Hedging Hype

Ted Butler is ripping Barrick Gold once again. Let's take a look.

Barrick Gold is the largest gold hedger in the world, holding a short hedge position of almost 13 million ounces. In the last quarter alone, because the price of gold increased by roughly $43, Barrick should record a mark-to-market loss of $560 million on its gold short hedge. The loss for the year and half-year comes to a cool billion dollars. This should increase the total outstanding loss on Barrick hedge book to just shy of $3 billion. With Placer added in, the loss has to be greater than $4 billion.

The almost $3 billion open gold loss on Barrick’s books is greater than their cumulative total profits for the entire existence of the company. To my knowledge, it is the largest derivatives loss in history. I ask you to think about that for a moment. The world was atwitter with the recent $200 million copper loss by China, as well as the $500 million oil loss and bankruptcy by China Aviation Fuel (Singapore) last year. Barrick is set to report a $560 million gold hedge loss for the quarter, $1 billion for six months and almost $3 billion in total, and the financial world looks the other way.

What makes the Barrick record derivatives trading loss even more shocking and remarkable is that the company was given ample time and repeated warnings about its outsized gold short position. I know this to be true because I personally warned them. Actually, I did a lot more than warn the company personally; I also warned them publicly. And I did it when gold was below $275 an ounce. In addition, I also contacted and warned their auditors, the New York Stock Exchange (where Barrick trades as ABX), the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).

Ted Butler has a rock solid case that what Barrick has done lately is silly. It wasn't the hedging that was so bad per se, it was the amount of it, the duration of it, the insistence on repeatedly doing it, and the refusal to do something about it on numerous occasions when they had the chance. That chance has now come and gone.

That said, Barrick is not losing billions as the article suggests, it is losing billions in potential profit. There is a huge difference. I agree with Butler that Barrick should have been massively covering their hedges at numerous opportunities. But failure to do so did not generate realized losses, nor will those losses ever be realized as long as Barrick can deliver the gold per its contracts.

Barrick can indeed get into enormous trouble if their mining costs rise above prices they forward sold at. That is not inconceivable. I do not know how to put odds on it but the further out one hedges the more likely the odds of a huge problem down the road. If Barrick has sold three years forward I am inclined to yawn, 10 years and perhaps we have a different story. Which is it?

Barrick might have the best, most cleverly written forward contract in the business, but at some point they still have to deliver. What will their production costs be at that point in time? Will the gold even still be there?

I do not have an answer to what their future production costs will be. No one does. That is likely the biggest real issue surrounding Barrick, as opposed to "losses" resulting from some kind of imagined short squeeze.

There is one more issue regarding Barrick's hedges that merits discussion. Their hedges are not entirely free of a margin call as the company's balance sheet must maintain a certain debt/equity ratio, and its credit rating must not deteriorate beyond a certain point. I don't know the details, but contracts do have such clauses. As long as Barrick can avoid those problems there simply is no massive derivative loss or pending short squeeze because of their forward hedging.

That said, I have little respect for Barrick and perhaps at some point they may run into problems. If they do, it will likely be for far different reasons than the rising price of gold. If gold soars to $1000 tomorrow, Barrick will be no worse off than they are today. In fact they will be better off because the value of their reserves will increase. I suppose the ultimate irony would be if JP Morgan, the "Derivative King", was on the other side of Barrick's gold contracts and the one ready to profit from the price increase.

Another thing we often hear about is the "massive short" by silver commercials. Not once has anyone ever complained about the "massive long" position by speculators. The thing about futures is that for every long there must be a short. If shorts should not be allowed to short what does not exist why should longs be allowed to buy what does not exist? It really is not possible to complain about one without the other yet all we ever hear is how the shorts are manipulating the silver market. Perhaps longs are manipulating the silver market. The statements would seem to make equal sense. As with gold, as long as someone is able to deliver the silver at the required date, there is no problem. For now, I would suggest there is no pending short squeeze in silver either (at least not for the reasons often cited).

Butler concludes with:

The purpose of this essay is not to pick on Barrick or Apex, but rather to offer something constructive. First, if you are going to invest in mining companies, you must be aware of your company’s hedging position. You don’t have to invest in a company that insists on hedging; there are plenty of companies that don’t hedge.

Second, if you are part of management of a mining company, think long and hard before shorting the resources you produce. Your shareholders generally don’t want you to, and much can go wrong. I can’t think of any management-hedging heroes. And please remember, selling more than one year’s actual production is not hedging; it’s gambling.

That logic is hard to argue with. It is the primary reason I avoid Barrick.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/