Gold Loan with a Twist
20 July 2009
Sean Russo
ON THE cocktail list of hedging and derivative products that have been offered up to gold producers over the years there are some very exotic products that have a kick like a mule. Think mescal with a worm. Our advice to clients is wherever you see ?exotic? think toxic and lie down until any urge to sip such a cocktail goes away.
ON THE cocktail list of hedging and derivative products that have been offered up to gold producers over the years there are some very exotic products that have a kick like a mule. Think mescal with a worm. Our advice to clients is wherever you see “exotic” think toxic and lie down until any urge to sip such a cocktail goes away.
Thankfully on any drinks list there is the set of old favourites that while they tend to go in and out in popularity are always there; think gin and tonic. Gold loans are the gin and tonic on the gold derivatives drink list, uncomplicated but highly effective.
After disappearing on the to back page over the last decade, like so many other simple and practical offerings, gold loans and other gold based financings have been on the ascendancy in recent months having been “rediscovered” by a new generation. To date we have seen more of them in Canada but we expect to see more of them in Australia and elsewhere in coming months.
Interestingly many of the gold loans we are seeing are different from those that people would remember from the late 1980s and early 1990s. In the “good old days” gold loans came from bullion banks. They borrowed gold from central banks and lent it to mining companies. The mining companies sold the gold for cash at the spot price and used the money to develop a mine, repaying the loan in gold (principal and interest) produced once the mine was operational. The bullion bank had no interest in the future gold price, the central bank had the entire price risk, as long as they got the ounces back from the miner and could repay their own loan the bullion bank was happy. Their prime exposure was to the performance of the mine, only if it failed were they exposed to gold prices because they had to buy gold to repay the central bank.
The miner for its part had effectively pre-sold the gold and was also ambivalent to future price having essentially hedged a proportion of production in return for development funds. (Of course all the analysts with perfect hindsight would claim it was expensive debt in later years if the gold price rallied, ignoring the dilution that debt had avoided!)
Many of today’s gold loans or gold based financings are quite different in as much as there are no banks involved and gold is not lent so much as gold price risk is exchanged at a price. The net result is the same, the producer gets money now (often a discount to the spot price) and repays gold in the future but here the “lender” is actually an investor looking for long-term gold price exposure and a yield or price advantage in the meantime.
The emergence of these particular products has three key drivers: the enormous interest to hold gold shown by funds and individuals, as evidenced by the increasing holdings of the gold ETFs; the reduction of banks looking to lend to the sector; and an emerging realisation among producers and prospective producers that the current gold prices represent very good relative value for raising funds relative to their share prices.
As advocates of sensible risk management the gold price protection inherent in gold loans and their simplicity makes them very appealing to our firm when assisting producers procure finance. As long as they are simple – get cash now, pay back in gold later. This is what we call “right way risk”, the financial payoffs offset the underlying risks of the miner.
Such is the financial world’s thirst for exotic that some of the recent transactions observed are not quite that simple. One transaction we observed had a twist where the miner pre-sold gold for a fixed dollar payment with a future commitment to repay in gold but then also agreed to pay back in cash, not gold, if the gold price fell below the original drawdown price. This is not a gold loan it is a cash loan with a granted gold warrant (or sold call). The investor/lender gets the upside but the miner gets no downside cover in return. This is what we would call wrong-way risk. That is not to say this product doesn’t have a place but it would need to be done alongside other hedging, ideally bought puts. Otherwise the miner will have increased downside gold price risk by having fixed dollar based debt against falling gold sales revenue while giving up price upside in the alternative scenario.
From our perspective at Noah’s Rule the return of the gold loan is welcome as is a renewed interest in hedging by many gold miners. Having seen the recent experiences of their unhedged “copper cousins” management teams are being a little more circumspect about their risk profiles and looking for sensible ways to reduce or transfer risk and gold loans are one of the simplest ways to do that.
While the leading mine finance banks will continue to play the key role in providing gold loans and hedging lines the introduction of investor based alternatives is a significant positive addition to the available sources of financing and risk management. We remain hopeful this market niche will continue to grow providing a solid alternative to bank based financings, creating positive pressure on both pricing and product development. Hopefully without needing to resort to flaming drinks, paper parasols and other exotic extras generally added to sell inferior solutions at exorbitant prices! Remember if you get the urge to try exotic lie down until it goes away.