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Central banks may scale back plans for gold sales, analyst writes
Hedging strategy ambushes canny investors
By Stephen Bartholomeusz
The Age, Melbourne, Australia
September 4, 2004
http://www.theage.com.au/articles/2004/09/03/1093939146279.html?
oneclick=true
One of the perplexing questions generated by this
week's collapse of Sons of Gwalia is how so many
very smart investors could have got it so wrong.
Stranded on the register of the failed tantalum and
gold producer are some of the cannier institutional
investors, while some of their equally clever peers
only just escaped in the nick of time.
Among Sons of Gwalia's substantial shareholders
are Templeton, Schroder, and Aviva Corp. Canadian
miner Teck Cominco owns about 10 percent of the
group, and a major tantalum customer, Cabot
Corp., is also on the register. The funds management
businesses of Goldman Sachs, Wellington, and
National Australia Bank were all shareholders until
very recently.
Also exposed to the collapse are some of the world's
biggest banks, including Citigroup, HBOS, Goldman
Sachs, JPMorgan, Dresdner, HSBC, and, locally,
ANZ and Commonwealth.
The institutions who were caught out are nonplussed
and angry. They were aware Sons of Gwalia had
challenges in both its tantalum and gold operations
but hadn't envisaged the implosion that enveloped
them this week.
While Sons of Gwalia is Australia's third largest gold
producer, that wasn't its primary appeal to the
institutions. They were attracted to the company
because it controls more than half the world's
production of tantalum, a rare metal used in the
manufacture of capacitors, which regulate flows
of electricity within integrated circuits.
Every mobile phone, laptop, and video camera has
some tantalum in it, which made Sons of Gwalia a
very seductive story indeed for the fund
managers.
While Sons of Gwalia's tantalum operations have
had their share of problems -- some production
difficulties, declining grades, and long-term
contracts that haven't enabled it to cash in on
rising spot prices -- they weren't part of the
explanation for the company's demise.
It was the "other bit" -- the gold operations --
that undermined the group.
Sons of Gwalia, founded by the Lalor brothers,
descendants of the Peter Lalor who led the rebellion
at the Eureka Stockade in 1854, has been producing
gold since 1984 and has produced about 5 million
ounces since then. Until this week it had been
expected to produce about 500,000 ounces a year.
Its ability to generate that production was critical
because throughout its history it has fully hedged
its production, in effect selling forward its entire
output using some sophisticated and extremely
complex strategies.
Generally that has been profitable, although in 2001
the group was hit hard when the Australian dollar
dived and its currency hedging generated losses.
Earlier this year, the Lalor brothers, Peter and Chris,
left the company and a new chief executive, former
Pioneer International executive John Leevers, was
appointed. Subsequently there were a number of
board changes and the new board commissioned
a major strategic review of its operations.
That review's findings, supposed to be released late
last month, appear to have been the catalyst for the
decision to call in administrators after discussions
with lenders over a standstill failed.
Sons of Gwalia chairman Neil Hamilton said this
week that the review identified a serious deterioration
in the status of the group's gold reserves and
resources, raising concerns about the company's
ability to meet its hedge book commitments.
The position in which Sons of Gwalia found itself
doesn't appear particularly complicated. It had a
commitment to deliver a net 1.3 million ounces of
gold to hedge book counterparties but the review
revealed a shortfall in economic reserves of about
500,000 ounces.
With the hedge book about $350 million under water
at June 30 on a mark-to-market basis and a rising
Australian dollar gold price exerting further pressure
on the economics of the book, Sons of Gwalia had
no way out. The group had sold more gold than it
could produce. Its fundamental problem wasn't the
hedge book or its gold operations but the
interaction between the two.
The issue of how that could have happened is now
being investigated by the Australian Stock Exchange
and the Australian Securities and Investments
Commission.
There would appear, however, to be an obvious
explanation. The stated reserve estimates and
production forecasts were wrong. Whether the
miscalculation was deliberate or inadvertent will,
obviously, be of consequence.
Sons of Gwalia had had some production problems
in its mines, particularly those it acquired from
Teck Cominco when it bought PacMin for $160
million in 2001. It experienced falling grades and
rising cash costs after the failure of a pit wall, heavy
rains, labour shortages, and drilling difficulties.
The company, however, revised its 2003-04 profit
expectation to $21-$22 million in mid-July but did
not indicate how parlous its position was. That
profit warning was the trigger for some of the
institutions to exit the register. Most were waiting
for the outcome of the strategic review before
coming to any conclusion about the company's
prospects.
In their enthusiasm for the "21st century metal"
prospects for tantalum, the professionals, with
hindsight, didn't focus sufficiently on the gold
operations and the hedge book.
The complexity of the hedging wasn't given
sufficient emphasis, nor did the investors
recognise that the problems within the gold
operations might create a question mark over
the economics of the resources and therefore
Sons of Gwalia's ability to meet its hedge book
commitments.
They will pay a steep price for their distraction.
The administration will crystallise the losses in
the hedge book and inevitably exacerbate them.
There are suggestions that at least two of Sons of
Gwalia's three gold operations are considered
uneconomic, which in turn suggests the losses for
the hedge book counterparties could be substantial.
That virtually guarantees that equity holders won't
see any return once the tantalum business is sold
and its proceeds absorbed by creditors.
The fate of Sons of Gwalia and its investors will
reinforce the lessons from Pasminco's collapse
and other hedge-related disasters.
Even sophisticated institutions will be reluctant to
invest in companies with extensive hedging
operations, particularly where the hedging
strategies are complex, and one suspects even the
investment banks who sit on the other side of the
hedges will be more cautious in future when
assessing the quality of the resources that
underpin the future production commitments
and the proportion of production that can be
sold forward.
Sons of Gwalia's strategy left it, and them, with
no margin for error.
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