Look Beneath the Numbers

February 27, 2006 – On February 22, 2006, a news report was published by Dow Jones Newswires based on a press release issued the same day by Barrick Gold Corp.  The Dow Jones article read in part:

“TORONTO — Barrick Gold Corp.’s profit increased by 12% in the fourth quarter as results were helped by a $50-an-ounce higher realized gold price, higher sales volumes and lower total cash costs compared to the prior-year period.  Net income totaled $175 million or 32 cents a share in the latest quarter versus $156 million or 29 cents a share a year earlier.”

The numbers sound impressive, don’t they?  And anyone reading that report would think it was a great quarter for Barrick.  However, when you look beneath the headline numbers, a different story appears.

Barrick has the biggest hedge book in the gold mining industry, currently standing at 18 million ounces.  Excluding the hedge book that they assumed from their recent acquisition of Placer Dome, Barrick at year-end had committed to some 13.2 million ounces by entering into various derivative contracts and forward sales.  These locked Barrick into the future price at which it will be required to deliver 13.2 million ounces of gold. 

Recall that the gold price rose from $469 to $517 during the quarter, an increase of $48 or 10.2%.  So how did Barrick’s hedge book do during the quarter?  Not so well, as I’ll explain in a moment, but I need to first explain what this so-called ‘hedging’ is all about.

Hedging is the term that describes those commitments made to reduce price risk through a variety of derivative instruments, such as futures contracts, forward sales and options.  For example, a farmer may choose to sell in May the corn he expects to harvest in September, thereby confirming in May the price he will receive four months in the future.  He is protected because he receives the price that has been committed in his hedge even if the price falls by the time he harvests his crop. 

Conversely, if the corn price were to rise by the time he is ready to deliver his crop, the farmer does not benefit – the upside is gained by the person who was willing to take the farmer’s price risk.  This “opportunity cost” is the farmer’s loss, but the farmer may consider this cost to be reasonable because he protected his profit margin by hedging.  Thus, hedging can be a useful tool to reduce price risk.  But let’s look at what Barrick has done.

They have locked in the price of gold, but not for just a few months forward as explained above in the example of the corn farmer.  Some of Barrick’s ‘hedge’ contracts do not mature for fifteen years. 

Now think about that fact for a moment in order to consider the implications.  Fifteen years.  Barrick knows today the price it will be receiving for gold that it will be mining and selling fifteen years in the future.  In fact, Barrick knew a few years ago what that future price would be when it entered into these contracts.  The price is – are you ready for this? – $301 per ounce.  How is it possible that the price is so low? 

Simple.  Most of these contracts were entered into when gold was under $290 per ounce.  Back then, perhaps a $301 price (which is currently the average price of Barrick’s 13.2 million ounces of outstanding hedge commitments) looked lucrative, but consider that low price now in view of gold’s $558 prevailing price.  Barrick’s hedging means that it is leaving a lot of money ‘on the table’ – already some $257 per ounce.

What’s worse, committing to deliver at that price in reality ran counter to the objectives that Barrick management was trying to accomplish.  These hedges increased risk, rather than lessened it.  This point requires some further explanation, and needs to be compared to my example of the corn farmer in order to understand how Barrick’s hedges actually increased its risk.

When the farmer in May sold forward the corn crop he expected to produce, he was locking in his profit margin.  He had a reasonable estimate at to what his costs would be from the time he planted his crop in May until harvest four months later.  But what about Barrick?  Does it have a reasonable estimate as to what its costs will be in five years, ten years or fifteen years down the road when it is committed to deliver gold into its hedges? 

Of course not.  It’s impossible to know what the future holds.  Barrick committed the mortal sin of prudent business practices.  It locked in its future revenue for 13.2 million ounces of gold but left unhedged the expenses required to mine this gold.  Barrick hedged its revenue but not its expenses.  It hedged the wrong thing!  In a world of fiat dollars that continuously lose purchasing power, the prudent course is to lock-in today your future expenses, but not the price of gold because it rises over time as the dollar is debased.

So as the price of crude oil – and just about every other operating expense as well – has risen over the past few years, Barrick’s margin on this gold it has yet to mine has been squeezed.  Recently though, Barrick has attempted to mitigate this error by entering into more ‘hedging’ contracts, for example, to purchase fuel, but it is impossible to hedge all of your expenses fifteen years into the future.  For example, what employee will agree today to his salary fifteen years in the future?  In reality, most operating expenses can only be hedged a year or so into the future.

So the question one needs to ask is what will Barrick’s cost of production be when it mines the gold it has sold forward?  We of course don’t know for certain the outcome of the dollar and therefore the true cost of the dollar-denominated expenses Barrick will incur to mine gold in the future.  Nevertheless, it is reasonable to conclude that given the ongoing inflation that is continuously eroding the purchasing power of the dollar, the trend is not good. 

In 2002 Barrick’s cash costs were $177 per ounce of production.  In 2005 its cash costs had zoomed to $227, a 28% increase in three years.  At this rate of increase, by mid-2007 Barrick’s cash costs will exceed the gold price it is committed to deliver under its hedge book.  And remember, cash costs exclude depreciation and other non-cash expenses. 

Consequently, despite all the rhetoric that its hedge book reduces the price risk to which it is exposed, the reality is that Barrick got it completely wrong.  By hedging the revenue and leaving unhedged the costs of mining 13.2 million ounces of gold, Barrick has increased risk by reducing the cash-flow that its shareholders could otherwise have reasonably expected to receive had it not entered into these hedge contracts.  What’s worse, though we of course do not know what the future will hold, given the growing inflationary pressures in the dollar, it seems increasingly likely that the 13.2 million ounces of gold Barrick has committed to deliver will be mined at a loss, to the detriment of its shareholders.

So let me return to the question I briefly answered earlier about how Barrick’s hedge book did in the past quarter.  I said it did not do well, but that was an understatement.  Just look at how badly it did. 

As of December 31^st, the marked-to-market value on the gold (and silver too) in its hedge book was negative $2.8 billion, compared to negative $2.4 billion as of September 30^th.  Thus, the value of its metals hedge book worsened by $400 million in the quarter, a staggering number that is more than twice as large as Barrick’s reported net income. 

How is it possible for generally accepted accounting principles to let Barrick report an operating profit that is not adjusted for the worsening position of its hedge book?  But if you think that question to be amazing, consider the following comment in a recent research report by J.P. Morgan Securities Inc. regarding Barrick’s acquisition of Placer.

“One intriguing snippet of the deal is that accounting regulations allow Barrick to revalue (for accounting purposes) the acquired Placer hedge book. Consequently, Barrick will be able to report Placer hedge sales at $567/oz rather than their current value of around $350/oz. This is accounting rather than value creation, since the benefit will be reversed in the financing section of the ABX cashflow statement.”

It’s been said that some company’s use accounting rules much like a drunk uses a lamppost – more for support instead of illumination.  The above accounting gimmickry is a good example.  What if Barrick in 1970 when gold was $35 an ounce committed in a hedge to deliver gold at $43 per ounce ten years forward?  It would have been delivering gold at only a fraction of its operating cost when it otherwise would have been receiving $600 per ounce or perhaps even more.

I have been recommending for years to completely avoid those gold mining companies that hedge their production.  As the gold price rises, the reasons to avoid companies that hedge become even more compelling. 

Barrick is a case in point.  As the gold price rises, its hedge book worsens by more than Barrick earns in net income.  Barrick’s future cash flow has been imperiled, and a rapidly rising gold price may mean a train-wreck for Barrick.