Gold hedging makes unexpected return
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 $1,200 US an ounce. New Gold is spending a hefty $500 million US 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 Anglo-Gold Ashanti Ltd. hedged millions of ounces of future production to lock in profitability at their operations. The practice peaked in 1999, when more than 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. 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 grew into 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 $1,000 US an ounce. The company ended up issuing $4 billion US 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 $1,200 US 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 $120 million US 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.
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, the industry embraced another 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 $4.2 billion US from stream sales in 2015 alone, according to Financial Post data.
Despite the small revival this year, it remains to be seen if hedging can totally she dits negative stigma and gain wide acceptance again.