Is it risky for a gold producer to trade or speculate through the use of Options or Futures to make money to improve the profitability of its hedge Book? If so, can they guarantee success? Arent they increasing the risk on their Hedge Book? What is the difference between 'trading' and 'hedging', speculation and investing. With major companies like Barrick, recently announcing that it "will resolve the problem of its hedge book [?] by selling on the 'spikes' and buying back on the 'dips', where it can and delivering to the market, where it cannot", the question becomes very pertinent.
In part two of this series we defined "Speculators" and "Commercials" as follows: -
• "Large-scale Speculators" are those with open positions of 200 contracts or more at any one time (in any contract month).
• "Small scale Speculators" are smaller than those with open positions of 200 contracts or more.
• "Commercials" would tend to be commercial users of gold that hedge their positions on the Exchange, i.e. jewellers, manufacturers of electronic components, etc.
Could we see Barrick defined as a "Large-scale Speculator"! On the surface, Barrick's position sounds reasonable, possibly a simple and effective solution?
So why don't all mining companies follow this approach, if it is so? Here are some of the answers: -
• This is a serious departure from the gold producing business Barrick and other Miners are in.
• It involves taking greater risks with Shareholders money, for who can tell where the "Spikes" and "dips" are - in advance? If they knew so certainly, why bother to mine?
Granted, if such trading is limited to Option trading, the risks would be only the Option monies involved, as one does not have to 'exercise' an unprofitable option [deliver or take delivery]. If they use futures contracts [selling / buying gold for delivery at a future time, usually on a margin down payment] the risks are considerably greater, particularly where large quantities of gold are involved!
It has to be realised by all, that 'trading' gold is a potential risk, far greater than simply hedging!
Too understand this, it helps if we examine the behaviour of those, on the other end of the market to the Miner, those whose profession it is to buy gold from the market, with the express purpose of selling it after adding some value, into the retail market. These market participants are called the "Commercials". Contrary to popular opinion, these are not a crowd perpetually in opposition to the "Speculators", and who are usually right. Indeed, like us all, they are being driven by the usual motive of profit, that acid test of existence in the markets.
We will look at the "Commercials" to try to see how they influence the gold price. The market understanding of a "Commercial" is that he is simply a dealer in gold, trying to lower the risks of holding gold, through the process of "Hedging" [selling bought gold, via an option or future, so that he has no exposure to the gold price, as he has both bought and sold gold] He is someone who buys gold to use in his usual business and not purely to profit from a movement in the gold price. The "Speculator" on the other hand, is seen as one who has an 'open' exposure to the gold price [he owns gold (long) or has sold gold he does not have (short)].
"Commercial" is an valid title insofar as it describes his business activity. He intends to add value to the gold by turning it into a gold based product. The different categories of Commercial are: -
Commodity facet - Industrial Users: -
Such as Electronics Engineers, Dentists, Decorators, who buy it from / through wholesalers, a commodity broker, or go direct to bullion banks, as and when they need it. To them gold is just a component of their products and simply a cost centre. The inherent qualities of gold motivate these buyers to use it. Its price is a very secondary issue.
They will remain constant feature in the gold market, buying gold, as long as they stay in business and as long as their products demands gold as a component. In turn, gold will be used in their products so long as its price does not make the final product too expensive for its market.
Industrial users such as the aeronautical and hi-tech industries use such small quantities of gold in their products, that only a price movement in several multiples of the current price would influence their decisions to use gold negatively.
Dentists and decorators are more influenced by fashion than by price too, knowing that cosmetic factors overwhelm price in buying such decisions, usually by the feminine gender. Nevertheless, theses "Commercials", if the values they buy are significant enough to justify the cost of the efforts needed to buy 'at the right price', will use options or futures to eliminate the time factor from their buying, taking a view on the price and buy forward to match delivery to their needs.
This industry stretches across the entire world, with key centres based in Italy, Turkey, India, the States and growing Dubai.
Far more complex than the Industrial user, the Jewellery market has several layers of attitude to the gold price.
- Well made jewellery is not price sensitive. With the cost of manufacture far outweighing the gold content's value, it seldom returns to the market. The workmanship involved adds such enormous value that it would be rare for such jewellery to end up in the furnace. In the West, in general, jewellery is bought for personal decoration and also, rarely involves the gold price. Indeed they may well feel that the because of its higher value, its ownership is more desirable.
- On the other hand, in India, where gold is seen as a superior money to paper, and is linked to religious factors, as well as a well-established tradition, the rural community, which buys almost 70% of the 850+ tonnes of gold imported annually into India, convert it into simple jewellery, whose price does not stray too far away from the underlying price of gold, so that some of the suspected 13,000 tonnes sitting in India, finds its way back to the market as scrap, if the price jumps too far and becomes unstable, as it did last December. At current levels and with the stronger Rupee, the jewellers, known as the 'physical' trade, are buying gold at just under and possibly just over $370. The "spike" to $394, had these buyers putting their money back in their pockets and walking to the sidelines. Should the price stabilise, even at higher levels, physical buyers will return to the market. They, like all businessmen, want to know that the price they pay for it is the price, plus their costs and margins, is the price they will get in the market place.
With such a huge industry at the middle and far eastern end, the structure of the market carries bullion banks, wholesalers and retailers, giving rise to a very broad scope of activity in the markets. The service offered by the banks and wholesalers can be so sophisticated that the trusted small retailer can take gold 'on consignment' [not pay for it until sold] and the wholesaler or bank will cover the risk, in the price he charges. This elimination of price risk is key to the size of this market, giving the flexibility the small man needs to earn a living with small if any capital.
In turn, the larger participants will buy gold for delivery at times they know the demand will arise [through the futures market] buying at times when they believe the price is right. Then for the cost of an Option, this same wholesaler will remove his price risk, by selling the same gold through a "Put" option, with an exercise period covering his delivery date on his futures contract. Hence, he has 'closed' his position, in reality removing the price risk entirely, whilst giving himself the certainty of supply, should he be prepared to 'walk away' from the option.
This is how he does that - the day he needs the gold in his business approaches and he looks at the price. If it has fallen, he would exercise his "Put" Option, making a profit on the option and take delivery of his futures contract, at the original higher market price. The profit on his "Put" option would be such that he could set that off against the loss on his futures contract established at higher price levels. With the profit on the option offsetting the loss on the futures contact, the 'net' price he pays for his gold would allow him establish a current market cost price. If he has allowed a client to become a Debtor, he can, by extending the option to the day he expects payment from the client, even hedge the period his debtors use his gold in the manufacturing process.
Should the price have risen and not fallen, by the time he has to pay, or is paid, he can enjoy the benefits of profits on his futures contract by "walking away" from his option [simply abandon it - having already included his option costs as part of his costs]. With the Option he can therefore protect his supply and price risks. So, when he, as a "Commercial", sells gold in the market on COMEX, he is not "shorting" the market, as many would assume. He uses the option, as a genuine "hedge" instrument of the gold price, to close an 'open' position! Indeed it is the Commercial who does best out of a rising price market!
The gold producer [the miner] does the reverse. He is a natural seller of gold. Hence, someone like Barrick benefited enormously from a falling gold price market. For him to now profit from "hedging" sufficiently to cover a 'hedge book' [looking well 'out of the money' on average] , this is what is required: -
• He has to trade against the trend of the market.
• The "Commercial", can build the costs of his options into his price and rely on his underlying business to earn him profits. A miner does not have any add-on value to his business, usually, so he must accept greater costs factors in his overall operation.
• A gold producer attempting to soften the blow being felt on already hedged gold production [which presently looks like it will achieve a price well below the market price if it matures now – Barrick's 'hedges' will mature in up to 15 years, so postponing the day of reckoning for that time. They hope the gold price will have fallen below their contract price by then – but this could be a dangerous risk!] has already established a potentially poor performance relative to other gold miners, getting higher market prices. To manage the increased risk of trading, he must have the necessary 'safety measures' [controls and limitations] so as not to reinforce failure!
• His venture into the options and futures market is now one of a "Speculator".
• Some of the best traders / speculators we know, will tell you that a really good trader / speculator will get 50 to 55% of his trades right. His objective is to earn more profits than he does costs, through frequent trading, to take short term gains staying in the market for a maximum of six months. Many traders perform far, far worse than this and exit the business with heads hung down. We all remember the Anglo Irish Bank debacle, or the Barings mess stemming from similar speculation and trading against the tide. And these were good professional traders, originally, were they not?
• One would have to convince Shareholders of not only the benefits of speculating, but of the pitfalls, so no more C.E.O.'s will be seen departing the boardrooms of Barrick. The first request, as a Shareholder of Barrick shares I would have, is to know, completely, the details of the trading policy, including limitations on trading, together with very frequent reports. Likewise, I would want to know on whose desk do the trading decisions lie and why the board believed he would make the needed profits?
• To be able to pick the price of the "spikes" and "dips", is easy with hindsight, but a different kettle of fish, ahead of the event. Risks are and will be taken far in excess of simple gold producers risks, does the operation have the competences to achieve the required result.
• And with Barrick, we are talking hundreds of tonnes of gold, a major volume to be contemplated in the options or futures market! The dependence on the Trader is going to be heavy, very heavy.
To illustrate, if Barrick were to have sold on the recent spike, not at $394, where very small volumes were dealt, but at around $385, and the gold price fell no further than the $370 and they felt it was going to fall to $330. They would hold their "Short" position open. Next the gold price rushes back up above $385. Hopefully, they would have a protective "Stop" in position, say at $386, so that they can exit with only costs to pay, no or little losses. If they did not get out but saw the price roar above $450, they would be sitting on a very unhappy situation and a $65 loss, per ounce.
• Remember the 'hedger' closes an 'open' position to remove risk. A Barrick would be opening a new risk position. Hopefully, Barrick will restrict itself to the use of options.
• One can only guess at the huge volume of successful trades a company like "Barrick" would need to achieve the aim of improving the condition of its overall "hedge" book.
• Should Barrick use new, unhedged gold for these purposes and attempted to close 'Put' Options by purchasing on the dips, again the decision would have to be to pick the right bottoms. That can be just as difficult as picking the "spikes".
Hedging Currencies in gold markets.
Gold price "Hedging" is complicated still further because of the international nature of the industry. The 'Commercials' have to face a foreign currency risk. They may well live in a country where they have to buy foreign currency with local Rupees or Lira, with which to buy gold, paying for it in Pounds sterling, Euros or U.S. $. The only way they can 'close' their risk on their currency positions is to export the gold after turning it into jewellery. This would allow the local currency to be almost neutralised in the transactions. Unavoidably therefore, they have to take a view on the currency they buy their gold in, should they be importers. Get this wrong and his hard earned profits will disappear quicker than they were made.
So significant are import costs related to currencies, that this year, a large interest rate differential between the interest rates charged by local state run institutions and the banks, that importers, by using letters of credit, could lower gold costs per ounce by between $3.5 and $6.00. This is why the big banks have seen very little business from India, so far this season. Add to that the stronger Rupee, and Rupee gold prices are cheaper than those found on COMEX by up to 1,75%.
In addition, the economy looks terrific, causing the Rupee to rise to new heights against foreign currencies, making gold imports cheaper in Rupees. In turn more gold is paid for by happier and richer locals.
Their foreign exchange risks could have been the opposite, as has been the case with gold producers in South Africa, who, when they sell gold, have to bring the U.S. $, or Euro, or Pound Sterling proceeds home to where the gold was mined in the first place, hand these foreign currency proceeds to the banks in that country, who then convert them onto the local currency, before giving them to the mines as consideration for their gold sales. If the currency is rising strongly [and the Rand, some years ago, fell from R8.00 to the $, to R13.5 to the $. Now it has revered to R6.85 to the $] it wreaks havoc with the profits of the gold mines who are busy laying off miners and reducing levels of reserves. So as a matter of necessity, they have to 'hedge' against the Rands rise. When the Rand was weakening, no 'hedging' seemed needed, as profits just kept on growing. But on the rising of the Rand, profits keep falling. Any mine not 'hedging' the Rand against the $, etc, has quickly seen his profits tumble!
Impact on the market of the Commercials and relationship with Speculators and investors and Gold Producers.
So the impression that the "Commercials" always get it right, and are opposite to the "Speculators" has no real foundation.
• The "Commercial" should be an operator who focuses on the business he is in, removing risk as best he can, not so concerned with where the price is. He wants a stable gold price knowing he is not paying away profits, resulting from falling prices after he has paid. He sat on the sidelines recently while the gold price rose to $394, not being prepared to buy into a frothy, overpriced market. With the pullback into the $370's he is reading the price back in stable territory and he will pay these prices, because he believes the price will be around these levels and his own clients can accommodate it.
• The "Speculator", to the "Commercial" is simply an entity affecting the price, not an opposing force. The "Speculator" is a Trader looking for short term profits, taking the greatest risks of the three to get them, unconcerned with the "Commercial", except respecting his market 'savvy'. He would not usually be concerned with "Hedging" risk, but see it as another source of potential profit.
• The Investor, on the other hand, is concerned with a good price with which to enter a medium to longer term investment, but as a secondary factor, primarily concerned with his moving from investments [even the $] whose total return will be less than he can expect from gold. He is aware that other investments from a fundamental view have structural flaws which cause him to believe gold will be a contrary investment, providing him with profits and protecting him against the fall expected from his previous investments.
• The Gold Producer is a miner who produces gold to sell for the best price he can get. His business is therefore to "hedge" risks that detract from this. He "hedges" currencies to maximise the profits he seeks.
So, Barrick appears to be a company, [not too alone] that misread the trend change and got caught in a rising market, having pre-sold gold at prices lower than that achieved by its unhedged competition. Now after realising this, it's trying to cover its back, by turning "Speculator". We hold our breath, hoping the best for them, whilst braced for less and watching with fascination.