Explainer: How does gold hedging impact shareholder returns?
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With the recent run up in the gold price, which is currently trading at over $2,500 Aussie, now is probably a really good time for producers not to be hedged.
Hedging involves a gold producer forward selling future gold production at a fixed price to lock in guaranteed revenue, rather than taking its chances with the spot price if it falls.
It is a common practice by gold producers as a way of protecting themselves against a slump in the price of the safe haven metal. But when there is a run in the gold price, like now, those that have hedged could miss out on significant additional cashflow.
According to a recent article by The Australian, if the gold price remains at record levels, several Aussie miners could sacrifice up to $2bn in extra cash because of ‘legacy’ hedges.
Roughly 3 million ounces of gold has been hedged at less than the current gold price by top miners including Newcrest Mining (ASX:NCM), Saracen Mineral Holdings (ASX:SAR), Regis Resources (ASX:RRL), Northern Star Resources (ASX:NST) and Evolution Mining (ASX:EVN).
But the level of hedging has dropped substantially over the years, according to data from Thomson Reuters and the World Gold Council.
In conversations with various gold players, investment bank Goldman Sachs discovered the reasons behind the decline including — that hedging might imply a bearish company view on gold, it can be too complicated to explain to investors, and it can be expensive.
These days hedging is more common when a new gold producer has a large amount of debt it needs to guarantee it can pay back.
“Essentially, [hedging] was set up as a risk management system to guarantee revenue for a company during tough times or when there’s a risk,” David McGowan, head of small cap gold producer Medusa Mining (ASX:MML), told Stockhead.
Medusa Mining, which has a sub-$100m market cap, is one of the few juniors that isn’t hedged.
“There’s a lot of things not going quite right or to plan at the moment in the world, so the gold price has gone up significantly,” McGowan said.
“It means our revenue goes up as well, essentially being unhedged.
“Given that we produce at [costs of] somewhere between $1025 and $1125, that’s a nice little margin on top that we didn’t plan for, but we’ll take.”
There are other unhedged juniors, but not many.
The +$250m market cap Tribune Resources (ASX:TBR) is not hedged, but it is currently embroiled in a legal dispute with JV partner Northern Star.
Alacer Gold (ASX:AQG), which has a market cap of around $335m, is also in the unhedged club, but it only has a secondary CDI (CHESS Depositary Interests) listing on the ASX. Its main listing is on the TSX. CDIs are a proxy for trading foreign shares on the ASX.
The problem gold producers face when deciding whether to hedge or not is the potential impact it will have on shareholder returns.
“That’s the trick; do I want to play roulette and gamble my shareholders’ money? If I go and hedge now and the gold price doesn’t go up — therefore I’m making money when it goes down — in that case I’d be patted on the back and told ‘you’ve done a great job’,” Medusa’s McGowan explained.
“If I go out and hedge now and the gold price goes up to $US1800, I’d be looking down the barrel and trying to explain why I should keep my job.
“At the end of the day, it’s not to say that we wouldn’t consider hedging, but we see the potential for upside and with that we accept the potential for downside.
“If [the price] goes down, as long as it’s above what it costs us to produce, we’re going to make money.”
In simple terms, for every dollar that the gold price goes up, a percentage of that covers royalties and income tax and the rest goes straight into the bank.
“70c of [every] dollar goes into our bank,” McGowan said. “That’s purely because we’re unhedged. So every time the gold price goes up, our bank balance should get healthier and healthier. That’s the upside.”
On the flipside, investors get nervous when the gold price goes for a run and fear all those gains will be quickly lost once the surge comes to an end.
“The difficulty is when the gold price goes for a run like it has now, we will have some investors telling us that we should hedge because it’s just going to fall,” McGowan said.
“There are a lot of gold producers that did that six months ago. There’s some Aussie gold producers that hedged 30 per cent of their production at $1800 Aussie dollars — they’re now missing out on $700 an ounce that’s not going to their bank account, it’s going to whoever they hedged with.”
As mentioned earlier, hedging is an added cost.
“It is a cost to go and do, so you have to be really confident that it’s the right step forward or you have to have a risk that if your revenue drops by a certain point the company starts to drown and we’re not in that position for a long way,” McGowan noted.
“Medusa has money in the bank, we have a good history of consistent production now and we haven’t had anything at risk.
“So if the gold price didn’t go up, we would still be making money. At the end of the day if you’re a gold miner you have to believe in your product, you have to believe that the world wants it, you have to believe that the world is going to pay a reasonable price for it.”