In Part I, I made several points. First,
that in the last gold bear market, miners capitulated after prices were low
and falling for a long time. Then they sold massive amounts of their future
production forward. Years into the subsequent bull market, they capitulated
again, this time buying back the rights to their own production at great
cost. Whatever the right approach to hedging, this manic-depressive approach
surely isn’t it.
I also argued that miners
have no crystal ball to predict the gold price better than anyone else. If
they did, then why would they bother with running a capital intensive and
risky business like a mine? They could make billions trading gold with
leverage.
Without knowledge of the future, miners must employ a hedging program. The
question is, what is the right approach.
Let’s start off by acknowledging the elephant in the room. There is no
free lunch. To use a healthcare analogy, if you neglect your health for
decades, when you finally visit the doctor, you may get the bad news that
little can be done. Similarly, a gold mine that has not been hedging on the
way down from $1900, and which has an all-in cost of $1350, does not many
options today. It may be able to continue as a going concern (temporarily) by
neglecting its capital, by postponing maintenance or by not setting aside
money to develop another mine when the current one is depleted.
If you operate a mine with an all-in cost of $1350 per ounce, hedging will
not provide a magic solution.
When the price of gold is falling, the benefit of having hedged is that
the mine can sell its output at much higher prices than are currently offered
by the market. The key is that you had to have hedged when prices were
higher. To use a homeowner analogy, when your house is on fire, the benefit
of having bought a fire insurance policy is that the insurance company will
pay for the damage. The key is that you had to have bought the policy when
your house was not burning.
There is another constraint that pulls the miner in the opposite
direction. In most businesses, you don’t want price exposure. You want only
to buy at X and sell at X + Y. You don’t want to care about X, only making
your margin of Y. However, investors demand that gold miners provide them
exposure to the upside of the gold price, preferably leveraged exposure.
The question, then, is how do we protect the mining operation so that it
can operate in both good times and bad while at the same time generating
profits that grow exponentially as the gold price rises? We’re not going to
design a real trading program in this short article, but let’s identify some
basic principles.
First, let’s start thinking of what we produce as money. That is
what a gold or silver miner pulls out of the ground. It’s not like copper or
oil. While we do have to sell much of what we extract to pay the bills, we
can and should keep some of our retained earnings in metal. My point in
stating this is not to start a philosophical debate, but to emphasize that
the metal could and should be working for us.
The least we can do is look at the ratio of gold to silver. At any moment,
one metal is outperforming the other. We should prefer to own whichever is
outperforming. This alone should enhance our upside and limit our downside.
More importantly, we can use our metal as collateral to get credit. With
credit, a variety of trading programs are possible. If we were a trading
operation only, we would have to limit our risk or else we could totally
collapse. But as a miner, we produce a constant stream of new metal. Selling
a call option, for example, would be risky for anyone else. For a gold miner
it can earn some income.
I have written many times about carry and decarry trades in gold and
silver. To carry metal, one buys it and simultaneously sells a future. One
stores it in the meantime, and makes a profit because the futures price is
higher than the spot price. There are times when the market offers a return
near 1% for this trade, though now is definitely not such a time. 1% may not
be that much (keep in mind this is in gold), but the market keeps changing
and provides opportunities trade in and out of the carry to enhance this
return.
There are other times when the market offers a positive return to decarry,
to sell metal and buy a future. Now is such a time, though the return on this
trade has been cut in half of what it was at the beginning of the month.
There are other opportunities to trade around these two basic positions. A
gold miner, of course, is always inherently long physical gold. Therefore, a
simple sale of future production in the futures market behaves like a carry.
The key is to think in these terms, and to know when to put such a hedge on
and when to take it off. Hint: let’s not sell low and buy high.
One major driver in this decision is to make sure that the costs of
operating the mine are covered. The lower the gold price, the more one has to
sell, and the higher the price, the less. The other driver is the estimated
probability of the gold price rising or falling from here. Many people use
technical analysis, or attempt to measure flows of gold from one market to
another, for example ETF holdings or COMEX warehouse inventories being
shipped to China. I have written many times about using the gold basis as an
indicator.
And of course, we should not ignore common sense. Gold is not going to
zero, and the price is not going to double (until the end, but we’re not
operating a mine based on doomsday scenarios). Therefore, the more the price
drops, the more we should be tempted to be exposed to the gold price. The
more it rises, especially in a short period, the more we should be tempted to
sell forward every gram we can be sure we will pull out of the ground. We are
interested in low-risk trading opportunities.
This leads to the next concept. We can use options. Let’s say that the
gold price has risen considerably. We could sell a call. We have three
advantages in doing this. First, we get the call premium today. Second, we
are committing to a higher price than the current price. Third, options decay
as time passes. Unless the price of gold rises significantly further, we will
make money with this strategy.
We could also buy a put. I am not normally a fan of buying options,
especially in the context of a gold miner. The options buyer must be right on
both direction and timing, or else the slow erosion of the options value
results in a loss. But there are times when options are cheap and other times
when they are expensive, depending on market sentiment. When they are cheap,
buying puts can help reach our goal: keeping the upside and protecting the
downside. A good time for this would be after a run up in price.
There are other, more sophisticated, variants of these options strategies
such as call spreads and put spreads.
In conclusion, nothing I have presented is earth shattering or even new
(except the basis indicator). I have not discussed all the possible
strategies, but I hope I leave the reader with one take-away. Hedging should
be dynamic, changing in response to market conditions. It can generate
positive returns that enhance the upside while protecting the downside.
In Part III, I will explore another direction. There is no reason why a
gold mining company couldn’t keep its books in gold, raise its capital in
gold, and run its operation for a return in gold. Indeed, of all companies,
the gold miner is one of the few who has a proper gold income (though it,
like everything else today, is papered over in a veneer of dollars).
