Hedging, whose risk? - the merits of commodity hedging
A great deal of debate continues concerning the merits of commodity hedging. Investors are bombarded with the opinions of company management, brokers, newsletter writers, and company investor-relations firms. All claim to be ‘doing the right thing’. Historically, some have proved right.
Barrick Gold Corp claims to have added US$1 billion in revenue during the 1990s as a result of its hedging strategy at a time of falling annual average gold prices. Cambior Inc and Ashanti Gold, at the same time, experienced significant losses and corporate financial damage due to their approach.
The intent of hedging is to reduce the risk caused by uncertainty. This risk can take several forms – it may be the commodity price which changes value over time, based on the cost of production and currency value in the production country to the international price of the commodity, usually in US dollars – as well as a few other lesser risks. In addition, the three principal stakeholders in mining projects – the mining company, lender or financier, and the shareholder – all accept significant risks associated with, for example, mining, loan repayment and share price fall.
Out on a limb
With this hierarchy, the shareholder will benefit least from hedging, although management are usually shareholders, as are financiers. Banks and investment companies may or may not be shareholders, the latter will be most likely to determine or insist on a hedge programme as it protects their loans. It may not, however, protect profits or shareholder value.
Rio Narcea Gold Mines Ltd is a gold, copper and nickel producer with mines in Spain. As part of the terms of the company’s financing for construction on the Aguablanca copper-nickel mine (see Materials World, September 2003, p32), it was required by the lender to take on hedging contracts for copper.
The copper agreement fixed the price of some of the metal produced and delivered in the third quarter of 2006 at prices lower than the average spot prices. This resulted in the ‘lost profit opportunity’ for Rio Narcea shown as a loss of US$8.4 million against what would otherwise have been additional revenue on top of the net income of US$15.6 million reported. In this circumstance, the company still made money, but less than it would have, had the hedge not been in place.
The benefit was that the company received the cash it needed to bring on the mine, while the lender was protected from the copper price (if it fell) and from the fees generated in arranging the debt in the first place. The shareholder experienced the losses realised on the hedge contracts, as well as the profit on the remaining copper and nickel produced over and above that specified.
Rio Narcea entered into the hedge arrangement in March 2004, at a time when it was not making a profit, to finance Aguablanca. From 2004 to May 2006, the company reported consistent corporate financial losses resulting from gold production and Aguablanca development costs. In the third quarter of 2006, the finance debt was fully paid off. The company, however, continues to hold outstanding copper hedges through 2008 that are significantly under the current spot prices for approximately 70% of current annual copper production from Aguablanca.
All three stakeholders have benefitted (though the shareholders gained least, in my opinion, from capital appreciation). As can be seen in the chart on the previous page, the share price has not performed to the same benefit as the copper or nickel price, which was not hedged over the same period.
One foot in
Yamana Gold Inc has taken a similar strategy with the development costs of its Brazilian copper-gold project in Chapada. The company announced in November 2005 that it had hedged approximately 50% of its early copper production at an effective price of US$1.27 per pound (lb) to secure the debt service obligations upon its finance loan.
It also enhanced the profitability for shareholders to participate in the copper price upside by taking out call options on the copper amounts hedged, should spot prices exceed US$1.67/lb. As can be seen from Yamana’s share price performance, this move, along with other development decisions and acquisitions of gold projects and companies, has had a positive effect on share prices.
Safety in dilution
AngloGold Ashanti is an example of a company burdened with a heavy hedge position of its own and inherited hedges in its takeover (rescue) of Ashanti Goldfields. The gold price and increased production have, however, to a large extent, offset the negative impact. The hedge is effectively diluted by increased spot prices as not all production was hedged. World Gold Analyst reported that AngloGold’s hedge position in December 2006 consisted of three million ounces (Moz) of gold sold forward to 2015 at average prices from US$301 to US$411/oz, as well as 8.6Moz of call options. Essentially, the latter gives one the right, but not obligation, to purchase ounces at a later date at predetermined prices – a derivative sold forward to the same date at prices from US$576 (2006) to US$525 (2015).
This position results in a current value of the hedgebook at a negative US$2.8 billion and represents almost two years of total annual production. The company delivered 1.4Moz (essentially all of its third quarter production and nearly 25% of its total annual production) into this hedge position, which reduced its potential realisation on those ounces by six per cent from the average spot price of gold during that quarter of US$621.
Total gold production costs have risen by 54% since 2002 while total annual ounces produced have stayed near the current rate of around 5.6Moz. The gold price has doubled over the same period.
Some major companies such as Barrick Gold have been able to grow its production and thereby diminish the impact of hedged ounces as long as the total hedgebook is reduced over time. The difficulty of finding, acquiring and producing so many new ounces to replace those produced has impacted on all of the major gold companies to the extent that those with hedgebooks, including AngloGold, will be delivering discounted ounces for some years to come.
The overall size of these companies is some consolation to shareholders in the current environment, since their market capitalisation and trading liquidity makes them eligible to be added to the portfolios of large institutions in this time of increased demand for gold stocks. This assists share price support. The share price of AngloGold Ashanti currently stands at around 110% above this time five years ago, and had been as high as +200% – a good medium-term return – and essentially matching the gain over the same period for Newmont, which is unhedged.
Hedging has ‘come of age’ in the past decade as a more widely used and sophisticated tool to manage risk. It has, in most recent years, been employed by companies to provide certainty in the pricing of production acquisitions secured against debt finance.
Such protection comes at a cost to shareholders in the form of earnings being ‘held back’ by the hedges when the underlying hedged commodity has risen in price between the time of the placing of the contract and its expiration with delivery of the commodity. These hedges have not led companies to ruin as they have done previously, most notably in gold and oil deals during the 1980s and 90s when the commodity price was falling faster than the hedges had been priced for.
More sophisticated strategies now preserve the integrity of the hedge purpose itself in most instances. As often is the case, bankers benefit the most from such deals. Hedges cannot, however, be characterised as ‘always bad’ or ‘inappropriate’ as some writers and companies would have people believe.
Price caps, price floors and pre-selling a portion of annual production is an answer to minimising commodity risk, but not the only one. Each company will need to review its own situation to determine whether hedging is the best use of funds at that particular period in its corporate development.
Paul Renken is a Mining Analyst at VSA Resources, 43 London Wall, London, EC2M 5TF, UK. Tel: +44 (0)20 7628 3989.