Gold Fever Trumps Gold-Hedge Fever

Calling Barrick's Bluff

by Antal E. Fekete, Jan 21/03

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Antal E. Fekete Professor Emeritus Memorial University of Newfoundland St.John's, CANADA A1C 5S7 e-mail: aefekete@hotmail.com

Source: www.goldisfreedom.com

In the December 20, 2002, issue of the Canadian newspaper National Post, economist Martin Murenbeeld, Ph.D., published an article under the title "Gold Hedge Fever", giving a clean bill of health to Barrick's hedge plan by calling it "perfectly defensible". Gold producer Barrick has sold forward tons of future output, by some estimates to the tune of 5 years of mine production. Dr. Murenbeeld correctly states that the origins of hedging go back to agricultural economies. Farmers need futures markets where they can sell forward their production in order to lock in a good price, or to reduce the risk of a price decline that could be ruinous to the farming business.

Unfortunately, the author forgets to mention that farmers would never accept commodity exchange rules that allow speculators to sell short futures contracts in excess of one year's output. They know full well that unlimited short speculation would be prejudicial to their interest, as it would suppress farm prices below the marginal cost of production. In fact, short selling in excess of one year's output is outlawed for farm products. In addition, exchange rules limit short sales for other commodities as well, including gold. If these rules are not enforced it is because exchange officers have adopted a "see no evil, hear no evil" policy. They don't want to invoke the ire of their biggest client.

The "gold-hedge fever" of which Dr. Murenbeeld speaks is a euphemism for the invitation Barrick has issued to gold speculators to abandon their traditional haunt, the long side of the market, and to get aboard the bandwagon of short speculation, in order to drive down the gold price so that Barrick's hedges may flourish. Gold speculators have always understood the true nature of gold. They know that the devaluation of currencies must show up in the leap-frogging of the gold price, usually in advance but, in any case no later than at the time of the fait accompli. Speculators also know that the louder politicians shout from their rooftops that the national currency will never ever be devalued, the more likely it is that soon they will eat their words. Revaluations of currencies are virtually unprecedented. The Deutschemark and the yen have been revalued a number of times as a result of arm-twisting from Washington, in order to camouflage the devaluation of the dollar. Because of this obvious devaluation-bias speculators have traditionally been long in gold. The gold price is another proxy for the devaluation of the dollar. This was changed temporarily, in response to the bullying of Barrick. Hence the "gold-hedge fever". But when the bluff of the bully-boy is called, as it must be when governments reach the end of their rope and devalue again, then speculators will reverse themselves with the speed of light. At that time genuine gold fever will take hold, trumping the wholly artificial "gold-hedge fever".

The Economics of Gold Mining

What Dr. Murenbeeld does not understand, and Barrick does not want to see, is that the task of the gold miner, far from maximizing annual profits, is to maximize the useful life of the mine in his care. Only in this way can he maximize total yield realized over the entire life-span of the mine. Only in this way can he make it sure that no value is left behind when the mine is exhausted and closed down for good. This follows from the fact that gold is the monetary metal par excellence. I quote monetary scientist and historian William Rees-Mogg who wrote in The Times on January 6, 2003:

"Gold is very different from paper money. It has had very long-term price stability, whereas currencies normally lose 90-100 per cent of their value in each century. Its price does not determine the export cost of the nation of issue. It cannot be created except by an expensive mining process and in small quantities; it cannot, therefore, be over-issued for political reasons, to win an election or to pay for a war. It is an asset which is not represented by someone else's debt or liability. It is the only form of asset that is both liquid like a currency, and real, like property. For these reasons, it is the canary in the mine. Major changes in the world exchange system usually show up in the gold market."

That gold is a monetary metal is also shown by the stock market as it places values on the shares of a gold mine. Each gold stock has a built-in option feature, augmenting the stock price with an "option premium" -- assuming, however, that the gold miner does not violate the principles of the economics of gold mining. The market capitalization of a gold mine regularly exceeds book value, not because of any speculative fever, but because the gold miner is expected to bring to surface greater value than that represented the by the payable grades of ore.

For this reason, gold is supposed to be mined very differently from copper or any other non-monetary metal. The copper miner always goes after the highest grade of ore. By contrast, other things being the same, the gold miner is mining his marginal grade (that is, the lowest payable grade) of ore. The mill of a gold mine, unlike that of a copper mine, is always run at full capacity. If the market price of gold changes, the gold miner responds not through changing mill-capacity utilization, but through a shift in the grade of ore to be milled. In case of higher gold prices he will lower it. By contrast, the copper miner will increase mill-capacity utilization in case of higher, and decrease it in case of lower prices for copper. At any rate, he will continue to feed his mills with the same top grade of ore. He must do this because he has to sell all the copper the traffic can bear, in order to protect his market share. The gold miner, however, is never in a rush to sell. He understands that gold sitting underground locked up in ore reserves represents value no less than gold sitting above ground locked up in the vault. His main concern is not market share, but the prolongation of the life expectancy of his mine.

In Praise of Hedging

The gold miner may ignore these principles only at his own peril. If he responds to a price advance by charging, like an elephant in the china shop, and tries to sell gold obtained through skimming the top grades in imitation of the copper miner, then the market will punish him for the indelicacy of his ways. The stock of his company will be denied the "option premium", available only to miners who understand and live by the economics of gold mining and leave the top grades of ore alone.

Worse still, shareholders will vote with their feet. They know that the life expectancy of the gold mine has been drastically curtailed by the wasteful and exploitative methods of its managers. They fear that the mine may have to be closed down prematurely, with a lot of valuable ore left behind, after the top grades of ore have been scooped up. Reopening the mine later when the gold price has advanced, making the sub-marginal grades of ore payable, may incur heavy additional capital outlays. The stockholders rightly feel that they will be better off if they invest their funds in a gold mine managed more conservatively, observing the principles of the economics of gold mining. Barrick may well be the number one star hedger, but it will always be the last one to benefit from a higher market price of gold by way of a higher stock price valuation. The word "hedging" as used by Barrick is a misnomer. It is to cover up the fact that Barrick is speculating on the short side of the market in anticipation of a lower gold price. Selling forward amounts to shortening the life of Barrick's mines, in defiance of the principles of the economics of gold mining which call for the greatest economy. It is a most wasteful dissipation of mining resources. It is just the opposite of good economy that gold, in and out of ground, is trying to teach man.

Barrick's are 'hedges-false': forward sale of future output. 'Hedges-true', by contrast, aim at shifting ore grade utilization from marginal to sub-marginal grades, in order to push mine life-expectancy out to the limit. It is made possible by virtue of the fluctuating market price of gold. The gold miner is a seller of gold futures whenever an upward spike in the price occurs. The amount to be sold short is not unlimited, however. It is strictly limited by the quantity of gold he could gain out of the submarginal grades of ore that have, thanks to the spike, been temporarily promoted to the payable category. The short position is covered as soon as gold from the sub-marginal grades of ore has been extracted, refined, and sold. As can be seen, when short selling is structured around a program of stretching the useful life of the mine, then the gold miner is creating value, as it were, out of nothing. Economically speaking, sub-marginal grades represent zero value. Yet through his 'hedges-true', the gold miner can squeeze blood out of stone. This is an almost miraculous extension of mining economy, a real contribution to prolonging the useful life of the gold mine.

Perpetual Option

The stock market rewards the economizing miner by the option premium augmenting the stock price. It regards each share as a perpetual option on gold. Perpetual, because it does not have a set expiration date. Under a gold standard gold mining shares have no option feature and the only way to gain value out of sub-marginal grades is to use it in diluting the better grades. The economics of gold mining changes its character under the regime of irredeemable currency, as the gold price becomes the measure of currency debasement. The higher it goes the more volatile it gets. As volatility increases, the mining of sub-marginal grades will become more profitable, and the useful life of the mine can be extended. The option premium incorporated in the stock price increases with the gold price. (Note that, in the case of options with a fixed expiry date the time premium is a decreasing function of the gold price.)

Moreover, the premium on perpetual options increases exponentially. This is so because the inventory of payable ore reserves expands with the increasing gold price. More and more sub-marginal grades of ore become payable, augmenting book value.

Fraudulent Hedging

Dr. Murenbeeld disapprovingly quotes me as saying that Barrick's hedging policy is fraudulent -- without mentioning the particular practice that I have condemned. If Barrick was merely selling gold forward, it would be stupid but not necessarily fraudulent. Fraud comes into the picture because Barrick reports paper profits as if they were profits that have been consummated. Profits are not consummated until and unless all deals connected with it have been closed out. I have explained this distinction in geater details elsewhere, as quoted in the book Gold Wars by Ferdinand Lips (New York: www.fame.org, 2002; p 161 ff):

"Barrick knowingly misleads shareholders, creditors, and the general public. For several years in a row in its Annual Reports, at its General Meetings, as well as at press conferences, Barrick has been reporting consistently higher profits, attributing them to its ability to realize higher prices for newly mined gold than those bid during the entire year under review. These reports of higher profits have been duly certified by reputable accounting firms, and they have never been questioned by academia, let alone the financial press."

"We all know what academia and the financial press would have to say if a company with publicly traded shares would announce that it is profitably manufacturing and marketing the 21st century version of 'perpetual motion'." "Barrick boasts that it can accomplish the miracle of consistently selling gold at a price higher than the market has been willing to bid during the entire year 'through the sophisticated tool of hedging'. Why not share this 'secret' with the American farmer? Would it not be wonderful if they, too, could consistently realize higher wheat prices than the market is willing to bid? Where are the farmers' organizations to demand that they should also be told the secret of turning the stone into bread?"

Paper Profits May Evaporate before Realized

"Barrick could not share its secret with anybody because the 'miracle' can only be accomplished through fraud. If one wanted to be charitable, one would assume that the accounting firms do not understand what they are certifying. Otherwise they would not give their good name to this chicanery aiming at misleading the public. Unfortunately, there are signs that suggest otherwise. The accounting profession may be a full accomplice in this conspiracy to defraud. It is not, has never been, and never will be possible to sell gold forward at a price higher than the highest price bid by the markets during the year under review, any more than it is possible to turn lead into gold profitably."

"Here is what Barrick is doing. It sells gold borrowed at the low lease rate, and invests the proceeds in high-yielding U.S. Treasury paper. Then it re-calculates its revenues boosted by the interest income (owing to the positive spread between the yield on Treasury paper and the gold lease rate) as if it had been received through a higher sales price on gold per ounce. Why is this a fraud? Because the transaction remains incomplete, and profits are only paper profits, as long as all the deals have not been closed out and gold has not been returned to the owners. It may not be possible to realize those paper profits. It is quite conceivable that these forward commitments will have to be closed out at hideous losses. For such a scenario nothing more drastic needs to happen than for the price of gold to return to a higher level where it has already traded for years or decades -- before the entire deal is closed out and the borrowed gold returned."

"Barrick simply assumes that 'what goes up must come down'. If the price of gold goes up, say, $200 per ounce, then it is duty bound to come down at least that much in due course. Those with financial staying power, such as Barrick considers itself to possess in good measure, will be able to ride out the storm caused by temporary spikes in the gold price. They can roll over all futures contracts showing a loss, several times if necessary, until the gold price comes down again. Barrick and others will, therefore, always be able to close out their deals at a profit." "The fact remains, however, that all Barrick has accomplished is to have swept margin calls under the rug, thereby concealing a potentially unlimited liability from its shareholders and creditors. Therein lies the fraud, which SEC and other watchdog agencies should uncover and expose..."

"It has happened any number of times in history that the gold price took off, never ever to come down again to the level it has started from. For this reason, any accounting assumption that a commitment to deliver gold can be closed out profitably in the future (if only one is willing and able to wait long enough) is simply fraudulent. It should never be allowed in a society with self-respecting legislators making meaningful contract laws. And the fraud should be exposed by self-respecting accountants."

"Just as grain-elevator operators are not allowed to treat in their balance sheets and income statements long positions in the wheat futures markets in the same way as they treat wheat owned outright and physically present in their elevators, gold mines should not be allowed to calculate and report profits on the sale of borrowed gold in the same way as they calculate and report profits on the sale of newly mined gold. There is a contingent liability on the long positions of a grain elevator. For the stronger reason, there must be a contingent liability on the short position of the gold mine. Until and unless these positions are closed out, there is no profit to report. As the proverb says, 'there is many a slip between cup and lip'."

"It is to the eternal shame of our civilization that it allows this unsavory conspiracy between the bullion banks, the gold mines, the accounting profession, and the government (with academia looking on) to defraud the general public through the hocus-pocus of 'hedging' and forward selling."

"Such blatant and ongoing abuse of trust is possible only under the regime of irredeemable currency. A most powerful argument in favor of the gold standard is precisely the one asserting that it will not tolerate the perpetuation of abuses of trust in dealings among upright people."

Invitation to Bankruptcy

Dr. Murenbeeld also takes me to task for suggesting that Barrick's reckless forward selling of several years of future production is an "invitation to bankruptcy". In his opinion the worst that could happen to Barrick is "to suffer an opportunity loss". It would, however, not experience direct cash loss: as long as it had the gold in the ground, it could bring it up and return it to the lenders. Too bad if Barrick is unable to sell at a price higher than that at which the borrowed gold had been sold, but an opportunity loss should not be confused with bankruptcy.

Yet opportunity loss is not the worst that can happen to Barrick. There is a serious, possibly fatal, mismatch of maturities. Gold is typically leased for a few months; at most for a year. Very obviously Barrick is in no position to return the leased gold to its owners from production if the loan is called. It would have to go into the market to buy it back at a price higher than that received for the leased gold it had foolishly sold earlier. There is your cash loss for starters. Even if further extensions of the lease can be arranged, the lease rate could go sky high. It is precisely the open-ended risks of an increase in the gold price plus that of the lease-rate which is threatening Barrick's solvency. Option pricing models can't handle the power-surge represented by the duble-whammy of a surging gold price and a simultaneously surging lease rate. Changes in either could take place much faster than that experienced during the quiet times when Barrick had sold the first ounce of leased gold. You had better be prepared for a scenario in which all offers to sell or to lease gold are withdrawn.

It is rumored that Barrick has already "hedged its hedges" by purchasing compensating call options. But what if the naked writers of those options default, leaving Barrick to hold the bag? No matter how you cut it, "a bird in hand is worth twenty in the bush". Gold in the ground is not the same as gold in hand. It will take years to bring it up, and Barrick may not be around to do it. I stand by my earlier statement that Barrick's policy of wrong-headed hedging is an invitation to bankruptcy.

A Short Course on Hedging

To recapitulate, it is the volatility of the gold price, and not a higher gold price per se, that justifies hedging. Instead of selling forward future production, thereby shortening the useful life of the mine, the gold miner sells gold to be extracted from sub-marginal grades which could not be mined economically in the absence of volatility. In this way the gold miner saves top grades and extends the life of the mine.

When the gold price spikes upwards, sub-marginal grades of ore will suddenly be promoted to the payable category. But, typically, spikes don't last long enough to allow a shift of manpower and machinery from one mining site to another. This is where hedging, properly understood, comes in. The gold miner sells gold futures now, and wrestles gold out of the sub-marginal ore reserves later. But it is important to observe that his short sales are at all times limited by the quantity of gold contained in the sub-marginal grades of ore that have been promoted to the payable category by the spike and the short position, so created, must be covered as those sub-marginal grades are depleted.

This is certainly not what Barrick has been doing. Some six years ago it was reported that Barrick had to close down five of its ten operating sites due to the low and falling gold price. This was a tell-tale, showing that Barrick was exploiting its best grades for a quick profit, rather than conserving them as a truly sophisticated hedge-plan would demand.

The Proof of the Pie

Time will show that Barrick's hedging policy is fundamentally flawed and bound to fail. The writing "Mene Tekel" is already on the wall. If it was really such a well-thought-out plan to sell forward production several years out into the future at an unexciting price, as Barrick and its solicitors claim, then surely now is the time to expand the hedge-book, when the gold price is exciting. But what do we see? The hedge-book of Barrick is shrinking. The heroes of hedging who were kicking gold when it was prostrate and down, cut and run with tail between the hind legs now, when gold is up and flexing its muscles. No more bold talk about "reducing risk exposure" and about "controlling adverse price outcomes". No more whistling the seductive tune that "opportunity loss is no cash loss". For six years there has not been a like chance to lock in such a high price. And look, who isn't locking? Barrick, that's who. Instead, it is delivering into its hedge-book with all deliberate speed. It has spot-deferred hedges, so why doesn't it defer? Because we may never see $250 gold again, that's why. What is the point of deferring if it only makes your predicament worse? The proof of the pie is in the eating. Barrick's pie is rotten to the core.

"Blanchard contra Barrick & J.P. Morgan" may be a frivolous lawsuit as suggested by Dr. Murenbeeld. The coming class-action suits "Shareholders contra Barrick" and "Shareholders contra J.P. Morgan" won't be frivolous, and that's guaranteed.

References

A. E. Fekete, The Texas Hedges of Barrick, www.goldisfreedom.com
Ferdinand Lips, Gold Wars, New York: www.FAME.org, p 160 ff, p xv, 2002
Martin Murenbeeld, Gold Hedge Fever, National Post, (Financial Post), Toronto, December, 20, 2002
William Rees-Mogg, When the Outlook is Golden, Start Worrying, The Times, London. January 6, 2003

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