Why does hedging remain such a highly contentious issue for gold and silver miners?
[This article originally appeared on BullionVault.com and is republished here with permission.]
There’s always a lot of talk about gold and silver miners and their hedging policies.
Selling some future production at current prices raises money today. It can also help the gold or silver miner smooth out changes in the market. That should be to the benefit of the shareholders. Yet the main concern in hedging isn't how to manage this trade. It’s the shareholders’ view of hedging which counts.
Why? Starting in the late 1990s, gold miners suffered major losses when the gold price rallied. This is because they had excessively large “hedge” positions in place far out into the future. It’s imperative that the act of hedging not get confused with the reality of mismanagement of hedging policies.
As gold prices began rising early last decade, investors came to hate the big hedge-book built up by the gold miners during the previous bear market. And simply put, miners need investment money to fuel their business. If the shareholders aren’t happy with the way they operate their business, then their share price goes down. And if the share price goes down, then the gold or silver miner’s capitalization also goes down, which then affects their ability to borrow from the banks.
So with hedging both weighing on profits and annoying shareholders a decade ago, the famous “leverage” to gold prices offered to investors by precious metals miner stocks went missing, even before the financial crisis hit.
An excessively large hedge is in effect a speculation. And “I am prepared to concede that we were reckless,” said Sam Jonah, chief executive of gold-miner Ashanti, as it faced bankruptcy thanks to a jump in the gold price at the end of the long 1990s bear market.
“We took a bet on the price of gold. We thought that it would go down and we took a position.”
Why speculate against the very mineral you’re in business to dig from the ground? First, because of the length and misery of the gold bear market. But unfortunately, companies too often rely on outside firms to consult on their hedging strategies, too. Such was the case with Ashanti, for instance.
Goldman Sachs had recommended that Ashanti purchase enormous hedge contracts, which of course lined the bankers’ pockets. Derivatives contracts and other structured products offer far greater income to the middlemen than straight buying and selling. But after making “easy money” at first as the gold price fell further, in the end Ashanti was not hedged. What it had done was establish a short gold position, which brought its own demise.
Lesson learned: Don’t take advice from outsiders who have no vested interest in your success—not without inside analysis and study.
Because of the poor decisions of some mining companies 15 years ago, hedging is still frowned upon today. The practice is still little understood by shareholders, too. The gold miners’ speculative hedging was entirely unwound by 2011, ahead of the peak in prices (so far). But the truth is that hedging is not a one-size-fits-all program and should not be static. Hedging should be elastic and managed daily by the mining company, not by outside firms.
The biggest concern that miners should focus on—and something that I believe they rarely do—is properly educate their shareholders about their hedging activities and goals. By educating their shareholders about their business model, they can have them participate and support the strategies the firm enlists.
When gold and silver started rising faster in 2005 to the current price levels we’re at today, many of the shareholders of many mining companies were unhappy. They believed they should have participated more in the higher prices. But lower prices were already locked in, and the shareholders blamed their lack of income on hedging. It was not hedging that limited their upside potential, however. It was the management or style of hedging.
Another truth must be told, because owning stock in gold or silver mining companies should not and is not a vehicle for tracking the price of the underlying commodity. Just like any other stock, an investor is buying into a business whose purpose is to make money. Mining companies’ purpose is to make money by the extraction of raw materials from the ground.
So upon looking at a mining stock, an investor must first decide if the miner has the ability to be profitable on a stable price platform. If silver were trading at $20 per ounce, when considering a mining stock, it would make sense to see if the company would remain profitable at $15 or even $10 per ounce.
In calculating what level the price of the underlying commodity needs to be for the mine to be profitable, we would have a better handle on this specific business model. Once this is established, an investor should look at how the mine handles price moves. The question lies in what tools the company uses to manage their market exposure.
There are many aspects to this question; therefore, it should be imperative that the mining concern have a strong background in the management of commodities in the financial markets.
