When sellers are buyers

There are a lot of hedges to unwind

When market pundits show off their commodity forecasts, the usual complaint from the peanut gallery is that they must have copied over each others’ shoulders; the digits may differ a little, but the broad trend of the market seems to be read the same way by all of them. In the worst years, someone that’s a nickel or so away from the average gets labelled a “contrarian” and invited to all the really good parties.

Not so among the gold analysts this year. The two principal forecasters in the gold market, GFMS and CPM Group, both recognized the short-term strength in the market, but CPM came off far more conservatively than did GFMS.

To summarize the mainstream bullish case: the U.S. dollar is weak, interest rates are low, and commodity prices are generally buoyant, implying gold’s best friend, inflation, may pay us a visit shortly.

Add to that a pure supply-side observation — there are not too many new ounces coming down the pipeline. Scarcity means rising prices.

There are arguments on the bullish side that don’t arise as often, but are just as sound. The world’s two other major reserve currencies — the euro and the Japanese yen — are not powerhouses, though the euro has recovered strongly against the greenback. With no clear favourite among the reserve currencies, gold becomes a reasonable alternative, especially for smaller economies with a currency to defend.

Another factor in gold’s favour is a chronic undersupply of new gold, which has slowly widened over the past decade. For as long as demand outstrips mine production, the supply is made up out of above-ground stocks. Last, investment demand is back — and is strongest of all in paper gold.

To summarize the mainstream bearish case: the U.S. dollar was weak, but there’s short-term evidence that it is getting stronger by the day; interest rates may have bottomed, and if inflation reappears, there’s plenty of room to raise them; and commodity prices may be near a top.

The bearish case has a supply-side observation, too, and it’s one we’ve made a few times before: there’s plenty of gold above ground, and enough people ready to turn it into cash.

Without turning the discussion into a session of vapouring about what central banks might or might not do, it seems that the issue of above-ground stocks is — and is likely to stay — the most potent downward force on the gold price. The other fear would have to be interest rates: the best way to increase the value of a currency is to pay people very well to hold it. Gold, alone among the competitors for reserve-currency status, pays no interest, unless you start lending it.

Balanced against that, we note how central banks’ enthusiasm for sales and leases has waned over the past few years. And at least a few of the men in grey pinstripe have taken comfort in seeing the bars back in their basement vaults.

So who’s right? Over the longer term, it’s likely that gold fights an uphill battle against a couple of millennia of bar hoarding. But in the near term, gold looks good for a while — for reasons that will appear shortly, we’d guess seven years.

Unwinding built-up hedges has been widely seen as the major “technical” support under the gold price. The past week saw more news about how Barrick Gold, the gold standard in gold hedging, has been retreating from its long-term hedging strategy.

Having announced it would ultimately reduce its hedge book to zero, Barrick knocked 600,000 oz. off its position in the last quarter of 2003. That went fine; the company realized US$2 over spot prices during that quarter, while still clearing off hedge contracts it no longer wanted.

Not so in the first quarter of this year, when average spot prices worked up to US$408 per oz. This past quarter, Barrick chose to take a US$26-per-oz. haircut on its first-quarter production, solely to get 800,000 oz. off its hedge book. Barrick did not do that out of the goodness of its heart, or to endear itself with gold bugs.

The company would only be walking away from its history of financial engineering if it was economically rational to do that. So it seems getting out of the hedging business was worth about US$33 million in foregone revenue last quarter. That’s a sum that would have nearly paid for the 2004 development program at the Tulawaka project in Tanzania, or bankrolled most of Barrick’s North American exploration. It follows that Barrick must have thought that rolling those hedges over would be more costly, whether in the short run or the long.

Barrick hasn’t been alone in that sentiment; GFMS estimated that almost 10 million oz. had come off producer hedge books in 2003. That need not have translated directly into 10 million oz. of new demand, but the relationship is there.

Even so, producer hedging, according to GFMS, was just under 70 million oz. at the end of the year. There’s plenty more where that came from.