October 18, 2004 - Readers are probably aware that I was interviewed in the October 4th issue of Barron's. The entire interview, which was fairly wide ranging, is posted at the Smart Money website: www.smartmoney.com.
I received a lot of feedback about the interview, but nearly all of it was directed to my comments about hedging. Its defenders were out in full force, taking aim at my comments about the now bankrupt Sons of Gwalia while claiming there is no similarity between its hedging position and that of Lihir and Newcrest, two companies with big hedge books whose stocks I said to avoid.
They are of course right in one sense - both Newcrest and Lihir have world-class properties, while Sons of Gwalia didn't. But that fact doesn't matter. Even a world-class property isn't going to help if the company sold gold forward at $350.
I recommend that investors avoid Lihir because of its hedge book and the difficult operating environment at its mine in Papua New Guinea. I have recommended that investors avoid Newcrest solely because of their hedge book. Newcrest has some great properties with significant upside potential, so if it were not hedged it would in all honestly have been one of my top picks, and probably as long as two or three years ago.
I have written about hedging before. But in view of the feedback I received about the Barron's interview, it may be useful to write a little more about it. Here are some of my major reasons for avoiding companies that hedge.
1) Hedging is not a "conservative" strategy. It is often portrayed that way, but to claim that hedging is conservative is financial quackery. All one has to do is to look at Sons of Gwalia (SGW) and determine the excessive risk they were taking. More to the point, would it have collapsed if hedging were a conservative strategy? Indeed, that they collapsed is proof that hedging is anything but conservative, and if they hadn't hedged they would now still be alive and prospering. What's more, SGW shows that the more a mining company hedges, the worse off it is, so hedging is speculative risk taking - the more a company is hedged, then the bigger the speculative risk it is taking.
2) It is popular to say that its hedge book killed SGW. However, that description is not sufficient to explain what really happened. By hedging, SGW fixed its revenue to pre-determined amounts that will not change, but it left open its expenses to inflationary increases. Therefore, they locked in their revenue with the hedges, and left unhedged their expenses. Their margins therefore were squeezed as expenses rose because of inflation, and this year's run-up in oil was the final straw that broke the camel's back and did them in. This basic observation about margins applies to all companies that hedge, so Newcrest's and Lihir's margin will also be squeezed in the future based on my expectation that inflationary pressures worldwide will continue to grow. Consider the impact that $54 oil must already be having on their operation and cash-flow.
3) While Newcrest and Lihir do have better properties than SGW, that fact does not provide a reason for them to hedge. To the contrary, the better the property (and therefore the lower the cost of production and the wider the operating margin), the less reason to try hedging to lock in margins. In any case, the only way to lock in margins is if there is a falling gold price environment, and we haven't seen that for three years. Gold has been in an uptrend since 2001 against the US dollar, and in an uptrend against the Australian dollar even longer, since 2000. The unimportant setback against the A$ price since last year is just a correction within gold's ongoing bull market
4) Lihir has 50% of its production hedged. Lihir has 20 million ounces of gold in reserves, but is presently producing only about 600,000 ounces per year. So to compare its 2 million ounce hedge book to its 20 million ounce reserve is irrelevant. What's important is the hedges to production, and 50% hedged for the next several years is very high indeed. The figures for Newcrest are harder to come by because I have not yet seen a full disclosure of its hedge book after its recent restructuring.
5) Lihir's hedge book is negative about $200 million. Before the restructuring, the marked-to-market value of Newcrest's hedge book as of June 30th was negative about $320 million. Thus, had they not hedged, that would be an additional $520 million of cash-flow these two companies would have earned, assuming of course gold stays unchanged over the next several years as they deliver into their hedges. But gold is going higher in my view, continuing the trend of the past three years. Therefore, every $100 rise in the gold price adds another $200mm of lost cash-flow that Lihir could be earning. The numbers are probably comparable for Newcrest, but again, I am uncertain because once again, I have not yet seen a full disclosure of its hedge book after its recent restructuring.
6) The restructuring of Newcrest's hedge book may be a step in the right direction, but all it does in the final analysis is delay for the future the lost cash-flow already baked into the cake. The reality is that as the gold price rises, the lost cash-flow incurred because of the hedge book will continue to grow. What's worse though is my perception that the restructuring was accomplished more to deflect criticism of its hedging policy, rather than to reduce the size of its hedged position. Newcrest has managed so far to stay one step ahead of its hedge book, and this restructuring seems to be another gambit by Newcrest to avoid getting steam-rollered by its hedge book. But at what cost? Consequently, I await a full disclosure of its hedge position to see how much the restructuring cost Newcrest in potential lost future revenue. In short, banks don't restructure hedge books for free.
7) Some argue that spot deferred contracts, by which the company can decide when to deliver into a hedge, is a good thing. But the reality is that the ability to roll hedges into future years is a recipe for disaster. It provides a company with an excuse to avoid taking losses for bad management decisions in the past, i.e., putting those hedges on in the first place. The reality is that as the gold price rises, the lost cash-flow caused by the hedge book will continue to grow. Here's an example of how dangerous this proposition can be. Let's assume that Newcrest was operating in 1971 when gold was $35, and they hedged 10 years forward at $40. The $5 margin may have looked like a good deal at the time, but consider the implications to the company's financial position and operating margins if by 1980 it was delivering into hedges at $40 when the spot market was over $600, and oil was 8 to 10-times more expensive than it was in 1971.
8) Newcrest seems wedded to the concept of hedging, which I think is unfortunate. As far as I know, they have not yet fully disclosed at what price they hedged their copper production, which was done this past June, nor have they provided other important details of their copper hedges. I assume that they must have thought the copper price 'seemed' high in June, but as we know now, copper has climbed higher since then. I guess in time Newcrest will eventually disclose the negative marked-to-market value of its copper hedge book.
So in conclusion, stay away from companies that hedge. Hedging is a recipe for disaster, as SGW's bankruptcy and past problems with other producers have amply demonstrated. But just don't take my word for it. At the recent LBMA conference in Shanghai, a Reuters article quoted Pierre Lassonde of Newmont saying that "Newmont expected more gold firms that hedged their output to declare bankruptcy as prices rose".
I want to invest in gold mining companies with exposure to the gold price. I do not want to invest in companies that lock-in their dollar revenue but leave open their expenses to inflationary price increases. In short, hedging is a bad business practice that comes with too much risk and a lost opportunity to maximize cash-flow. I recommend that investors stay away from gold companies that hedge.
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