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Box 6187, Depot #1

Victoria, British Columbia
Canada V8P 5L5
Tel: (250) 477-7579
Fax: (250) 721-3524
www.murenbeeld.com

M. Murenbeeld &
Associates Inc.

In Defense of Gold Hedging

The Case of Barrick

August 2002
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M. Murenbeeld &
Associates Inc.

In Defense of Gold Hedging The Case of Barrick

INTRODUCTION
Not a day goes by without some comment on the newswires or gold commentary sites that gold hedging is a scourge on the gold market, and that the
gold price would be much, much higher were it not for hedgers Invariably,
Barrick is mentioned as the leading miscreant among hedgers, and devoted
to suppressing the gold price lest its outstanding hedges are overtaken by a
rising gold price.
A sample of the commentary I have collected serves to highlight the vitriolic nature of the criticism levied at Barrick - criticism tantamount to slanderous, and which a company smaller than Barrick might otherwise find
profitable to litigate. Among the worst commentaries is a piece written by
Antal Fekete, entitled The Texas Hedges of Barrick, which can be found
on a number of gold-related web sites, including www.gold-eagle.com. The
commentary starts with the nonsensical claim that [hedge] sales must never
exceed one years output and that the hedges of Barrick represent an unlimited liability. It deteriorates from there. Barricks spot-deferred contracts are fraudulent, may well ruin the company financially, and are an
an invitation to bankruptcy. This will leave Barrick open to class-action
suits by the shareholders, and the officers of Barrick are blockheads
wrapped up in their own glory who do not understand the very nature of the
product they help bring up from the bowels of the earth.
Those who claim the existence of a conspiracy to suppress the price of
gold, directed by no less than the US Federal Reserve, also finger Barrick
among the conspirators. In an official Complaint (dated December 7, 2000
and undertaken by one Reginald Howe supported by GATA, the Gold AntiTrust Action group) point number 13 claims that an examination of the gold
hedging activities of the worlds two largest gold mining companies,
AngloGold Ltd. based in South Africa and Barrick Gold Corp. based in
Canada, suggest that both companies have material non-public knowledge of the gold price fixing scheme which they have used to their advantage.
What is the gold investor to make of all this? Indeed, the claimants of
Barricks fraudulent behavior come with impeccable credentials. Antal
Fekete, for example, is Professor Emeritus at Memorial University of Newfoundland.
Yet, impeccable credentials do not imply that such charges against
Barrick and its officers are remotely accurate. I have a Ph.D. from Berkeley,
2

M. Murenbeeld &
Associates Inc.

California, and was on staff at the Faculty of Management Studies at the

University of Toronto during the 1970s. I am currently an Adjunct Professor
at the Faculty of Business at the University of Victoria. I can say honestly
that not every professor is up to snuff. Indeed, one of the motives for this
article is my affront as a part-time academic by the diatribe that passes for
argument from those with impeccable credentials.
This paper presents a defense of the practice of gold hedging, and a defense of Barricks hedging program specifically. The paper will start with a
somewhat detailed explanation of hedging. It will then highlight the costs
and benefits of hedging before delving briefly into the debate about hedging
under the section The Costs to the Industry. The paper will conclude with
an analysis of Barricks hedging strategy in order to highlight the costs and
benefits of this strategy to the Barrick shareholder.
The informed reader may skip any section except the last, without
loss of continuity.
It is worth noting right at the outset that we have found nothing inherently dangerous or ill-conceived in Barricks hedging strategy. It is a
strategy that has provided Barrick with cash flow well in excess of the market over the last 58 quarters, and which has therefore benefited Barrick
shareholders despite very difficult market conditions.
Just how well it has served the shareholder can be gleaned from the
chart below, which compares the Barrick share price with the gold price, with
the TSE Gold and Precious Minerals Index (which includes Barrick), and

RATIO BARRICK SHARE PRICE :

3500

Month end
Dec 1985 = 100

3000
2500
2000
1500
1000

With Gold
500

With TSE Precious Minerals Index

With XAU

0
85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

01

02

M. Murenbeeld &
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with the Philadelphia XAU index (which also includes Barrick). The rise in
the Barrick share price attests to just how much it has outperformed these
benchmarks over the last 17 years. Clearly the blockheads at Barrick have
been doing something right.

THE THEORY AND MECHANICS OF HEDGING

The Theory of Hedging
Hedging is defined as the process of reducing exposure to an event
that could be costly to a firm. Speculation is defined as the process of
increasing exposure to an event that could be profitable to a firm.
By definition, hedging is the opposite of speculation. (Antal Feteke
writes about Barricks arbitrage activity, but arbitrage is the process of
profiting from buying in one market and selling in another something quite
unrelated to hedging.) It follows that if the event turns out opposite to what
was expected there will be costs opportunity costs (in the case of hedgers) or
cash costs (in the case of speculators).
The origin of hedging goes back to agricultural economies where peasant
farmers would commit to sell their output to a middleman in order to avoid
the volatility of future produce prices. (Ergo, commodity exchanges grains,
hogs, etc. are among the oldest exchanges.) These farmers would transfer
the risk of price declines, to which they were exposed and which could be
ruinous, to a middleman - a risk-taker (possibly an outright speculator who
hoped to benefit from a future price rise). The farmer was risk-averse,
meaning he would prefer the certainty of a fixed price at which to sell his output. Obviously, in the event the price of his output turned out to be higher
than what he contracted for with the middleman the farmer would suffer an
opportunity loss but he would experience no direct cash loss.
The farmer would not typically contract to sell next years production forward, because the vagaries of weather and other variables left him uncertain
as to the size of his harvest a year out. He recognized that if he was unable to
deliver produce that was sold forward, and market prices were higher than
contracted, he could be ruined.
This basic need to transfer risk has, over the years, spawned whole industries. In the financial industry it has led to the development of numerous
derivative markets and instruments, each instrument having very specific
risk-transference characteristics. The management of risk has also become a
highly specialized field within the general field of business management. In-

M. Murenbeeld &
Associates Inc.

deed, there are probably very few managers still working in major corporations today who have not at one time or another had to transfer a specific risk
by way of some derivative instrument.
Gold price hedging, or the process whereby the risk of a future gold price
decline is transferred to a risk-taker(s), also developed naturally. I was an
advisor to Lac Minerals in the early 1980s when that company (since merged
with Barrick) began to apply risk management techniques developed in the
foreign exchange market to the gold market. (It is an interesting aside that
back then a gold company might very well hedge its Canadian Dollar exposure, but not its gold price exposure. The prevailing view was that you did
not hedge the gold price risk if you did you were speculating that the gold
price would not go up. No such double-think was applied to currency hedging however.)
In gold hedging it is not strictly necessary for the risk manager to
have a view of the future price of gold. A good risk manager needs to
know the degree to which the company will accept adverse price outcomes; a
risk manager needs to know the risk profile of the company, in other words.
Once someone like myself a gold price analyst - lays out different gold price
scenarios for the future (remember, no one knows what the price of gold will
be in the future) the risk manager can construct a profit and loss profile for
the company and act in accordance with the companys risk profile to mitigate the worst outcomes.
The point is, a good risk manager is not directly taking a bet on the
gold price! The manager is managing the risk of adverse outcomes; he/she is
managing the companys exposure to events that have cash cost implications.
It does follow, however, that when all the gold price scenarios are bullish
i.e., when there is a low perceived probability that gold prices will decline
the risk manager will typically hedge the price risk less than when all the
gold price scenarios are bearish i.e. when there is a high perceived probability that gold prices will decline. The perceived probability of losses is higher
in the latter case. A risk manager isnt directly interested in the pinpoint
forecast of the future gold price furthermore, which is invariably wrong
anyways. He/she is interested in a range of potential price outcomes with the
subjective probabilities of such outcomes.
Currently, the gold price scenarios are more bullish than bearish. Accordingly, gold producers are scaling back their hedging activities. Yet the
sharp decline in the gold price the week of July 26 serves as warning that
nothing is certain, and even the low probability scenario of a price decline can
turn up.

M. Murenbeeld &
Associates Inc.

The foregoing does not apply to hedging that is motivated by issues related to new mine development. It is often a requirement of the lender that
some percentage of future output of the new mine be hedged in order that
the risk of future financial difficulties is reduced. But here, too, the driving
factor is risk, and how to reduce it!

The mechanics of hedging

When a gold producer contracts to sell gold forward it is for a specific
date at a specific price. For example, a producer may contract to deliver 100
ounces of gold one year from today. The buyer, or counter-party, is typically a
bullion bank, and it is legally bound to pay the contracted price upon delivery
of the 100 ounces. The price is set today, of course.
The forward price is calculated from the current spot price of
gold, the current lease rate for gold, and the current US Dollar
LIBOR rate (the London interbank offer rate). Because the bullion bank
borrows gold from a central bank at that banks lease rate, sells the gold directly into the market at the spot price, and invests the proceeds at the
LIBOR, its net return is spot + LIBOR lease. This net return is paid to
the producer.
Since LIBOR is invariably higher than the lease rate the forward price is
typically at a premium to the spot price. The premium is called a contango.
When the contango is large (when LIBOR is high and lease rates are low)
there is a financial inducement to the producer to sell gold forward. Indeed,
the risk manager typically compares the forward price of gold with the various gold price scenarios and the respective probabilities to help formulate a
hedging strategy.
It follows when a producer sells gold forward there is a spot market sale of gold, and this affects the price of gold. In effect, selling gold forward accelerates the impact of future supply. From a central bank perspective gold loans provide a way to earn a small return (the lease rate) on their
gold assets. If central banks (or in rare cases, private holders of gold) were
not willing to lend gold, producers could only sell gold forward to another
buyer directly, with the bullion bank acting as a broker (much like selling
gold in the spot market). The forward market would collapse to a small fraction of its current size.
A forward sale is not the only means of hedging gold price risk. The gold
market now encompasses all the sophisticated derivative instruments used in

M. Murenbeeld &
Associates Inc.

currency and credit markets. A producer can also buy a put option on
gold, for example. If open for one year, the producer has the right to sell a
certain quantity of gold at a specific (floor) price one year out. The producer
would exercise the option in the event the actual gold price fell below the
floor price (the correct name is the strike price). In the event the gold price
did not fall below the strike price, the producer would sell gold in the market
directly, loosing only the premium paid for the put option.
The seller, or writer, of the option typically, again, a bullion bank has
a more complicated task of managing its own exposure to gold price fluctuations however. With a forward contract the bullion bank expects to receive
(the 100 ounces of) gold, which it will return to the central bank from which it
was lent. It is square, gold bullion coming in matches gold bullion going out.
With a put option the bullion bank doesnt know for certain whether it will
receive gold from the producer however. At regular intervals the bullion bank
therefore makes a statistical estimate of the likelihood of receiving gold, and
sells/buys gold forward as the likelihood increases/decreases. This delta
hedging by the bullion bank is quite complicated; suffice it to say that a put
option generally leads to less spot market selling of gold than a forward contract.
A third method of hedging gold price risk employs both put options and call options. A producer can buy a put option as above, and at
the same time sell a call option. The call option sold to the bullion bank gives
the bank the right to receive gold from the producer at another, higher strike
price. The bullion bank pays the producer a premium for this right. If for example the producer buys a one-year put option at $280 and sells a one-year
call option at $350, then the price the producer will receive one year hence for
its gold will fall somewhere between $280 and $350. If the actual price of gold
fell below $280 the producer has the protection of the put option with a
$280 floor price, and if the gold price rose through $350 the bullion bank will
exercise its right to call up the gold from the producer at $350. (This sort of
hedging instrument is sometimes referred to as a min-max call option. In
the foreign exchange market it is sometimes called a range forward.)
Min-max call options are popular among some producers because
the premium received for the call option helps pay for the cost of the
put option. With luck, the producer can structure an acceptable price range
with no out-of-pocket expense. (Smaller producers often find this a net benefit, as cash is generally tight.)

M. Murenbeeld &
Associates Inc.

THE COSTS (AND RISKS) OF HEDGING

Opportunity Cost
As they say, there is no free lunch! The benefit to a producer of transferring gold price risk to a bullion bank has costs attached to it. The trick is to
keep these costs to an acceptable level. (We will see below how Barrick does
it; what follows here are the textbook costs of hedging.)
The first, and obvious cost is that a producer will not profit as much as it
might from a significant rise in the price of gold. This cost is an opportunity
cost an opportunity missed, as it were. (My economics dictionary defines
it as a gain foregone.) With a forward contract the opportunity cost is the
difference between the forward price, and the actual price in the spot market
on due date. If 100 ounces were sold forward at $325, for example, and the actual gold price on due date was $335 then the opportunity cost is $10 per
ounce, or $1000. (Of course, the opportunity cost has to be compared against
the cash gain of a potential decline to, say, $300.)
In theory, the opportunity cost of a forward sale is open ended. In
the event gold shoots up to $1000 the opportunity cost of a $325 forward sale
is $67500 for 100 ounces. Yet, an event that causes gold to shoot upwards to
$1000 is by its very nature a low probability event, and therefore not generally expected. A good risk manager is aware that low probability events do
happen however. (LTCM, for example, was bankupted by a confluence of several extremely low probability events.) The risk manager will therefore ensure that there are provisions in the contracts and in the companys gold production schedule to deal with such chance events.
A put option is designed to limit these opportunity costs directly.
By ensuring a floor price for gold, but not limiting the upside, the producer
only ever pays the premium for the option. In the event the premium is $500
for a $295 put option on 100 ounces (or $5 per ounce), then a price rise to
$350 nets the producer a $345 price. In the event gold falls to $275 the producer exercises at $295 for a net price of $290. The $500 premium is a cash
cost, paid up front, and never recovered. It is often referred to as an insurance cost.
The cost of a min-max call option is generally just an opportunity cost,
provided the premium collected for the calls equals the premium paid for the
puts. In the above example, where the range is $280-350, the opportunity
cost starts above $350 and is again open-ended.

M. Murenbeeld &
Associates Inc.

A Lower Stock Price

While an opportunity cost is not a cash cost, it will be registered somewhere. In the event gold prices rise beyond the forward price, theory holds
that the stock price will be lower than otherwise because the producers
earnings/revenue stream will be lower than otherwise. (Of course, when the
gold price sinks below the forward price the stock price will be higher than
otherwise because of the extra revenue received.)
To the degree that a gold stock is also a call option on gold bullion to be
produced, and since such a call option becomes more valuable when the probability of higher gold prices rises, a cap on the gold price to be received by the
producer will also hurt the stock price. (Theory seems to support the notion
that gold stocks are options on gold bullion, meaning that upward volatility
in the gold price is positive for the value of gold stocks.)
It follows that investors who have a very bullish view of the gold
price will prefer to invest in gold stocks that have few/no gold hedges
outstanding. But when the price outlook is very bullish risk managers are
also very likely to hedge less gold output! A certain synchronicity develops, in
other words. Yet the risk manager, by the very nature of the role, is unlikely
to unwind hedges as fast as the investor might wish. Ergo, the cost of hedging to the producer when the gold price outlook is very bullish is a shift of investor sentiment to other, less-hedged producers.

The Economic Cost

The third cost of hedging is more difficult to establish. There should be
an economic cost to hedging, in so far as risk takers need to be
compensated for accepting a risk the producer does not want to bear.
The academic literature is not conclusive on the actual cost however. Suffice
it to say that in the currency markets forward rates are not particularly biased, meaning that over long periods of time there is no advantage to not
hedging the amount received in the spot market when not hedging averages
out to be about the same as the amount received in the forward market when
hedging.
I am inclined to say that because central banks have lent their gold at
too low lease rates however, that there has been a definite advantage to hedging gold the contango has been higher than it should have been in a perfectly competitive market these last 15 or so years. Accordingly, I believe
hedgers have on average received more for their gold than non-hedgers have.
But 15 years may be too short a time period of analysis.

M. Murenbeeld &
Associates Inc.

Suffice it to say, that more academic work needs to be done on this aspect
of the costs.

The Risks in Hedging

This section deals with the risk of inadvertently constructing hedges
where something goes wrong. (Hedging tools are sophisticated, and the legal
contracts are often complicated.) The reader has heard of a number of cases
where hedges nearly bankrupted several producers. Without referring to
specific cases (I dont have full knowledge of these cases in any event), let me
outline areas where hedging mistakes can be made and/or where frictions
can develop between the producer and the bullion bank to the detriment of
the producer.
The first risk is that a producer may have inadvertently oversold
its output forward. It is understood that a producer must deliver the contracted amount of gold on due date. If the producer cannot, there is a problem! (I witnessed first hand a large Canadian manufacturing bankruptcy in
the early 1980s because the company could not deliver the billions of US Dollars sold forward against Cdn Dollars, and the Cdn Dollar declined precipitously in the meantime. The company had made US Dollar revenue forecasts
that did not materialize because of the 1980-82 recession.)
If a producer cannot deliver the agreed amount of gold on due date the
producer must buy gold in the market and deliver that to the bullion bank. In
the event the price of gold is below the contract price (below the forward price
negotiated some time ago) the problem is academic. The producer buys the
gold in the market and delivers it on the contract at a profit. In the event the
gold price is above the contract price, however, there will be a cash loss
which can potentially be huge. If gold is sold forward at $300, for example,
and gold shoots up to $400 the cash loss will be substantial. Such cash losses
could bankrupt the producer.
Along similar lines, there is something called a margin call . Margin
calls are a requirement in the futures industry, where small and large speculators take positions in a market with only a fraction of the total value of the contract. The broker marks to market a speculators position daily and subtracts
any hypothetical loss directly from the account balance. In the event the remainder falls below a minimum level, the broker makes a margin call to the speculator. The speculator must then deposit more money in the account or the contract
is liquidated and all losses are charged to the speculator.
Margin calls could come into play in gold hedging when a producer has
sold gold forward, and the price of gold skyrockets. When the forward con10

M. Murenbeeld &
Associates Inc.

tract is marked to market the hypothetical loss could exceed the credit limit
of the producer, for example. Despite the producers full ability to deliver gold
against the contract on due date, the bullion bank may depending upon the
specifics written in the contract ask for more margin. In the event the producer cannot raise the required amount of cash again, depending upon the
specifics written in the contract the bullion bank may liquidate the contract
at very significant loss to the producer. (This is a terrible situation for the
producer, of course! The producer might very well have been able to deliver
the required amount of gold on contract date, and incur an opportunity loss
only maybe not even an opportunity loss, in fact, were the gold price to fall
as sharply as it rose. But instead the producer suffers a punishing cash loss!)

The Costs to the Industry

This is a most contentious issue, and one that needs some illumination because it threatens to fracture the generally good relations
among gold producers generally.
It is true that when a producer initiates a forward hedge contract the accelerated selling of gold will lower the spot price of gold somewhat. Gold that
will be produced in the future is sold immediately, meaning that often both
current and future output is sold in the spot market at the same time. Since
producers have gone from zero hedging in the early 1980s to 3073 tonnes
hedged at the end of 2001 (source: Gold Field Mineral Services - GFMS) there
will have been an impact of these extra 3073 tonnes on the market. Table 1
provides an estimate of the average yearly price impact of hedging these 3073
tonnes.
It follows that those producers who chose not to hedge will have
received somewhat lower prices for their output than otherwise. These
non-hedgers could have also hedged their future output of course, but that
would have lowered the price of gold yet further. One is apt therefore to conclude that the cost of hedging has been borne by the non-hedgers.
But there is more to this issue! It is undoubtedly true if all producers refrained from hedging and the central banks that otherwise lent their gold
did not turn around and sell it then the gold price would have been higher
in past years. But the same can be said about gold production; if gold
production had been lower in recent years the gold price would have
been higher as well! Does it therefore follow that producers should collectively curtail production when gold prices are soft? That would be dangerous
in the extreme! While OPEC might be able to fix production schedules to
maintain higher oil prices, the full weight of anti-trust legislation would fall
on gold producers who attempted to do that for the gold price.
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M. Murenbeeld &
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TABLE 1

Year
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Total

Hedging
Net
4
38
62
45
149
353
178
234
66
135
142
105
475
142
504
97
506
-15
-147

GOLD PRICE
Actual
change
$/oz.
(%)
423.61
12.91
360.78
-14.83
317.26
-12.06
367.85
15.95
446.22
21.30
436.87
-2.09
380.79
-12.84
383.59
0.73
362.26
-5.56
343.95
-5.05
359.82
4.61
384.15
6.76
384.05
-0.03
387.87
0.99
331.29
-14.59
294.07
-11.23
278.56
-5.27
279.11
0.20
271.07
-2.88

SUPPLY
adjusted
(tonnes)
1326
1846
1868
2023
1973
2438
2899
2719
2868
3181
2932
3016
3345
3285
3887
3592
3763
3731
3488

% of
Supply
0.30
2.10
3.46
2.25
8.18
16.95
6.54
9.42
2.36
4.43
5.09
3.61
16.55
4.52
14.90
2.78
15.54
-0.40
-4.04

3073

HEDGING
impact on
price - %
-0.12
-0.84
-1.38
-0.90
-3.27
-6.78
-2.62
-3.77
-0.94
-1.77
-2.04
-1.44
-6.62
-1.81
-5.96
-1.11
-6.21
0.16
1.62

impact
US$/oz
-0.51
-3.06
-4.45
-3.34
-15.10
-31.77
-10.23
-15.01
-3.45
-6.21
-7.48
-5.62
-27.23
-7.14
-20.99
-3.30
-18.46
0.45
4.32

average

-9.40

Assume producers de-hedge the full amount over the next 8 years
2002
2003
2004
2005
2006
2007
2008
2009
2010

-300
-300
-350
-400
-400
-400
-400
-400
-123

Total

-3073

325.00
335.00
345.00
355.00
365.00
375.00
385.00
395.00
405.00

19.90
3.08
2.99
2.90
2.82
2.74
2.67
2.60
2.53

3400
3400
3400
3400
3400
3400
3400
3400
3400

source: GFMS, Murenbeeld estimates

12

-8.11
-8.11
-9.33
-10.53
-10.53
-10.53
-10.53
-10.53
-3.49

3.24
3.24
3.73
4.21
4.21
4.21
4.21
4.21
1.40

10.21
10.52
12.42
14.34
14.75
15.15
15.56
15.96
5.58

average

12.72

M. Murenbeeld &
Associates Inc.

Hedging is a means of guaranteeing higher expected future production than otherwise. The criticism of hedging therefore comes down to
criticism of an action intended to secure higher future production. But should
a producer not attempt to secure higher output? Should a producer not use
all the tools available to it to secure what it perceives to be in its shareholders best interests? Indeed, should a new ore body be mothballed, despite a
producers willingness to risk time and development capital, because it might
require the guarantee of a forward contract? To put it more squarely, whose
interests should a producer serve: its own shareholders or the shareholders of
those producers potentially hurt by its actions?
The fact that individual gold producers actions may depress the price of
gold is also a fact of life in other markets. Indeed, even central banks complain that the collective action of participants in the currency markets (spot
and forward) often drives the price of the currency beyond reasonable levels
and accordingly hurts the economy. And the currency market is huge in
comparison to the gold market!
It is in the nature of any market that if both producers and consumers
collectively feel that the price of the commodity is more likely to decline than
rise, their collective action will make it happen. Accordingly, if everyone
thinks the gold price will go down, it will indeed decline. Should those producers who have determined that such a decline represents too much risk
nevertheless stand firm and forgo actions to reduce this risk?
Lest we forget, the knife cuts both ways! Producers who have hedged in
the past are, in light of more bullish price expectations, now paring back
their hedges. And this is contributing to a rise in the gold price which
will now benefit the non-hedgers disproportionately. Table 1 also provides an estimate of the price impact of a hypothetical decline in gold hedging
over the next 8 years. What hurts non-hedgers on the way down should feel
very good on the way up! That in the interim some non-hedgers may have
had to pack it in, well, that is the markets way of cleaning house. Quite literally, their lost output has been gained by the hedgers.
So, what can we conclude? First, the gold market is small; individual actions by large producers do have an impact on the gold price. Large
gold producers are not, in the strictest sense, price-takers. While the action of any one of a million little gold producers will not affect the gold price,
the gold market is in a period of consolidation - meaning the impact of any
one producers actions in the market will be magnified in the future. Yet, provided that there will be a number of large producers in the industry, it does
not follow that each producer should serve the markets interest before its

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own shareholders interests. Rather, large producers should support the

markets interest through programs which boost the demand for gold, as has
been proposed by Barrick and others. Indeed, the large hedgers are, to my
knowledge, among the most active in promoting gold demand.
As long as there is a forward market for gold and a perceived
need to transfer price risk, hedging will continue. It will rise as the
markets view turns bearish and it will fall as the markets view turns
bullish! All producers should therefore make their peace with hedging
and let the gold equity investor decide which management style best
suits the investors own risk preference a management style that allows for hedging, or a style that does not.

AN ANALYSIS OF BARRICKS GOLD HEDGING PROGRAM

The Barrick Program
In Note 16 of the 2001 annual report it states, The Company maintains
a commodity-price-risk-management strategy that uses derivative instruments to mitigate significant, unanticipated earnings and cash flow fluctuations that may arise from volatility in commodity prices The Company
uses spot deferred sales contracts and options contracts to manage these
risks. One can safely conclude from this that the companys intent is to manage price risk, much as we indicated under The Theory of Hedging.
Table 2 provides a summary of data made available in Barricks annual
and quarterly reports. We have made some simplifying assumptions in the
table for the purposes of exposition. Barrick will not agree with these (unrealistic) assumptions for obvious reasons. The first is that Barrick will generate
no new additions to its reserves. At an assumed 5.7 million ounces of production per year going forward (with which Barrick will also take issue), Barrick
will have an effective life of about 13 years before its reserves run out. Even
under these stringent assumptions, however, Barrick appears more
than capable of delivering against all its hedge contracts as they fall
due!
Indeed, the total number of ounces hedged is only 27% of (assumed) 2002
reserves. The hedge contracts are spaced out, furthermore, so that no more
than 62% of assumed production is due in any one year. Bear in mind that
in reality Barrick will find more reserves it has every year of its existence.
This means that the hedged ounces, if not replaced with new hedge ounces,
will decline sharply as a percent of reserves. Output is also very likely to be
higher than 5.7 million ounces going forward.
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TABLE 2
BARRICK Gold Hedge Positions - June 30, 2002
2002

2003

2004

2005

2006

2007+

Total

1400
365

2800
340

2650
340

1600
335

1600
340

7850
346

17900
344

500
342

420
320

400
328

170
349

820
362

2310
343

Spot Deferred
thousand ounces
average price ($/oz)
Call Options - variable price
thousand ounces
strike price ($/oz)
Min-Max Call Options - variable price
thousand ounces
cap price($/oz)
floor price ($/oz)

200
297
266

350
303
272

150
310
280

Call Options - fixed price

thousand ounces
strike price ($/oz)

Total Hedges - Deferred, Call, Min-Max

230
354

405
344

1770

8900

20965

5700

5700

51800

77580

57500

51800

60
310

115
343

1600

3510

3185

2000

2980

5700

5700

77580

68900

63200

Assumed Production*
assume current production forward

Proven and Probable Reserves**

year-end, assuming no yearly additions

* Expected production for 2002 is for July-December

** Reserves are at mid-year 2002, assuming there were 80.3 million ounces of reserves at 2001-end and no additions during the first half of 2002

Hedges - Percent of Production

Hedges - Percent of Reserves

54%
27%

62%

56%

35%

31%

17%

All Barrick hedges are of a spot deferred type, which means that
they do not represent a direct claim on production in any one year.
There is accordingly no reason for Barrick to get itself into the situation of
having to deliver gold that it has not produced. Ergo, the worst disaster in
hedging that of having inadvertently hedged more gold than can be delivered is not relevant in the case of Barrick. (Only in the last few years of its
assumed 13-year life, when reserves are nearly depleted and Barrick has not
yet delivered against any of its contracts, will there be a potential opportunity cost.)
I did not discuss spot deferred contracts in the theory section because it
is more appropriate to do so here. (Spot-deferred contracts are often producer-specific, owing to the nature of the credit and trust involved.) The typical spot-deferred contract is a forward contract that may be rolled over into a
new forward contract on due date. If we assume that a producer has negotiated a one-year spot deferred at a price of $340, it may deliver against this
contract one year from now, or it may roll over the contract into another
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M. Murenbeeld &
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one-year forward contract. The new forward price will be $340 plus the prevailing one-year contango, regardless of what the spot and forward prices are
at the time. (Only the contango is uncertain!)
In the standard spot deferred contract the roll-over isnt necessarily automatic however. The counter party (bullion bank) may require
margin or other comfort measure before agreeing to a roll over. In the
above example, were the actual price of gold on due date to be $375, the spot
deferred would be underwater by $35. Even the roll over would only have
a contract price of about $350 ($340 plus a one-year contango of, say, 3%),
which would still be less than $375! It follows that a bullion bank might become nervous in such a situation. Suppose gold rose by another $50 in the following year? Without absolute confidence in the producers ability to produce
the agreed amount of gold and without deep producer credit lines the bullion
bank might panic and pull the plug on roll over date, if not before.
The Barrick spot deferred contracts have the unique feature of
being of 10 or of 15 years duration. This means that Barrick can roll the
contracts for 10 or 15 years before termination, without question. The
Barrick contracts have shorter pricing dates however. Much like a 10-year
mortgage might be re-priced every 1, 3, or 5 years, depending upon whether
the borrower chose a 1-year, 3-year, or 5-year term, Barricks spot deferred
contracts are re-priced at regular intervals before their maturity/termination
date. (Table 2 also shows when the repricing dates occur.) And much like a
10-year mortgage, the lending institution cannot close out Barricks spot deferred contracts before maturity/termination date only Barrick can close
them out early.
There are some caveats to the last statement, to be sure. Barricks
counter parties can request termination at the next price setting date
if there has been a material and lasting impact on Barricks ability to
deliver gold (if something disastrous were to happen to Barricks production
facilities, say), or if the counter parties are unable to acquire bullion in the
open market or any organized exchange or to fund any such acquisition (if
the bullion bank cant borrow any more gold anywhere). Barrick must also
have a minimum net worth of $2 billion, and a long-term debt to consolidated
net worth ratio of no more than 1.5-2.0:1. Currently these are $3.2 billion and
.25:1 respectively. These caveats are clearly spelled out in the Master Trading Agreement which covers all Barricks contracts. Were Barrick to fall
afoul of its obligations in the Master Trading Agreement the hedged
ounces will be the least of shareholders worries.

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Last, Barricks counter parties cannot make a margin call just

because the value of the spot deferred contracts, when marked to market, are
in significant loss. There are no margin clauses in the Master Trading Agreement. (Again, as with a mortgage, the lender does not ask for margin when
the value of the property falls below the outstanding mortgage.) Barricks
only obligation is to deliver gold on a date of its choosing; depending upon the
spot price of gold on that date, all Barrick will incur is an opportunity loss!
Lets look at an example. In Table 2 there are 2.8 million spot deferred
ounces of gold coming due in 2003 at an average price of $340. Regardless of
the actual price of gold in 2003, Barrick may choose to deliver against these
contracts or have them re-priced for the next 1-5 year period. In the event
the gold price was less than $340 Barrick might choose to deliver against
these contracts. In this case Barrick would report another gain on its hedging
activities.
In the event the gold price was, say, $500 however, Barrick might choose
to roll over all 2.8 million ounces. The counter party cannot force Barrick to
deliver against the contracts. But Barrick might also choose to deliver some
of the 2.8 million ounces, in which case it would average the $340 received on
the contract with the price received in the spot market for the rest of its production. The average price received will then be lower than otherwise, and
there will be an opportunity loss!
While spot deferred contracts are Barricks preferred hedge contracts, it
also has option contracts at variable prices, and options at fixed prices. The
Master Trading Agreement states however, An exercised option shall be
treated as a forward contract. This means that Barricks call options, when
the counter party exercises them, become forward contracts at the strike
price. If Barrick so chooses, these can be deferred in a manner similar to the
other spot deferred contracts.
For all intents and purposes, Barrick need not deliver any gold at
below-spot market prices before final termination date of the contract
and these termination dates are all at least 10 years into the future. (Indeed, it will be more than 10 years into the future on the 15-year contracts
because Barrick must be given 14 years notice when a 15-year counter
party decides that the agreement will not be extended. I have assumed for
the purposes of this discussion however that Barricks mine life is only 13
years.) Ergo, even the 62% hedge/production ratio for 2003 is relatively meaningless given Barricks ability to roll the 2.8 million spot deferred ounces, and
the .71 million optioned ounces, into the future as it sees fit.

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The Benefits of Barricks Hedging Program

I will dispense with the benefits quickly. They are self-evident. The Program has insulated Barrick more than adequately against the risk of a sharp
gold price decline. Some 27% of reserves has been hedged at prices well above
$300 per ounce. The Program to date has generated significantly higher revenues than could have been obtained through the spot market only. Over the
last 58 quarters, 14.5 years, these higher revenues have contributed an extra
$2 billion. This money has been spent on exploration, development, production and acquisition in other words, on increasing Barrick production without shareholder dilution. The $2 billion has also helped increase Barricks leverage to gold, because the extra expenditure on exploration has led to significant increases in gold reserves. (This fact seems to be neglected entirely
by Barricks detractors; the Program has allowed the company to grow in a
very difficult environment!)
In the event gold prices were to decline again from current levels (at the
time of writing, gold was trading around $315) Barrick should continue to do
well. With the exception of 200,000 ounces with a floor of $266, due in the
second half of this year (but which can be deferred, of course), and 150,000
ounces with a floor of $280 due next year, all contracts have a floor price well
above $300. (In fact, the weighted average price per ounce of hedged gold over
the next 13 years is $343 see Table 2. And the actual price Barrick will receive could be significantly higher, depending upon the contango at the repricing dates.)

The Cost of the Barrick Program

The cost of the Barrick Program is either an opportunity cost or
the cost associated with Barrick not being able to deliver what it has
contracted to deliver. (The latter leads Professor Fekete to speculate that
Barrick will be ruined financially - see above.)
With respect to opportunity cost, there is no doubt that if/when Barrick
delivers gold on outstanding contracts at below-spot market prices it will
suffer an opportunity loss. Such was argued in the theory section as well.
Barrick mitigates opportunity losses, however, through the flexibility
of the spot deferred contracts. As noted above, Barrick can choose not to
take an opportunity loss by simply rolling the contracts forward on re-pricing
date to the next re-pricing date. In other words, Barrick need not take any
loss at all on any of its contracts until termination date 10-15 years
from now.

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Will Barrick have to take an opportunity loss at termination date? That

depends upon a number of factors; the simple answer however is that there
will be no opportunity loss if the spot price of gold on termination date is below the contract price. And that could happen! Remember that on each repricing date a new contango is added to the original contract price. In theory
there is a point in time when the additional contango catches up with the
spot price, provided the spot price doesnt forever rise by more than the
amount of the contango. In theory, therefore, Barrick need never take an opportunity loss. The point in time when the contango catches up to the spot
price might well be beyond Barricks assumed 13-year life, however.
It follows there is risk of opportunity losses during the last four years of
Barricks assumed 13 years of remaining life. This would happen if [1] some
of the 20.965 million ounces currently hedged were rolled forward continuously until there were only an equal amount of reserve ounces left to be
mined, and [2] the spot price of gold was above the final contract price on termination date. In theory, these opportunity costs could be substantial.
Yet they are still not cash costs! And we must assume that the average investor, noting Barrick has not replaced any of its reserves, will
have long abandoned the company to its deserved fate.
In reality, Barrick will add reserves going forward, and it will be able to
roll its contracts forward as well. In short, if one assumes that Barrick is an
ongoing concern, demonstrably so if the past is a guide, then much of the risk
of opportunity cost will be mitigated.
Barrick does face a potential problem however in the event the
contango turns negative. A negative contango (backwardation) could lead
to significant opportunity losses for Barrick. Backwardation represents the
biggest threat to the Barrick Program because the new contract price declines on each re-pricing date when there is backwardation. If the spot market for gold continues to rise or simply trends sideways - then rolling over
means rolling over into larger and larger potential opportunity costs!
So, how likely is a negative contango? The fact is, the gold market is
almost never in backwardation (LIBOR is almost always higher than the gold
lease rate). The two charts herewith show that the three-month contango has
not been negative since 1993, for example, while the one-month contango was
negative exactly once on March 9, 2001. Barrick contracts have re-pricing
dates of 1-5 years, and the contango for these dates have not been negative in
my experience. It is therefore safe to assume that the contango will be
positive on re-pricing dates. I wont shrink from saying however that
backwardation represents a risk to the Barrick Program, which can only be
alleviated through delivery and booking the opportunity loss immediately.
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GOLD CONTANGO
3 month contango

6
5
4
3
2
1
0
-1

Friday data
Last Date: August 9, 2002

-2
6/3/94

7
6

6/9/95

6/14/96

6/20/97

6/26/98

7/2/99

7/7/00

7/13/01

7/19/02

7/13/01

7/19/02

GOLD CONTANGO
1 month contango

5
4
3
2
1
0
-1

Friday data
Last Date: August 9, 2002

-2
6/3/94

6/9/95

6/14/96

6/20/97

backwardation

6/26/98

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7/7/00

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With respect to the second cost of the Barrick Program, Barricks potential inability to deliver against its contracts, let me note immediately that
Barrick need only deliver see Table 1 62% or less of any one years production. Unless Barrick production problems exceed some 3 million ounces
per annum, Barrick will be able to deliver on all contracts. Further to this
point, Barrick operates in geographic regions that are no more politically unstable than those where other major gold producers operate. Suffice it to say
that if the investor is worried about Barricks ability to produce less than half
of the 5.7 million ounces a year I have assumed, that investor is probably too
risk-averse to be investing in the stock market altogether!
The Master Trading Agreement does deal directly with this issue, however. Barricks counter parties can force delivery on re-pricing dates if it has
been established that there has been some material and lasting impact on
Barricks ability to deliver gold. But again, if that impact is greater than half
the assumed yearly production then Barrick has larger problems than its
hedge contracts.
Barricks average counter parties are of AA credit standing, meaning
that if central banks refuse to lend gold to these parties there simply will be
no gold lending market. In this event the counter party can force delivery on
re-pricing date. But here again, the fact that Barrick has structured the repricing dates such that only about half of expected production falls due in any
one year mitigates this potential problem.
In short, there are no life threatening scenarios that we can develop for the Barrick Heding Program without first assuming that
Barrick will suffer some apocalyptic event at its various mine sites.

CONCLUSION
Global public companies must have a business strategy that takes advantage of every opportunity to improve returns and reduce risk, states the
2001 annual report. Looking backward, one can certainly see that Barrick
has done exactly that. It has generated some $2 billion with the Program in
the last 58 quarters, which has allowed the company to grow under the most
difficult market conditions.
Criticism of the Program, and of Barrick management, is therefore largely off base. Producers who received lower gold prices for their output because Barrick (and others) were hedging the price risk of their future
output do have a point, to be sure. The price of gold would have been higher
had there been no hedging. But given that Barrick management believes that

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their hedging Program is in the best interest of the company and its shareholders, it seems to me that there could indeed be a class action suit against
Barrick by its shareholders if management went against its own best judgment in this regard.
Yet despite an enviable record, Barrick has come under yet more
criticism in recent days, criticism bordering on the libelous. One would
think, now that the outlook for gold has improved, non-hedgers would be
thankful that the hedgers are delivering against old contracts and thereby
keeping gold bullion off the market and helping its price to rise! Indeed, I am
wont to conclude that criticism of Barrick has taken on religious overtones.
Those who argue against hedging just dont believe that gold price risk
should be hedged, regardless. I doubt whether reason and debate will have
any impact on the most vociferous of Barricks critics.
I have set forth the argument for hedging gold price risk. I have not said
that it will always be profitable, after the fact. Hedging may incur opportunity losses, a lower equity price in rising bullion markets, and significant financial risks if structured badly. The inability to deliver gold when required,
for example, can be life threatening. As in all management matters however,
bad decisions, poor contracts, misunderstandings of obligations, etc., can do
untold damage to shareholder interests.
Hedging is a tool, to be used by those who understand it and feel
they can profit from it. In the case of Barrick the tool has enhanced revenue, smoothed out the impact of price fluctuations on revenues, and eliminated the impact of the worst possible gold price scenarios. Not all gold managers want to avail themselves of this tool, and not necessarily all shareholders want management to do so. That is why there is a market, so that all
types of shareholders the risk takers and the risk averse can find the particular stock that best suits their needs.
For Barrick, being somewhat risk averse compared to other gold producers these last 15 or so years, has been extremely profitable. No one can know
whether it will continue to be as profitable over the next 15 years. Yet the
data presented in Table 2 suggest that it is very likely to be quite profitable
for the next eight or so years. More to the point, I have uncovered none of the
bombs, or other dangerous and ill-conceived aspects of the Program that
Barrick detractors are so quick to claim. I rest my case.

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