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Alas, poor Barrick. Hedges can't survive gold's rise

ByEric Reguly
Globe amp; Mail, Toronto
Thursday, December 4, 2003

a href=http://www.globeandmail.com/servlet/ArticleNews/TPStory/LAC/20031204/Rht...
REGU04/TPBusiness/TopStories

Barrick Gold chairman Peter Munk in 2000 on hedging:
quot;It's not only rock-solid, it's an absolutely primitive
undertaking of the simplest, most understandable
format.quot;

Mr. Munk last month: quot;The commitment to hedging
is gone.quot;

This week, Barrick officially pushed its hedging program
down the mine shaft. Yesterday, at a mining conference
in London, chief executive officer Greg Wilkins found
himself in the unusual position of defending a corporate
policy that had helped the company become one of the
largest and financially strongest players in the industry.

Barrick's hedge book had been active for about 20
years, had generated about $2-billion (U.S.) in profit
that would have otherwise been denied, and was touted
as a sure-fire way to make a buck regardless of the
gold price. If that weren't enough, the forward sales
contracts were highly flexible. This allowed delivery
to be deferred -- for years, if the company chose -- so
that immediate production could be sold at the higher
spot price. To top it off, Barrick, the anti-Christ as far
the unhedged miners were concerned, argued forcibly,
although not always convincingly, that hedging did not
put downward pressure on prices. Au contraire, Mr.
Munk would say; the practice quot;assisted in the
evolution of a healthy gold price.quot;

Why did Barrick lose religion so quickly?

First, an example in gold hedging. An investor -- say,
a bank -- realizes it can borrow an ounce of gold from
a central bank at the bargain rate of 1 percent a year.
Suppose a government bond pays 4 percent. So the
get-rich-slowly plan is to borrow the gold, sell it in the
spot market -- say, at $400 -- and invest the proceeds.

In five years, the investor would have made his 4
percent, less the 1 per cent he paid to borrow the gold,
for net proceeds of $460. At that point, the investor can
buy an ounce of gold and hand it back to the central bank.

The problem, of course, is that the investor doesn't have
a clue what the gold price will be in five years. If it's less
than $460, he's in fine shape. If it's more, he's out of luck.

This is where Barrick would enter the scene. It might
agree to sell gold to the investor in five years for $450.
The investor would have enough money to pay for it,
plus make a small profit. Barrick, meanwhile, would
sell the gold short in the futures market, knowing it
had a buyer at $450 down the road. At that point,
everyone would be smiling: Barrick was protected
from the low spot price and the investor would be
protected from a high spot price when it came time
to settle the trade. For Barrick, rising gold prices
were the risk. If the price were $500 in five years, it
would receive $50 less than it could get in the spot
market. This is not an outright loss, per se; it's an
opportunity cost. And it might not even be that if
Barrick exercised its option to defer the deal for a
few years in the hope the spot price would fall.

Given that the system worked so beautifully for so
long, Barrick has some explaining to do, and Mr.
Wilkins has been doing that. quot;The problem,quot; he
says, quot;is with financial derivativesquot; -- that is, investors
either don't understand them or, if they do, worry
they have the potential to cause a lot of damage.
Indeed, stories of about the implosion of Enron and,
a few years ago, Long-Term Capital Management,
both liberal users of derivatives, have raised anxiety
levels among investors.

The unravelling of the hedge book of two lesser gold
companies, Cambior and Ashanti Goldfields, didn't
help. Neither did Warren Buffett's warning this year
that derivatives are quot;financial weapons of mass
destruction.quot;

OK, but Barrick has never been the victim of a
hedge-book disaster and has said one is unlikely
because it had hedging down to a fine art. Investors'
alleged wariness about derivatives doesn't fully explain
why Barrick has substantially underperformed its peer
group in the past year or so.

There is the quot;grassy knollquot; theory, which says a
nervous creditor read Barrick the riot act. Why would
it do that? Because if Barrick were forced to close out
all its hedges -- it has 16.1 million ounces sold forward
-- it would cost the company $1.2 billion. Worse, every
$1 rise in the price of gold puts Barrick another
$16.1 million into the hole. (Gold has gone up about
$30 an ounce since mid-October.) But Mr. Wilkins
says this is nonsense. Creditors are not worried and
the company would have absolutely no problem
meeting its hedge contract obligations.

So let's ask the question again: What went wrong?

The answer, simply, is rising gold prices. Mr. Wilkins
will admit the tipping point came with the quot;flip over in
the price of gold. Investors want [full exposure] to the
run on gold prices.quot; Barrick, because of its hedge
book, can't deliver full exposure. In other words,
Barrick was right when it said it could make money
at any gold price. That, however, didn't mean investors
would stick around when Newmont and other big
unhedged mining companies were realizing full value
from rising prices, and more. Gold shares are
discounting prices well in excess of the current
$403. Not Barrick's.

The irony is that Barrick, the industry pariah because
of its hedging strategy, is now the industry's best
friend. When Barrick hinted it would halt forward
sales and wind down its hedge book, gold prices
took off. When the biggest short seller of them all
called it quits, gold bugs knew their optimism was
warranted. Poor Barrick. It might take it years to
close and bury the hedge book, and that will put a
drag on its shares.

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