Hedging hangs in the balance

By Mandi Zonneveldt
Herald-Sun, Melbourne, Australia
Monday, January 8, 2007

http://www.news.com.au/heraldsun/story/0,21985,21023721-664,00.html

Market master Warren Buffett famously said: "A group of lemmings looks like a pack of individualists compared with Wall Street when it gets a concept in its teeth." The same anecdote has been used to describe the Australian resource industry's approach to hedging -- a risk minimisation strategy.

Although they remain relatively healthy, metal prices fell sharply last week and the promise of blue sky has darkened. But hedging is still a dirty word.

Companies not fully exposed to the upside of the resources boom are being called to task over their hedging policies and many have rushed to reduce their hedge books.

Three quarters of gold mining companies with price protection in place reduced their forward sales, options and other hedge positions in the September quarter, according to The Hedge Book, compiled by Virtual Metals and Halliburton Mineral Services.

Sean Russo, director of Sydney-based risk advisory and funds management firm Noah's Rule, said the trend was not surprising.

"When the markets are going up, companies are almost embarrassed by their hedging," he said.

"It's like hemlines. The fashion is to be unhedged."

Hedging is a form of insurance used to manage the risk of fluctuating currencies and commodity prices.

In its most basic guise, hedging involves selling something that hasn't yet been produced, at a fixed price, for delivery on an agreed date.

However, Australian resource producers have been instrumental in developing some of the more complex price protection mechanisms.

As well as forward sales, there are put options, call options, deferred contracts, collars, caps, floors and swaps, making hedging a mind-boggling maze that can confuse even the most sophisticated investor.

Jim Pollock, a long-time practitioner with the Financial Services Institute of Australasia and statistician for consultants Surbiton Associates, said hedging was a complex subject that very few people understood.

"I bet if you went to the board of a large or even medium-sized gold producer and said can you individually explain to me how to calculate the mark-to-market value of your hedge book, I'd be very surprised if many of them could do it," he said.

"I think in many areas it's a dirty word, but I also wonder whether those who regard it as a dirty word really understand what it's all about."

The trend against hedging has been most noticeable among gold producers.

The hedge impact of the global book -- the measure used by The Hedge Book -- has fallen from 52.6 million ounces to 41 million ounces in the past nine months. At the same time, the gold price has doubled.

Australian producer Newcrest announced in November that it had deferred the sale of 1.6 million ounces of gold into set-price contracts, giving it more exposure to the soaring spot price.

Smaller miners, including Kingsgate Consolidated and Lihir Gold, have also made inroads.

Newcrest chief executive Ian Smith said recently people bought shares in gold companies to gain as much exposure as possible to the gold price.

"I don't think, as a normal part of business, you want to be playing the role of pre-supposing ... that you can play the position on gold better than the average investor," he said.

There is no doubt soaring commodities prices have turned the tide against hedging, but Mr Russo said companies were also under pressure from large institutional shareholders who were playing the metals markets themselves.

"We're really seeing a fashion where the big investors are putting pressure on companies to be totally unhedged, which is not in the interest, necessarily, of all stakeholders," he said.

"The big hedge fund managers and the big investors, they have the financial sophistication to be able to hedge the metal prices separately," he said.

"Some of the stakeholders, the mum and dad investors, can't go out and hedge their exposure to the zinc price if they want to hang on to Zinifex for a takeover premium."

Hedging has also received a bad rap in recent years due to the spectacular crashes it has been associated with.

Pasminco's $3 billion collapse in 2001 was the result of a failed currency hedging strategy that left the company hundreds of millions of dollars out of the money. It's successor, Zinifex, does not hedge commodity prices.

Sons of Gwalia came undone in 2004 because it sold more gold than it could produce and gold miner Croesus called in administrators earlier this year after difficulties meeting its hedging commitments.

But Mr Russo argues that hedging is often the innocent victim when companies collapse.

Those companies "were speculating, they weren't hedging," he said.

"It's easy to blame the hedging ... but at the end of the day there's very few companies that have actually failed from doing sensible hedging."

Mr Pollock agrees. He takes exception to suggestions from some corners that hedging is akin to gambling.

"It is considered good business practice for companies to insure their plant against damage and calamity. They insure stocks of raw materials that they've got at a mine site. They even insure the lives of their senior executives," he said.

"I think for shareholders and institutions to say ... it's bad to insure against a fall in the price of the commodity you're producing is just illogical."

Meanwhile, unhedged producers are crowing from the rafters.

Zinifex's billion dollar-plus profit was largely the result of its unhedged exposure to the sky-rocketing zinc price and Oxiana has not been shy about the benefits that being unhedged have bestowed on its bottom line.

Even the world's largest miner BHP Billiton is singing its own praises.

Asked this year to reflect on the key decisions that had led to the company's success, BHP chief Chip Goodyear said emphatically: "Stop hedging."

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