AngloGold stumbles over hedges

By Jim Jones
The Times, Johannesburg, South Africa
Sunday, May 24, 2009

http://www.thetimes.co.za/Business/BusinessTimes/Article1.aspx?id=1005280

Back in the mid-90s, when Anglo American's gold division (AngloGold, as it came to be called) was more or less happy to be a South African company, management strategy was simple. The idea was to hedge about 10% to 20% of annual gold production forward for each of the coming five years. Annual revenues would be protected from a fall in the gold price and, should gold rise, the company would benefit from the rise on 80% to 90% of its output.

The company's hedge book was then in the region of 100 tons of gold against annual production of about 200 tons.

But international expansion entered the picture. Under Bobby Godsell, AngloGold started heading out of South Africa.

By 1999 that expansion had introduced a sophistication that had lifted AngloGold's total hedge book to 11.9 million ounces, stretching out 10 years and approaching almost twice the group's annual production of 6.9 million ounces.

The suits running the show could congratulate themselves because, while the gold price was slipping, hedging gave the company a couple of percentage points on top of the spot gold price -- $6/oz when spot gold was averaging $300/oz.

To be fair, Godsell gave marketing director Kelvin Williams a free hand to manage the hedge book, and Williams delighted in the alchemy of hedging, as was clear at results presentations. Godsell's grasp of hedging was less sure. Worse, according to colleagues who sat through some pretty tense management meetings, little love was lost between the two men. Nor was there between Godsell and Tony Trahar, the boss of AngloGold's then-controlling shareholder Anglo American, who backed Williams.

After the hedge position peaked in 2001, things calmed down a bit. By end-2003, the hedge book was 8.6 million ounces at an average price of $416/oz, equivalent to a year-and-a-half's production at 2003's annual rate of 5.6 million ounces.

But AngloGold's position at the top of the production heap was already threatened -- so heigh-ho, mergers and acquisitions. AngloGold lost out to Newmont in 2002 in the contested bid for Australia's largest gold miner, Normandy. That left egg on Godsell's face, but acquiring Ghana's Ashanti might restore his corporate star to the ascendancy. Ashanti was there for the picking -- perhaps not surprisingly as Ashanti was and remains something of a dog.

It is not clear whether, in the scramble to increase AngloGold's size, anyone considered what taking on Ashanti might do to AngloGold's liabilities -- or the size of the post-merger hedge book. Ashanti was up to its neck in hedged production -- 5.6 million ounces at an average price of $360/oz.

But merger would propel AngloGold back to the top of the gold production heap.

In 2003, when the merger was mooted, Ashanti's 5.6 million-ounce hedge book was equivalent to 3 1/2 years of its then-1.6 million-ounce annual production. And although management might not have even considered the possibility, gold started to advance from $360 in August 2003 and never saw that price again.

By the time the Ashanti merger was completed in April 2004, spot gold was temporarily peaking in the region of $420/oz.

Combined, the hedge book totalled 14.2 million ounces, twice the combined annual production. All very well -- were spot gold to fall or hang around -- but potentially catastrophic for a decade or more if the price moved ahead.

At the start of the merger negotiations the marked-to- market value of the merged hedge book was a negative 1.2- billion, equivalent to 60% of 2003's $2-billion total gold revenue. Nobody seemed worried -- any possible reckoning would come only some years down the track -- even though the spot gold price was moving against the merged company's hedged position.

Now the reckoning has arrived in spades.

Of course today nobody is to blame. Within a few years of the merger, Williams had retired to the Cape and Godsell was packing his bags to make way for Mark Cutifani, who is less enamoured of hedging but who immediately had to start dealing with the legacy.

Last year delivering into the hedge book alone cost AngloGold Ashanti more than a quarter of its potential revenues. On top of that were the costs of early closure of the hedged positions.

In round figures? Selling into the book cost the company $840 million last year, and the cost of early closure of some four million ounces of hedge positions lifted the effective hit to $2 billion or more -- more than R17 billion at today's exchange rate.

All of which, possibly, shows just what can happen when egos get in the way of common sense, when corporate size is chased for size's sake, and when fundamental or prospective flaws are overlooked in mergers and acquisitions.

Shareholders are paying for the mistakes of the past 20 years or so. AngloGold has just needed to top up its resources with a $732 million convertible bond issue that will eventually dilute current shareholdings, and which follows the $1 billion sale of the one-third interest in the Boddington project.

At the end of March this year the total commitments in the hedge book were standing at 5.84 million ounces after an early closure of 154,000 oz. Cutifani has warned that a further cut to four million ounces is targeted by the end of 2010.

At end-March the marked-to-market value of the hedge book was a negative $2.64 billion. This year's likely cost of selling into the hedge book and early closure of some of the positions? It depends on the gold price, but indications are of a 6% discount to spot on the year's five million-ounce expected production -- say, $300 million or so for selling into the hedge book and maybe that again for early closure.

Most of the early closure to Cutifani's four million-ounce target will come in 2010, at a time when the discount to spot looks likely to be twice this year's percentage. Cutifani has his work cut out managing his legacy.

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