital on pre-stripping to access ore that would be mined one to two years ahead. The hedges were first put in place to ensure that we locked in a margin on the investment we were making. Our hedges were also denominated in New Zealand dollars to account for much of our costs being in New Zealand dollars.”

This strategy “turned out to be an effective one,” he says. This year, OceanaGold has hedged 155,000 oz. gold production at Macraes at a put option strike price of NZ$1,650 per oz. and a call option strike price of NZ$1,810 per ounce. The current gold price in New Zealand dollars is NZ$1,738 per ounce.

The company does not plan any more hedging after this year at Macraes, as its margins have increased by adding a higher-grade discovery at Coronation North, Pazuki says.  OceanaGold has no plans to hedge gold or copper at any of its other assets, because each of them (Didipio in the Philippines, Waihi in New Zealand and Haile in the U.S.) have strong margins. (Its Reefton mine was placed on care and maintenance in February 2016, and the company is closing the mine.)