News & Thoughts

Gold-hedge haters focused on the hole, not the doughnut

Aug 29, 2019

The USD gold price has been on the tear these past 13 weeks. Gold prices in most other currencies have been running hot for quite a bit longer, and the list making new all-time highs this year keeps getting longer, but it’s the USD gold price that drives broader sentiment and it gets the headlines.

Fair enough too. It had been performing woefully for much of the past six years, unable to break $1,350 in any meaningful way since 2013, when it collapsed, ending what had been a pretty extraordinary decade. It’s been a long time between drinks, so why not celebrate!

When rising USD gold prices hit the headlines the playbook from brokers, analysts, vocal fund managers and corners of the media is very predictable. It’s a well-worn playbook.

First when the gold price ran there was, as there always is, much handwringing about the “exposures” of those gold mining companies that hedge. Brokers’ reports tallying the mark-to-market exposures are great for getting headlines like, “$1 billion lost to hedging”, and the accompanying graphics looking at the hedge exposures five different ways, can bulk out a report otherwise light on detail, or give any real explanation of why a gold miner operating a very capital intensive business in a very uncertain world shouldn’t want to have some revenue certainty. Tick.

Fund managers have been vocal about miners needing to stay calm and not give up the upside through hedging, but also very careful about getting too excited about M&A at these “elevated” levels. Don’t forward sell existing ounces, don’t buy new ounces: very helpful. Tick, tick.

Given the hedge books these days are really quite small, with Australian producers that hedge having an average of 27 weeks production hedged, it’s such a shame that those same brokers don’t instead produce graphics of the increased value of all the reserves and resources that haven’t been hedged and look at the stellar share price performances of the hedged producers; concentrating on the doughnut rather than the hole.

Then last week, about a week or two late on the normal cycle, we had the, “USD gold to $10,000/oz” article in the local paper quoting an overseas expert. Tick.

The other thing long-time watchers of the gold equities market know happens in this type of scenario, is beleaguered miners that have struggled with too much debt, but eschew hedging, start coming to the market raising big chunks of equity. Tick.

The latter is a trickle for now, with the early movers probably being the ones most stressed in the recent past, but given the high levels of debt still in the sector it’s likely to swell.

Whether explicitly listed as a reason or not, much of that money raised is (or will be) used to repay debt or to keep sweating lenders off their backs. Long-suffering shareholders generally don’t get a look in. Bought deals are done by brokers inundated with institutions that need to “refocus” on the sector but don’t want to suffer the indignity of buying on market.

Raising equity to repay debt! I wish someone would do a study on the difference between the share prices when the industry, particularly in North America, took on debt versus the share prices at which the debt repayments were and will be raised. I would be willing to bet it wouldn’t be pretty.

Every share a gold miner issues reduces the gold backing per share. By comparison, gold ounces that are sensibly hedged increase the certain value of each share of that ounce and I would argue also reduces the risk that existing shareholders will see their gold backing diluted except through production.

Which nicely brings us back to hedging. Until late in the last gold price up-cycle, debt and hedging were usually seen together; hedging was mandatory for all but a precious few. If a growing miner wanted to borrow they had to give the lender some confidence that the revenue required to repay that debt was more certain than the market’s best guess.

Somewhat ironically, Australian gold producers have some of the lowest levels of debt in the industry but speak for a reasonable percentage of the (albeit tiny) global hedge book. Most of them started hedging as part of a funding arrangement, but more recently a modest level of hedging has been the very reason they have been able to develop and grow without too much debt and without too much equity issuance. It’s been about capital discipline and creating a sound platform for growth.

“The market always does what it’s expected to do it, just never does it when it’s expected” is one of my favourite Richard Russell quotes.

Cast your mind back to just prior to the last US Election. “Everyone” knew if Trump became president it would be good for the gold price. Thirty months later it appears “everyone” was right. There was, however, that very small problem of the post-election collapse to $1,120/oz and the $1,160 low in 2018 we had to deal with in between.

Everyone seems to again be convinced that the gold price is only going up from here. Certainly, there are couple of things in its favour that either weren’t around, or as favourable, in 2016.

Gold could go nuts here, it could slip all the way back to the high $1,200s, or possibly even lower, shake out all the newcomers (and even many of the true-believers) and then go nuts, or, it might just do nothing at all. Meanwhile, gold producers who don’t have a USD cost base need to also think about the ramifications of those above scenarios on their cost-currency.

It’s an impossible task to get that all right. They can’t know and we the punters can’t know either. The central bankers certainly don’t know but they certainly seem to be proving one of my favourite adages in relation to financial markets: “The most dangerous person in the room is the one who is convinced they know what happens next”. Oh, and for everyone crowing about how bullish all the recent central bank buying is, I remind you of the selling done right at cycle lows by Australia and the UK, to name just two.

If you want to buy gold mining shares because of your view on the gold price and you accept that there is a risk that you might be wrong in your reasons for doing so, and that in many instances there is a high likelihood that you could suffer regular and on-going dilution for no good reason, and that gold mining is a tough game and management can make a real difference when it’s not just about gold prices going nuts (which sadly is most of the time), then I suggest to you some of the best all-weather opportunities to invest in the gold mining sector sit within the list of producers who sensibly hedge.

Concentrate on the doughnut and not the hole.

*Sean Russo is managing director of Noah’s Rule, a specialist debt and risk advisor