An Open Letter to Hedgers

Dear Mining Company Executive:

I am addressing this letter to all mining companies that continue to lock in today the forward price of the Gold they plan to mine in the future. This process – which is generally called hedging – is rightfully being closely examined by investors, and the result of this careful scrutiny has been an unfavorable pall cast over the stock price of Gold mining companies.

For example, the XAU Index is today no higher than it was when Gold was trading in the mid-$260’s. This result stands in stark comparison to the experience of 1993, a moment in time when hedging was far less prevalent. A comparable rally in the Gold price from March to May of 1993 resulted in a 41.8% rise in the XAU Index from 76.00 to 106.78.

Clearly, the market today does not like what it sees, and it is not too hard to understand why. The experience of Ashanti and Cambior speak volumes about the ‘dark side’ of hedging. That these companies had higher market valuations when Gold traded at $255 than at $325 is not ironic, it is tragic.

It is also tragic that the stock price of neither company outperformed the rest of the industry as the Gold price was declining. One can only conclude that the market already knew what lay ahead for these two companies. The only question that remained unanswered was when the Gold price would finally turn, an event that would cause these two companies to blow-up. That event we now know has occurred.

Before addressing the current Gold price, I ask you not to try drawing comparisons between your company and Ashanti or Cambior. Many of you will claim that your hedging structure is fundamentally different and technically bullet-proof. It probably is, and I am not arguing that point. Moreover, you and your colleagues are to be commended for creating structures that have improved your cash-flow in the past, when Gold was falling.

However, while past performance is always a factor when making a decision to invest, stocks are purchased for reasons that are forward-looking. Therefore, the all-important question now is what will be the result of your hedge program in the months and years ahead? It is this issue that is of primary importance to investors, and therefore of fundamental importance to your company’s prospects and stock price. In this regard, I offer the following thoughts for your consideration.

When viewed in terms of the concept of insurance, hedging may make some sense. The question of whether to hedge (i.e., buy insurance) or not to hedge then depends upon the cost. In other words, is the insurance worth the cost of that insurance?

The cost of ‘hedging insurance’ is best measured in terms of opportunity cost. In other words, the cost of protecting revenue from the downside should the Gold price fall comes from forgoing some of the upside, if the Gold price were to rise. Thus, the cost of hedging is an opportunity cost.

Even though the opportunity cost is forward-looking, which means that it cannot be predicted nor measured, I believe it can be evaluated. After all, this is what the stock market is always doing on each and every company, and the net result of all of these subjective judgements by investors around the world are reflected in a company’s stock price.

In this regard, the above chart offers an interesting perspective on how the market may be viewing the cash-flow potential of companies that hedge, and the cost of this insurance today. This chart presents what I call the ‘real price’ of Gold. The real price is obtained by adjusting the $35 rate of exchange established in January 1934 with the CPI in order to put the current Gold price into an historical perspective. Presently the real price of Gold is $445, substantially above the current price.

The chart shows that there have been several periods when the current Gold price was above or below its real price. These periods can be characterized as overvaluation (i.e., the current Gold price was high, relatively speaking) and undervaluation (i.e., the current Gold price was low based on this objective, historical measurement).

Presently, the current price of Gold is very low. Note also that the most recent level of highest overvaluation was reached when Gold touched $507 in current terms in December 1987. Ever since, the Gold price has been declining from this level of overvaluation to its current level of undervaluation. Further, the level of undervaluation seen recently when Gold was in the mid-$250’s was the most extreme degree since the Dollar’s formal link to Gold was abandoned in 1971.

Therefore, it is clear that you and your colleagues that hedge have conducted your hedging program (and generated additional revenue from it) up to now in a period when the current Gold price was changing from an overvalued level, to the present Gold price, which is undervalued. Consequently, it seems logical to conclude that the results of future hedging will be substantially different from the revenue enhancement received over the past 13 or so years. And further, your stock price will underperform the result that would have been achieved if you did not hedge.

One other possible conclusion from the above chart is worth considering. In the periods of undervaluation in the 1960’s and the 1970’s, the then current price of Gold at its low was $35 and $100 respectively. To date, those prices have never been seen again. Gold subsequently returned to undervaluation, but did so at a higher nominal price because the Dollar had been debased.

Therefore, as Gold moves higher from its current level of undervaluation, it seems logical to conclude that the low nominal prices now being seen will, like $35 and $100, never be seen again because of the ongoing debasement of the Dollar’s purchasing power. As a result, the length of the time in which you have to deliver against spot deferreds is not going to enable you to avoid the opportunity cost.

I remember very well when Gold rose to $110 in 1976 shortly after hitting its $100 low. Few people then even recognized the possibility that $100 would never be seen again, let alone give this possibility any serious consideration. Using the same logic by examining Gold’s current undervaluation, which is even greater now than it was in 1976, is it not possible that $253, or $260 and perhaps even $285 will never be seen again?

If so, it means little to say that you have a 10-year or 15-year period in which to deliver spot deferreds. If these prices will never be seen again, you will not be able to avoid the opportunity cost that arises from booking these forward transactions in terms of Dollars.

You are giving away the upside from this new mine production, regardless whether you choose to give it away now, or give it away later (i.e., accounting for this opportunity cost). The market understands this possible outcome, and as the market always does, it votes with its feet. Hence, the stock price of mining companies is underperforming what otherwise would have been expected given the rise in the Gold price.

Given the above, it appears that the opportunity cost of this insurance (your hedging program) will prove too costly in the future, resulting in significant underperformance of your stock price. This conclusion is all the easier to accept given the underperformance that Gold mining stocks have experienced subsequent to the European Central Bank announcement that led to the recent rally in the Gold price.

Needless to say, the Gold industry is in a sad state of affairs.Long suffering shareholders have little joy and even less reward from the recent rise in the Gold price. This unfortunate situation must change, and it can change if hedging is stopped. The end of hedging will enable shareholders to participate in all the upside potential that the Gold price has to offer. I hope that you agree with this conclusion, and choose to collapse your hedge book.

Sincerely, James Turk.