Barrick Backs A Stronger Gold Price

This story features NEWCREST MINING LIMITED, and other companies. For more info SHARE ANALYSIS: NCM

By Greg Peel

When a gold miner is uncertain about the direction of the price of gold, it is typical for that miner to hedge its gold production. It seems an eternity ago now, but at the turn of this century the gold price was wallowing at its lows around US$250/oz post the collapse of hedge fund LTCM, making gold production a marginal business. Even as the gold price began to climb in the twenty-first century, on the back of a weakening US dollar, gold miners were never sure such price gains would be sustainable.

A gold miner can nevertheless hedge its gold production by selling forward that production, usually to an investment bank gold derivative specialist playing proprietary middle-man. The miner might hedge for one of two reasons. Firstly, a mature miner may be concerned that by the time it gets this year’s production out of the ground, the price of gold will have fallen below the cash-cost of the production process, forcing sales at a loss. Or alternatively a mature miner might look to expand production, or a start-up miner might look to open its first mine, confident of reserve indications. Rather than go cap in hand to a bank, or issue fresh equity, the miner can sell forward its expected production and thus lock in both funding and a forward price.

In the early twenty-first century, gold hedging was de rigueur. Miners would hedge production on a rolling contract basis for several years into the future, perhaps ten or more. While this provided comfort to the miner that a profitable business could be maintained, it also provided frustration for the investor in a listed gold producer. The hedge book may have provided a safety net for earnings sustainability, but having sold gold ahead at a fixed price meant any upside beyond that price was lost to the gold miner, and thus not available as earnings growth to the stock investor.

On that basis, the prices of listed gold stocks tended to be a lot less volatile than the gold price itself. Stock prices would not fall by the same percentage as the gold price given the hedges in place, but nor would they rise as much, given the hedges in place. This is one reason why investors looking to hold gold in their portfolios as their own hedge against risk would often shy away from gold mining stocks and stick to the actual metal.

Then in 2005, two things happened. With the US dollar ever falling as the US trade deficit ever widened, gold went through US$400/oz with a bullet. Suddenly the yellow metal was back in vogue. And the World Gold Council was doing its best to talk gold up. The other development was the introduction of the first gold exchange traded funds in the US, and the trickle of listings that soon became a flood. For the first time, US investors could invest directly in a gold-backed instrument without the associated risks of futures trading, and without the difficulties and insurance problems of holding actual gold bars or coins.

A combination of various factors, including those of a weak US dollar and the introduction of ETFs, sent gold soaring ever upward as the decade progressed – through 500, 600, 700… In the meantime, listed gold miners which should have been experiencing an earnings and share price field day were not – for the simple reason they had already hedged the bulk of their production away at what were now much lower prices, locking in “opportunity losses” potentially out to ten years. With gold investors turning away from listed gold stocks, a decision had to be made.

And so it was that one by one, from a period beginning about 2005 to recently, hedged gold producers decided to bite the bullet. They bought back their hedge books from investment banks – and at great cost, given the spot price of gold was now well above original forward price levels. The cost of hedge book unwinding meant a big one-off negative in that year’s accounts, but thereafter the gold producers were free to participate in further gold price upside. They become “highly leveraged” to the gold price, or even “pure-plays”. And in so doing, they brought stock investors back into the game once more.

What they were implying in such a move was that they no longer feared gold price downside, or at least that their cash-cost was well below the current gold price and thus a sufficient earnings buffer was in place anyway. Implicit in such a move also was that gold producers honestly believed gold would continue to trend higher. And they were not wrong. Included in the hedge book-sellers in the period were Australian miners including the biggies – Newcrest ((NCM)) and Lihir ((LGL)).

The world’s biggest listed gold producer – North American-based Barrick Gold – did not, however, join its peers in coughing up to buy back its hedge book. What Barrick did do is decide not to enter into any additional hedge deals, and that was in 2003. Thus in a way, Barrick was ahead of its peers in its hedge book response, but by not biting the bullet, Barrick still carried long-dated hedge positions, painfully watching as each year its hedged volumes slowly ticked down – very slowly.

Then in 2007, the year in which gold smashed through US$700/oz on its way to its first breach of US$1000/oz, Barrick did finally bite the bullet, but only partially. The gold miner bought back its production hedges – those put in place to hedge the miner’s existing mature production – but it declined to buy back its 9.5moz of financing hedges – those forward sales used to fund production expansion. In short, Barrick didn’t have the money, and no wonder – it had been missing out on full gold price-related earnings all the way from US$300/oz to US$700/oz.

As a result, Barrick has been suffering a near decade-long earnings drag. The effect of the hedge book has been diminishing over time, given first the 2003 decision and then the 2007 decision, but for Barrick shareholders it’s been a frustrating few years.

“The gold hedge book has been a particular concern among our shareholders and the broader market, which we believe has obscured the many positive developments within the company,” Barrick Chief Executive Aaron Regent said in a statement last night.

And so it was that last night Barrick announced it would issue US$3bn worth of new stock and use the proceeds to buy back all of its fixed price hedge book, and a portion of its floating price hedges. While not becoming a completely pure play, Barrick will now join its peers in almost total leverage to a rising gold price. Its remaining floating hedges still represent a $2.7bn opportunity loss on the balance sheet, but with the buy-back of the bulk of the book Barrick will now discharge a US$5.6bn loss.

So what does this mean for Australian gold and gold stock investors?

Well one might argue that given gold pushed through US$1000/oz last night – for the third time in history and the first time since January – the equity raising was an opportunistic one. However, opportunistic or not, Barrick has implicitly backed ongoing gold price strength by leaving itself almost naked to any downside correction. Just as an apparent turnaround in central bank gold activity is a bullish sign for gold (see Central Banks’ Dwindling Gold Sales), so is it a bullish sign that the world’s largest gold producer has elected to go it unhedged.

It is clear gold currently has upside momentum, despite likely having to do some work to push meaningfully through the psychological US$1000/oz mark. Investors should take note, however, that if we ever are to see a pull-back in the stock market before Christmas, there would be a subsequent bounce in the US dollar and a bit of a short term thumping for gold.

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