When Australian gold producer Newcrest Mining announced in late June it had completed the close-out of its hedge book, it also revealed the actual cost of unwinding its positions had been A$172 million ($149.7 million) higher than the estimated cost of A$1.5 billion. Newcrest officials said the added cost came as a result of rises in the cost of gold over the 12-month process to close its positions. But in quarterly and annual reports, they emphasised the additional costs were paid out of internal cash, rather than through debt financing as originally announced.
Newcrest's decision to close its hedge book was partly guided by shareholder sentiment calling for unhedged exposure to spot gold prices. The decision to hedge in the first place was made as part of a deal to obtain financing, says Daryl Corp, a general manager at Newcrest in Melbourne.
"It needs to be understood the hedging was put in place as a requirement imposed upon us by our lenders. Five years ago, when we were securing substantial debt finance for a very strong pipeline of development and project work, the lending banks put on as a condition of lending that we need to lock-in the gold price. Subsequent to that, substantial upward shifts in the gold price meant the hedge positions were materially out-of-the-money," explains Corp.
"Shareholders were saying they prefer exposure to the gold price. Hedging may not allow that to occur. In response, we were seeing hedged producers across the global gold industry unwinding the positions they held," he adds.
Newcrest is not the only gold producer to unwind its hedge book. Indeed, Newcrest is not even an early mover in comparison to industry peers, notes Jim Copland, a resources analyst at Macquarie Bank in Sydney.
"There is very much a trend for closing hedge books," Copland says. "Newcrest was one of the more substantially hedged and it wasn't the first to do it. In fact, since 2001, the global gold industry has been actively de-hedging, delivering into and buying back hedge contracts."
For example, AngloGold Ashanti, a South African gold producer, is in the process of unwinding its hedge book as well. At the end of July, the company announced it had reduced its hedge book by 3.15 million ounces during the second quarter of 2008, with commitments now standing at 6.88 million ounces - and the cost of its close-out is also exceeding cost estimates. The company has hedging positions in place until 2016.
As condition to obtaining financing, Newcrest's banks - which the company declined to name - put in a prerequisite that the company hedge the price on 2.85 million ounces of gold for five years, says Ben McCormick, corporate treasurer at Newcrest. When closing the book in 2007, the company had in excess of 4 million ounces of gold at an average hedge price of A$570 per ounce when gold was trading at around $800 per ounce in the spot market, McCormick explains. Maintaining the hedge book cost the company A$436 million in the 2007 financial year, prior to beginning the close-out, as compared to A$34 million in the 2008 financial year, as the company gradually unwound its positions.
It is not unusual for banks to require mining companies to put in place hedges to secure terms and keep financing viable, but this is dependent on many factors, including the size of the company, its existing balance sheet and cashflow, and its phase of development, notes Nick Chipman, a partner in PricewaterhouseCoopers' Australian practice in Melbourne.
"They are attempting to secure debt, but this may be in conflict with the interests of investors who may want exposure to gold mining and gold price risk they can clearly understand," he says. "Therefore, management needs to drive a balancing act around risk, growth and returns."
While hedged positions for gold often come as part of financing covenants, there was also an element of revenue enhancement in the late-1990s as opposed to downside protection, Macquarie's Copland says. "It was seen as a winning trade in a falling gold price market," he notes. "Producers locked in a price for three to five years down the track at a premium to the then-spot price; and by the time it came to deliver into the contract, the spot price was even further south."
When Newcrest announced the move in September 2007, it was met with wide-scale shareholder approval, if share price is any indication. From September 2007, the company's share price moved from above A$24 to nearly A$34 by last November. The equity was trading at A$24 as Risk Australia went to press.
The A$172 million cost increase was a result of a rise in the price of gold between the company's projections in September 2007 and the closing out of its positions on 20 June, 2008, Corp says.
"While we paid in total a little more than we originally intended in the entitlements offer, we were selling gold in the spot market and we benefited from that," Corp says. "We had a material leverage, insofar as we were selling gold into the spot market. If we net that off, we ended up in a better cash position than we anticipated in the entitlement offer."
Risk advisory analysts concur Newcrest's move to close its hedge book reflects greater acceptance among mining companies of both shareholder sentiment on unhedged positions, and a feeling that the use of complex financial instruments can result in less than transparent financial results that are harder to explain to shareholders.
"Each company has a different appetite for risk and that's an important starting point. There is mixed appetite for entering into sometimes quite complicated financial instruments around commodities, foreign exchange or interest rates; and occasionally, as has been the case for some mining entities, there has been a view those particular financial issues are difficult to explain to investors - how they work, what physical and financial positions they have to show benefit or show loss," explains Chipman of PricewaterhouseCoopers.
"The accounting rules around these instruments have changed as well. With that in mind, there has been a move philosophically plus economically to become more transparent, so that when the price of gold changes investors have a pretty clear understanding of what the position is. But with hedge books, each contract can move in different directions, depending on what has been purchased. What the mining companies are saying is 'if you want to be exposed to the gold industry, than we're making it more transparent for you to understand where we are'," Chipman adds.
While Newcrest has closed its book and is not considering re-hedging gold prices in the near future, it has put in place some form of insurance against downside risk. At the same time as the company announced it would unwind its hedged positions, it also declared it would purchase put options to protect against falls in the gold price. The company has paid A$80 million to purchase put options for up to 500,000 ounces of gold per year for four and a half years, McCormick says. Newcrest purchased the put options from ABN Amro.
"It's insurance, but not hedging," McCormick adds. "We own the position, but it is not a fixed obligation. It gives us security that, if the Australian gold price does fall, we have put options we can exercise. I think a lot more companies, if they could afford to buy the puts, would. They are not cheap."
Other gold producers have taken similar measures, says Chipman. "What the industry is saying is, 'while our view is to not necessarily hedge our positions, we may need to hedge the extremes, and how the extremes are hedged are a function of what is on offer and what can be created with the help of financial engineering and the banks'," he notes.
But while the strategy of purchasing put options may be prudent, it may not be wholly in lockstep with shareholders' short-term views, which tend to focus on upside gain, not downside risk, says Copland of Macquarie.
"There can be a bit of a disconnect sometimes. Miners are running a long-term business whereas some investors buy gold stocks purely because they think the price of gold is going up and they want full upside exposure."