Many a miner’s dirty little secret
The vast majority of gold mining companies globally make a very big thing about being non-hedgers. They have it on their website home page and it often features heavily in all investor communications. Rather like the shop windows that have the “no cash kept on premises”, they are strongly declaring no “financial derivatives inside”.
Hedged or not, with the possible exception of Resolute Mining (ASX: RSG) which recently announced it was now sometimes accumulating bullion, all gold producers must essentially convert all their gold production into currency in any given reporting period. Hedgers will generally have a modest proportion of quarterly production pre-priced, whereas the non-hedgers are challenged with selling all of their production this week, next week and every other week. At 2,600 tonnes a year of production around the globe that’s nearly 51t a week, or nearly 325,000 ounces each and every day of the year that gold producers collectively have to get to market.
Take a look at a gold price chart and you will notice it’s quite volatile from quarter to quarter and there are plenty of periods where prices are falling, sometimes for extended periods. It is, after all, as mining companies like to tell us in the dark depths, a cyclical business. Gold prices cycle!
The problem for all gold producers is that no one needs to buy gold like producers need to sell it. Not a day goes by where people, companies, traders, central banks don’t buy gold; there is always a clearance price. However, the periods of time where the buyers of gold need to buy with the urgency that most producers need to sell are few and far between. Gold buyers seldom need to part with cash to acquire gold with the urgency most miners consume cash producing it and replacing reserves; let alone getting on top of their debt pile. Buyers can sit on their hands, keep their cash and come back tomorrow. That’s quite easy to do when prices are falling. For the unhedged producer every day/week that they don’t sell gold just means the more they have to sell. When prices are falling all the pressure is on them. This pressure has been obvious in the gold price behaviour on a number of occasions over the last 4-5 years in particular.
The reality of this situation seems to divide the “non-hedgers” into two basic camps; fatalists and flippers. The fatalists say there is no point trying to do more than match the average price for the week. Each and every week of the year they sell on the London fixes. They sell a bit every day or many just sell it when the refiner rings up and says they can. What is probably not well understood by many investors is the flippers, while saying they don’t hedge because you can’t beat the market, set themselves the challenge every quarter of trying to beat the market average. In short they do hedge but only ever intra-quarter so the reader of their accounts would never know.
The flippers look at the charts, they talk to their bankers, they listen to their shareholders, they divine the minutes of the Fed. Sometimes they accumulate gold for weeks at a time without selling it. Sometimes they forward sell to the quarter end. Some sell call options (and a bolder few also sell put options!) to “tweak” their returns. The one constant for the flippers is all this activity must be within the reporting period. No evidence of hedging instruments or other derivatives must exist when it reports.
Why anyone who believes they can consistently outperform the gold market in discrete 90-day windows would bother with all the hassles associated with actually mining gold is beyond me.
On closer inspection of the accounts of many of these “non-hedgers” it would appear the reason flippers do stick to mining, and many often revert to being fatalists, is that there is little or no evidence in the quarterly reporting of gold miners the world over that flippers add any value for shareholders at all.
Many of the world’s gold producers who proclaim to be open to the average price consistently fail to even match the annual price average. Astoundingly that seems to include a great many of the fatalists! On our analysis of a decent sample it would appear that in strongly rising price environments flippers seem to do a little better but they seem to give it all back and more in those periods where the buyers of gold go on strike. Looking back over many years at the reporting of some of the largest miners, some have consistently underperformed the average fixing price by between US$2 and US$6/oz over many years.
In a market that moves around like USD gold does, many flippers might try and argue that’s not a significant margin, but I beg to differ.
If a producer exposes it shareholders to greater risk by being a flipper, rather than a fatalist, then it should deliver a solid outperformance over the average price or cease the activity. No ifs, no buts. Particularly when you can also assume that all the costs associated with all that trading activity don’t appear in the reported gold price, reducing its operating margin further. And the point is that you really have to try hard not to achieve the average, you really having to be trading and losing.
Many miners became declared non-hedgers in direct response to criticism from investors about poor hedging in the past. Similarly, talking about how they care about costs at every level of their business is a direct response to the criticism from investors about how they let costs blow out in the past. It has become very fashionable lately for mining CEOs to talk publicly about initiatives that have reduced costs by $1 million here and $2 million there. I am not denigrating the cost savings, every little bit counts and I applaud companies that empower workers to innovate and experiment in order to reduce the operating costs they can control.
It does seem slightly cynical to spend limited time in an investor presentation talking about savings that shave a few dollars off the overall costs when treasury is giving as much away trying to beat the market you openly say is unbeatable.
There is of course a third group of producers – the ones who hedge and don’t try and hide it. They are a small but growing band, in size and number. The vast majority of these companies have shown great discipline in recent years. These companies don’t hedge with an aim to outperform the market. They hedge so that they reduce the chances of underperforming the financial goals they have set for themselves. Many of these companies, certainly those who are clients of Noah’s Rule, also recognise that gold mining is a marathon and not a sprint. Their goal is not to outperform the spot price every quarter. Nor are they willing to simply accept that they must sell their production evenly through the year and be a victim of the vagaries of the buyers of gold. Their goal is simply to create a small but effective platform of predictable cash flow that will increase their chances of surviving and thriving through the cycle. They determine their own future instead of having their vital cashflow planning, and all the activities that flow from it, dictated by the vagaries of the market.
Calm, as they say, is contagious. Which is why it shouldn’t be surprising to learn that in these volatile markets many of those hedgers who choose how and when they price their production, and are happy to have some hedging on the books at quarter end, also do a better job of selling that proportion of their quarterly production that isn’t hedged than either the flippers or the fatalists.
*Sean Russo is managing director of Noah’s Rule, a specialist debt and risk advisor