So where’s the top for gold? $1006, the recent high? $1150, a target among a group of middle-of-the-road analysts? $2000, the ravings of a minority but not necessarily wrong for all that?
At least in the short run, to know where gold is going watch the market for gold hedges that guarantee the right to sell future production at a fixed price. It’s vanishing as more and more gold producers decide to unwind their hedges–most of which give them a guarantee that they can sell golod at prices hundreds of dollars on ounce below today’s prices–against falling gold prices and go naked. When a producer does that, it pushes up the price of gold some more.
Gold producers started to unwind their hedges to sell future production big time last year. Anglo Gold (AU), for example, used money it raised in a stock offering to reduce its forward hedges from 11.3 million to 6 million ounces in 2008.
But the big force in the gold market this year has been the decision by Barrick Gold (ABX), the world’s largest gold producer, to completely eliminate its forward hedges. For 2009 the company had fixed price hedges on 3 million ounces of gold and floating hedges on another 6.5 million ounces. That’s equal to about 128% of Barrick’s projected 2009 production.
The average price at which Barrick agreed to sell its future production? $396 a ounce. With gold over $1000 you can see why Barrick has decided to end all its hedges.
What might not be so clear is why a company would pay good money–yes, a contract to sell future production at a fixed price costs money–to sell gold at more than $600 a ounce below the current market price.
The answer is predictability. By selling tomorrow’s production–still in the ground remember–at a fixed price in the future a gold producer can guarantee future cash flow. The company will have the money it needs to cover costs, to invest in expanding production, whatever. And at a time when it was very hard to raise capital in the financial markets guaranteeing that you wouldn’t wind up going bust because the price of gold suddenly collapsed seemed a good investment.
And you have to be really, really, really convinced that gold prices are going to stay way north of that guaranteed $396 an ounce to decide to end your hedges because buying them out is really, really, really expensive.
In announcing its plan to end its hedging program on September 8 Barrick Gold said it would raise $4 billion from a stock offering and another $1.6 billion in debt–and all of that would go to buying out the hedges. (Remember that on the other end of the deal there’s an investor who holds a guaranteed right to buy gold in the future at $396 an ounce. Pretty valuable.) The company will take a $5.6 billion charge to shareholder equity in the third quarter of 2009.
What does all this have to do with the price of gold? Ending Barrick’s fixed hedges, gold analysts calculate, is equal to cutting global annual gold production by about 4%. Ending the floating hedges is equal to removing another 7%. That’s an 11% cut in global gold supply.
See why that might raise the price of gold?
Of course, ending hedges only pushes up the price of gold until everybody has done it. Here the player to watch is AngloGold. The company reduced hedges by more than 5 million ounces in 2008 but it still had 4.5 million ounces of hedges at the end of July. So far the company has announced plans to cut hedges to 4.1 million ounces by the end of 2009.
As long as gold investors think AngloGold still stands to eliminate its hedges, they’ve got a reason to bid gold higher. Once the company announces a plan to eliminate its hedges, then gold will be left to rise and fall with supply and demand and fear and hope.
Just like usual.