Sons of Gwalia & Hedging – R.I.P

September 13, 2004 – Last week Sons of Gwalia, one of Australia’s largest gold mining companies, declared bankruptcy. It is being labeled as an $800 million collapse, but the betting is that the company’s liabilities will top $1 billion when the debt on its balance sheet is toted up with its off-balance sheet liabilities.

Off-balance sheet liabilities? Yes, not only was SOG one of Australia’s biggest mining companies, it was also one of the world’s biggest users of gold forward sales and gold derivatives. These off-balance sheet commitments (for those gold mining companies that use them) are colloquially referred to as their ‘hedge book’. In short, SOG was destroyed by its hedge book, which is to say that SOG was destroyed by bad management decisions.

I hate to say it, but not only was SOG’s collapse predictable, it was well deserved. Here’s how the August 31^st headline on www.minesite.com put it: “Few Tears Shed In London As Sons Of Gwalia Gets Its Comeuppance.”

Their article goes on to say: “Back in February 2002 Minesite carried an article entitled, ‘Sons of Gwalia And Its Off Balance Sheet Items Brings A Whiff Of Enron To Australia.’ The Lalor twins, who were running the company at the time, leapt for their lawyer and tried to sue Minesite for daring to expose what a number of Aussie analysts and commentators were saying about the dangers of Sons of Gwalia’s hedging positions.”

The “Lalor twins” are Peter, who was CEO of SOG and his brother, and their litigiousness was exceeded only by their arrogance and what was to reasoned-observers their extreme and irrational defense of SOG’s hedge book. I have a guess to explain why they had the blinders on when it came to their pro-hedging attitude. Because SOG was one of the first companies to use hedging, I think that Peter Lalor probably believed he invented the concept, and therefore guarded the notion of hedging like a mother hen. Too bad he didn’t spend his time defending something more useful.

Anyway, as you can see, I don’t think too highly of Peter Lalor. I did have my run-ins with him, but fortunately was never threatened with litigation, as was MineSite.com. But I have been out there warning people about SOG.

Readers may recall that SOG was one of the two mining companies that I panned in my September 2002 interview in Barron’s. When asked what mining companies I didn’t like, I replied: “I don’t recommend any Australian stocks now, simply because their hedge positions are underwater. Newcrest Mining is one pan; its hedge book is negative US$440 million. But my top pan is Australia’s Sons of Gwalia. It has a US$340 million unrealized loss on its hedge book and is relatively more hedged than Newcrest, and its properties aren’t as good.” But this wasn’t the first time I warned about the potential problems in SOG.

Long-time subscribers may recall my article entitled “Linear Thinking” in Letter No. 204 published May 5, 1997. It began: “It happened yesterday; it happened today; therefore, it will happen tomorrow. So goes linear thinking, and it is a dangerous principle to be wedded to in the dynamic and non-static world around us. Nevertheless, like ‘flat-earth’ theorists, linear thinkers emerge from time to time, even in the gold industry. This thought came to mind when reading a report on Sons of Gwalia.“

After listing some of SOG’s achievements, I went on to say: “By selling forward gold production, revenues have been enhanced throughout the company’s 10+ year history. But here is where the linear thinking comes in. Just because hedging has been successful for ten years, is it necessarily safe to assume that hedging will be successful for the next ten years? No, clearly not for the simple reason that circumstances do change. Therefore, the report I read on the company’s hedge position was startling. Not only has it now sold forward 10 years of production, but they have sold forward 65% more gold then they have in proven reserves, an astounding proposition.” [Emphasis in original]

I then went on to analyze the implications of the decision by SOG’s management to enter into this commitment. It meant that the interest rate they earned on their forward sale would have to be more than enough to offset any inflationary pressures that would cause their costs to rise. It also meant they believed that it was more likely they would discover gold that could be economically mined than the gold price would rise in ten years, which is another astounding proposition.

I then went on to say why this last point was particularly important. I explained that SOG “is no longer a gold mining company. Yes, they still mine gold, but their operations may be better described as a manufacturing company that has locked in its revenue for ten years. There is no upside leverage to the gold price. There is no protection if inflation begins eroding at their potential profit by causing costs (labor, electricity, oil, chemicals, etc) to rise.”

Clearly, there were some bad management decisions at SOG. And it’s tragic that SOG’s shareholders are probably going to be completely wiped out once the debts are liquidated in the bankruptcy administration. But it was foreseeable. I saw it, and so did others – even if the Lalors were too blind to see it or too arrogant to consider or even listen to the advice of others.

After my 1997 article appeared, Peter Lalor wrote to me to defend his hedging decisions, and concluded: “Hedging is now and will continue to be a fundamental part of the global gold mining industry“. If he had replaced the word ‘fundamental’ with ‘destructive’ he would have got it right.

But I am not bringing up the woes at SOG to beat up on the hapless Lalors. Rather, I am bringing up the SOG disaster to highlight the perils of hedging. There are still dozens of mining companies that think hedging is a smart management decision, rather than seeing it for what it really is, a bet that the gold price is going lower before the company has to deliver on its hedge commitments.

Despite the collapse of SOG and other hedgers in recent years, some gold mining management continue to use hedging and believe it is the right tool for their company. Avoid these companies like the plague.

After the SOG bankruptcy was announced, Reuters carried an interesting interview with Pierre Lassonde, president of un-hedged Newmont Mining, one of the top picks in my recommended portfolio of gold mining stocks. He said: “With the gold price rising, I expect more companies will declare bankruptcy as the liabilities associated with their hedge books continue to rise.”

Returning to my 1997 comments about SOG, I noted back then: “Many investors in gold shares believe that hedging takes much of the risk out of investing [in gold mining shares]. But alas, there is no free lunch in this world. Some risks are reduced, but coincidentally, other risks are increased.”

I then concluded my analysis by saying: “Maybe SOG will be proven right and that ten years from now shareholders in that company will be smiling. Maybe, but I wouldn’t want to bet on it. I think it more likely that we are seeing some over-reaching, which itself is human nature. In other words, if a little bit of something [hedging in SOG’s case] works well, it is only natural to assume a bigger amount of it will work even better. In the real world things don’t necessarily work out that way.”

We didn’t have to wait ten years to find out what hedging would do. It created the Eunuchs of Gwalia.