By Javier Blas
Published: December 15 2010 09:23
In traders’ parlance, gold mining executives are naked.
Investors should not panic about dress codes: suits and ties still prevail on the boardrooms of bullion companies. But they should worry about the miners’ lack of protection – hence the term “naked” – to any sudden drop in bullion prices.
And in fact some investors – and bankers – have started to fret about the problem in what amounts to a U-turn after years of asking the miners to simply remain “naked”.
For years, gold miners bought insurance against lower prices by agreeing rates with their customers in advance, a practice known as forward-selling.
They forward-sold most, or even all, of their output, securing a stable, even if low, price. Investors in gold mining companies liked the system for a while, particularly when gold prices declined in the 1990s, to hit a bottom of $250 a troy ounce in 1999.
But when prices started to rise in the 2000s, investors complained as the prices realised by the miners were much lower than prices on the open market. In the most extremes cases, miners were selling gold at $500 an ounce, when market prices were above $1,000.
As gold prices surged even higher, equity investors told executives to buy back and cancel their expensive hedging policies.
Executives from companies from AngloGold Ashanti to Barrick Gold capitulated one after the other, buying their hedges back at a great financial cost to gain exposure to the ups and downs of the gold market.
Consultants estimate that by the end of this year, the global gold mining hedge book will have shrink to less than 100 tonnes, down from more than 3,100 tonnes – equal to 75 per cent of total annual consumption – a decade ago.
Now, some question whether miners – and investors – have gone too far.
Ironically, one of the most interesting voices pressing miners to reconsider their hedging policies is Graham Birch, the former head of natural resources at BlackRock who was for years a big critic of miners’ hedging practices.
Over the past few months, he has told executives at conferences that the problem is not hedging, but bad hedging: particularly hedging all the production, rather than a fraction: hedging when prices are low as in the late 1990s, and the use of forward sales, rather than options.
He thinks that miners should consider hedging some of their production now.
Mr Birch has been mostly alone in expressing his views in public, although others, from consultants to bankers, share some of his views in private.
But Goldman Sachs has also gone public this week. In the bank’s commodities outlook for 2011, it tells investors to expect higher gold prices next year and the following, with prices averaging $1,700 in 2012 (up from $1,400 nowadays).
But it also warns that current nominal record prices will not continue for ever, and investors should prepare.
“We think is prudent for gold investors to begin to prepare for gold prices to peak in 2012, and suggest protecting against downside risk with zero cost collar,” says the bank.
If investors need to buy insurance – and at current prices, it is cheap to protect the downside with out-of-the-money put options –, why not the miners? The miners should not wait and start some smart hedging program right away.
Copyright The Financial Times Limited 2010.
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