THE HEDGE IS BACK
LONG A DIRTY WORD FOR GOLD MINERS, HEDGING’S LUSTRE HAS RETURNED.
New Gold Inc. was braced for a vicious backlash from the investment community when it decided to hedge some gold production this month.
After all, hedging is the gold industry’s ultimate dirty word. It became such a toxic subject during the last decade that most chief executives decided that even talking about it was off limits. And New Gold is led by Randall Oliphant, who headed up Barrick Gold Corp. back when it had the biggest — and most reviled — hedge book in the business.
But the response to New Gold’s move wasn’t negative. Instead, almost everyone cheered.
“We’ve heard nothing but positive reactions from shareholders, analysts and media people to what we did,” said Oliphant, New Gold’s executive chairman. “So that will give other people who want to do this sort of stuff some ammunition.”
New Gold’s hedge position is pretty minor in the grand scheme of things. The Toronto- based miner entered option agreements to sell 270,000 ounces of gold at prices no lower than US$1,200 an ounce. New Gold is spending a hefty US$ 500 million on an Ontario gold project in 2016, and this small hedge position simply ensures that it can build the mine and maintain a healthy balance sheet even if gold prices go in the tank.
Still, this deal violated one of the industry’s biggest taboos and it took some nerve for New Gold to do it. But the warm reception it received, combined with the recent rally in gold prices, suggest there could be a lot more hedging to come.
The heyday of hedging came in the 1990s and early 2000s, when gold was mired in a prolonged bear market. Companies such as Barrick, Newmont Mining Corp. and AngloGold Ashanti Ltd. hedged millions of ounces of future production to lock in profitability at their operations. The practice peaked in 1999, when more than 3,000 tonnes (or over 100 million ounces) of gold was hedged.
The gold bugs despised this financial engineering, because miners were giving away much of the upside to rising gold prices. Of course, one reason for all the hedging was that the mining companies simply didn’t believe gold would go up as much as it did.
But the anti- hedgers ignore an obvious truth: during the bear market, hedging often paid off.
Barrick, for one, grew i nto the world’s biggest gold miner largely because of its hedge book, which allowed it to make more profit per ounce than many of its rivals. As a result, its stock traded at a premium to most of the sector, and it could then use that stock as currency for acquisitions.
But the downside of hedging became obvious when gold began its long upward climb in 2001. As prices rose far above the levels at which companies hedged, the industry’s hedging liability became bigger and bigger.
The smarter companies, such as Newmont, eliminated their hedges relatively early in the bull market. Barrick, on the other hand, waited until 2009, at which point gold had quadrupled from its lows and was worth roughly US$ 1,000 an ounce. The company ended up issuing US$4 billion worth of stock — still the largest equity offering in Canadian history — just to unwind its 9.5-million-ounce hedge book.
No one wanted to replicate that nightmare, and hedging was pretty much dead by the dawn of this decade. Just 152 tonnes of gold remained hedged at the end 2010, according to GFMS analysts at Thomson Reuters, which is less than five per cent of the 1999 peak. By 2012, that figure was down to 130 tonnes.
Gold prices rose every year between 2001 and 2012, so there wasn’t any shareholder support for hedging. Hedge funds and other institutional investors were piling into the sector to get exposure to gold’s rising fortunes, and they wouldn’t touch a company with a significant hedge book.
But the gold bull market ended abruptly in the spring of 2013, when prices plunged 25 per cent in a matter of weeks. Gold miners suddenly realized an unfortunate truth: most of them weren’t making any money.
Had they hedged some production at any point in the past two years, they would have created an excellent buffer against falling prices. Instead, some of them struggled just to stay afloat and manage their large debt loads.
The gold market has turned positive again in 2016. Prices have jumped as much as 20 per cent since the start of the year ( they remain above US$ 1,200 an ounce despite slipping last week) so it makes sense for companies to think seriously about hedging again.
New Gold announced its hedge on March 8. Just seven days later, Canadian miner B2Gold Corp. announced it is raising up to US$ 120 million from prepaid gold sales, which amounts to a form of hedging. That capital will be used to build B2’s Fekola mine in Mali.
Hedging is gaining popularity outside Canada as well. A few Australian and Africans firms, including Evolution Mining Ltd. and Acacia Mining PLC, have announced new hedge positions in recent months, as has Polyus Gold, Russia’s leading producer.
These transactions, which are all relatively modest in size, point to what a new era of hedging could look like. It won’t be the massive financial engineering schemes of days past that were orchestrated by corporate finance whizzes trying to outsmart the gold market.
Instead, it will be used in small, targeted doses by companies looking to protect their balance sheets or reach a specific goal, such as funding a new mine.
“Hedging for a specific reason or a specific project has always made a lot of sense in the mining industry,” said Clive Johnson, B2Gold’s CEO. “The fact of the matter is that (Barrick and others) gave it a bad name. But I never went there.”
Despite the small revival this year, it remains to be seen if hedging can totally shed its negative stigma and gain wide acceptance again. It still isn’t a word many executives will say out loud.
But as hedging went out of favour during the last decade, the industry embraced another financing scheme that has some similarities: metal “streaming,” in which a mining company receives upfront cash from a streaming firm ( such as Silver Wheaton Corp.) in exchange for future sales of physical gold and silver at below-market prices.
Mining companies raised US$4.2 billion from stream sales in 2015 alone, according to Financial Post data. Barrick, Teck Resources Ltd. and Glencore PLC are among the companies that eagerly sold streams last year.
Some experts are surprised that streaming has become so popular while hedging remains beyond the pale. In certain circumstances, streaming can be very expensive. If metal prices go up after a stream sale, the miner ends up giving away a great deal of profit.
Streams also usually last for the entire life of a mine, and include the exploration upside. So if a company finds more gold or silver on its property after signing such a deal, it has to sell a portion of that new discovery in the stream as well.
Johnson said the streaming model doesn’t make sense for a company such as B2Gold, which has a well- regarded exploration team and is known for buying projects and then finding more gold on them.
“The streamers want a piece of the upside forever,” Johnson said. “With our ability to find more ounces, there’s no way I’m going to give those up.”
There has been some backlash against streaming deals in recent months, as commentators have expressed concern that miners are giving up too much upside in order to get immediate influxes of cash.
Ironically, those concerns could pave the way for more hedging, which faced similar criticisms two decades ago.
Ron Stewart, an analyst at Dundee Capital Markets, said there are still plenty of investors that see hedging as an “evil financing tool.” But those same people probably think streaming deals are too expensive and may see them as an even worse alternative.
“It might actually be that streaming and royalty deals have turned hedging back into something that is a little bit more palatable,” he said.
For New Gold’s Oliphant, the argument in favour of hedging is much simpler. He pointed out that gold was US$ 1,050 an ounce just three months ago, compared to Thursday’s closing price of US$ 1,223 and a peak of US$1,277 earlier this month.
Miners tend to have short memories, but you don’t need a long one to recall how much the industry was suffering at US$ 1,050 an ounce just three months ago. Back then, locking in a floor price almost 15-per-cent higher, as New Gold just did, would have felt like a dream come true for many executives.
“People know exactly how they felt when we were at those low prices,” Oliphant said.