A number of gold miners have closed their hedge books or are in the process of doing so. If you are a gold investor, you will likely know what this means… the miners are expecting higher prices ahead.
Just what exactly is this hedging all about, anyway? And why do producers do it? More importantly to investors, which companies are hedged and which are not? Knowing the difference can make all the difference between an investment that grows a little and one that grows a lot.
Production Hedging
Simply put, miners hedge by selling production before it comes out of the ground to protect themselves against falling prices. By selling futures contracts some 6 to 24 months into the future, sometimes longer, the producers’ sales revenues are known ahead of time, which helps them better plan their operations and determine the budgets they have to work within.
Hedging can be very beneficial in a falling market. As analyst Matthew Piggot of Thomson Reuters GFMS explained to the Financial Times, “Australian dollar denominated put and forward sale contracts became increasingly in-the-money during the second quarter.” In other words, miners made a lot of profit during the correction of Q2 from having pre-sold their production at higher prices months earlier.
Many banks will even require some miners, especially the smaller ones, to have a certain amount of hedged positions in either futures or options to ensure some protection against falling prices before granting loans, just to make sure they get their money back.
But hedging can often aggravate shareholders, since in a rising market, hedging can result in capped revenues, causing hedged producers to underperform unhedged producers or even the underlying commodity itself. This is why you will often note that producer stocks can lag behind commodities on the way up, since many of them are stuck with pre-sold delivery contracts at lower prices.
For this reason, many producers are closing their hedge books now, which accomplishes two things: it locks in profit from those pre-sold short futures contracts, and it clears their future production from any sales obligations, leaving them open to benefit from rising prices.
Unhedged and Ready to Run
Case in point, Australian miner Reed Resources (ASX: RDR) closed off its outstanding short futures contracts early, before delivery was due, locking in some $27 million in cash profit and using $19 million of it to pay off outstanding debt with Credit Suisse.
Not only does this make the company’s stock more attractive today, given a much smaller debt burden plus an infusion of $8 million to ramp up production, but it also gives the stock some fantastic upside potential when metals prices start rising again. Think of it as a horse that has been unhitched from his wagon. He’s now free to run as fast as he can without that weight slowing him down.
Other junior miners that have recently closed their hedge books of pre-sold production include Mutiny Gold (ASX: MYG) and Teranga (TSX: TGZ).
“Many shareholders still have bad memories from hedging in the early 2000s,” Piggott reminds us. It took some producers until 2007 or 2008 to finally close their hedge books, by which time commodities had already mounted half their run.
This time around, few producers have returned to forward selling to such an extent as before. Instead, they have been working hard to cut expenses and reduce operating costs so as to be as unbridled as they can be going forward.
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Indication of Another Leg Up?
By concentrating more on reducing costs and less on forward sales, miners could be giving us a clue as to where they see commodity prices heading – up. As Thomson Reuters GFMS recently published, gold production pre-sold by hedging fell by 9% from the previous quarter, with total hedging now at its lowest level since 2002.
The correction in metals prices these past 22 months may very well be in its final days. And now looks as good a time as any to add to our producer stocks. With the costlier mines padlocked and only the most profitable mines open right now, metal producers may finally be able to play “catch-up”.
Having lagged behind gold, silver, and other metals for several years, producer stocks finally have some potential to outperform the metals on a percentage basis in the second half of this year and the first half of the next.
Some commentators, though, see this lack of hedging by producers not as a sign of higher prices to come, but rather as just plain foolishness. They feel prices are going to continue plummeting, while costs will continue rising. They cite South Africa – which houses one of the greatest concentrations of mining operations in the world – as plagued by deteriorating ore quality, lower ore quantities, labour unrest and shortages, and burdensome government policies.
However, these are all reasons supporting the bullish case for metals, as all such problems in South Africa and elsewhere have been limiting supply. These shortfalls in stockpile replenishment will at some point push prices higher, as new supply will be unable to meet new demand.
The producers have a pretty good reading on the supply/demand fundamentals of their businesses, and they are choosing to unhedge. As the GFMS reports, 32 producers around the globe have reduced their hedge books this past quarter, while only three have increased them.
Understanding that the prices of the metals have fallen to about the cost of production, any further fall in prices will shut down even more mines. It is a self-correcting mechanism, where falling prices reduce supply, and reduced supply buoys prices.
If you follow a plan of allocation adjustment in your portfolio, you will have already begun adding at these lower prices to restore your target percentage of gold and other metals. Some unhedged miners could certainly be substituted in.
If you don’t like picking individual horses in the race, you might consider some miner ETFs, such as Market Vectors ETF Trust Market Vectors Gold Miners (NYSE: GDX) or Market Vectors Junior Gold Miners (NYSE: GDXJ). If the miners’ own expectations are correct, their stocks may finally outperform the commodities for the first time in a long while.
Joseph Cafariello
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