UTILISATION OF BORROWED GOLD BY THE MINING INDUSTRY DEVELOPMENT AND FUTURE PROSPECTS - WORLD GOLD COUNCIL
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WO R LD G O L D CO U NCI L UTILISATION OF BORROWED GOLD BY THE MINING INDUSTRY DEVELOPMENT AND FUTURE PROSPECTS Ian Cox, Ian Emsley Research Study No. 18
UTILISATION OF
BORROWED GOLD
BY THE MINING INDUSTRY
DEVELOPMENT AND
FUTURE PROSPECTS
Ian Cox, Ian Emsley
Research Study No. 18
April 1998
WO R LD G O L D CO U NCI L2
CONTENTS
The Authors..............................................................................................................4
Acknowledgements ................................................................................................5
Foreword ..................................................................................................................6
Introduction..............................................................................................................8
Summary ..................................................................................................................9
Part One
The Growth in Mine Utilisation of Borrowed Gold ........................................11
The Case for Hedging ..........................................................................................15
Hedging Instruments – Their Development and Usage ................................19
Australia ................................................................................................................21
North America ....................................................................................................22
South Africa ..........................................................................................................23
Gold’s Price Decline in 1996/97 – Its impact on Hedging Strategies ..........25
Part Two
The Supply of Leased Gold and Banking Risks in the
Gold Forward Market ......................................................................................29
The Market Supply of Gold to Lend: Private Investors and the
Central Banks ....................................................................................................29
Potential Supply and Likely Future Availability ....................................................29
The Return on Gold Lending and the Change in the
Perceived Risk/Reward Ratio............................................................................31
Legal Political and Institutional Constraints ..........................................................32
The Supply of Gold Hedging Services to the Producers:
The Bullion Banks ............................................................................................34
Counterparty Risks ..............................................................................................34
Interest Rate and Funding Mismatch Risks ..........................................................37
The Evolution of the Gold Risk Profile ..............................................................40
Increased Political Risk..........................................................................................40
The Credit Risk of New Hedgers ........................................................................40
The Rise of Project Finance..................................................................................41
The Future of Lease Rates....................................................................................42
Conclusions ..........................................................................................................43
Appendix
Hedging and the Forward Markets – Definition of Terms ..................................44
3THE AUTHORS
PART ONE
Ian Cox
Currently an independent consultant, Ian Cox worked for almost 20
years in the Precious Metals Department of Samuel Montagu, a
leading British merchant bank, and one of the founding members of
the London Gold and Silver Fixings. From 1986 onwards, he was
Head of the Trading Desk.
After gaining an M.A. degree at Cambridge University, where he
studied Natural Sciences, he worked for ICI in Australia and the UK
as a Research and Development Officer. During this period, he
undertook a number of raw material research studies for the
Purchasing Department, and later assumed responsibility for the
purchase of precious metals for the world-wide group, before
joining Samuel Montagu.
PART TWO
Ian Emsley
After higher education at the universities of Bristol and London, Ian
Emsley joined Anglo American Corporation of South Africa, where
he has worked as an economist and commodity analyst for 13 years.
Currently based in the London office of the Corporation, he spent
three years in Johannesburg between 1992-95.
4ACKNOWLEDGEMENTS
Much of the background material which forms the basis for this study
and accompanying statistical tabulations was obtained during the
course of discussions with a number of mining companies, dealers
and market analysts. The authors would like to thank them for their
assistance, and also staff of the World Gold Council whose comments
were most helpful in finalising the Study before publication.
The views contained in the report are those of the authors, and not
necessarily those of the World Gold Council.
5FOREWORD
Whatever happens to gold prices and the restructuring of the gold
industry, it is the authors’ view that gold lending and derivative
markets will continue to play an important role in gold markets.
Hedging strategies based on derivatives and lending meet basic risk
management needs that go beyond finance of new mine expansion.
During the 1980s advances in sophisticated financing techniques,
driven both by new analytic techniques and the availability of ever-
increasing amounts of computational power, spread to the gold
markets. Bullion banks saw the opportunity to augment their inter-
mediary role and the concomitant profits by applying both project
financing skills and derivative-based techniques to the needs of the
mining community. Gold producers had experienced a step change in
demand for finance generated by a dramatic increase in gold prices
during the 1970s. As a result, exploration grew strongly and the new
mines needed appropriate capital.
The new project financing strategies and derivative-centred
hedging required a source of borrowed gold and the traditional
sources of private gold deposits were declining. Bullion banks went to
the central banks and convinced them to move into the gold lending
market by offering steadily increasing interest rates for the use of a
previously dormant asset.
As a result, the gold banks were able to offer producers medium-
term gold loans which better matched assets and liabilities as well as
forward- and option-based structures to hedge existing (and new)
developments. These hedges retained exposure to gold price move-
ments, but provided shareholders with assurance that net worth
would be safeguarded in the case of violent price movements.
According to the authors, the gold banks did not gain their new-
found profitability without accepting some incremental risk. Central
banks continue to be loath to lend gold on a medium-term basis. The
bullion banks must accept the rollover risk in borrowing short-term
and lending long-term, as well as some gold interest rate mismatch risk.
Derivative-based hedging techniques required both the acquisi-
tion of sophisticated new knowledge (Black-Scholes option pricing,
delta hedging and others) and the willingness to act on that knowl-
edge by implementing complex skeins of obligations in spot, forward,
futures and options markets.
Confidence of all parties has increased substantially, as indicated by
a tripling of gold borrowing over the last 10 years to an estimated
4,000 tonnes per year currently. The market shows encouraging signs
of moving into longer-dated maturities. Central banks and commer-
cial banks continue to respond to increased demand with measured
supply. Both Germany and Switzerland, who have large gold reserves,
6recently entered the gold-lending market. Unless there is a large
default, the market should continue to push into new territory for
producer-related products.
In this valuable contribution that should help further public
knowledge of interesting developments in these important markets,
the authors take the view that the increase in central bank lending
and associated producer hedging has probably contributed to the
price trend. However, these practices have allowed central banks to
earn a return on their gold assets and for producers to facilitate mine
finance.
Robert Pringle
Centre for PublicPolicy Studies
7INTRODUCTION
Previous studies covering the growth and development of the gold
lending market have highlighted the prominent role played by the
mining industry through its use of borrowed gold to support hedge
programmes.
The first part of this study examines the processes which led to
the development of progressively more sophisticated hedging tech-
niques, and analyses the various factors which have produced a
considerable diversity in the use of hedge strategies. It also explores
the arguments for and against hedging, and finally assesses the impact
on the gold mining industry, following the substantial fall in prices
over the past eighteen months.
The second part focuses on the risk profile of the market, exam-
ined from the perspective of each of the three main participating
groups. It highlights the various factors which might act as a potential
constraint on the market’s future growth, and discusses the manner
in which problem areas are being addressed so as to ensure that
further expansion of the market can continue.
8SUMMARY
During the past ten years the market for gold borrowing has more
than tripled in volume, and is currently estimated at around 4,000
tonnes. The driving force behind this rapid expansion has been the
demand resulting from the hedging activities of the mining industry,
which increasingly has become the predominant user of borrowed
gold.
Development of the market has been facilitated by the interaction
of three major participating groups – the mining companies which
have successfully accessed and exploited new sources of gold supply
– the bullion banks, acting not only as intermediaries but also as inno-
vators of new and complex techniques in order to meet the needs of
the producers – and the central banks, which through loans and
swaps have provided a substantial proportion of the liquidity which
is essential for the funding of hedge transactions.
The resulting growth in mine hedging has increased its utilisation
of gold lending from around 400 tonnes, or less than 50% of the total
market a decade ago, to a current level estimated at between 2,550
and 2,650 tonnes, approximately 65% of all gold borrowing.
The rapid expansion over the last decade of the market for
borrowed gold has been made possible by central bank readiness to
lend gold from their reserves. Central banks have become more pro-
active in the management of their reserves in recent years and have
sought a higher return on their assets. The increase of average lease
rates to the 1-2% range has been sufficient to elicit increased levels
of central bank supply. Bullion banks have used borrowed gold to
expand the market for hedging services to gold producers and others.
Although gold hedge products carry lower risks for the bullion
banks than those which exist in the market for base metals hedging,
nonetheless, risks still exist, in particular counterparty risk and interest
rate/term mismatch risk.
Bullion banks are confident that the risks involved in gold hedge
products are relatively low. They have already managed these risks to
an extent by placing greater weight on options and floating gold rate
contracts. If the hedge market continues its rapid expansion, the risk
profile of the market may increase. Factors to be considered include:
the risk to producers of mining increasingly in politically unstable
parts of the world; the credit rating of companies seeking to increase
their hedging, in particular that of new mines carrying heavy debt
obligations; and the future level and volatility of gold lease rates.
9ESTIMATED BREAKDOWN OF DEMAND FOR GOLD BORROWING
End 1987: Total 800 - 900 Tonnes
Mine Hedging
45-50% Physical Market
Inventory Funding
40-45%
Speculative/Investment
Hedging
10-15%
End 1992: Total 2000 - 2100 Tonnes
Physical Market
Inventory Funding
Mine Hedging 25-30%
55-50%
Speculative/Investment
Hedging
10-15%
End 1997: Total 3900 - 4000 Tonnes
Physical Market
Inventory Funding
15%
Speculative/Investment
Mine Hedging Hedging
65% 15-20%
Source: Ian Cox
10PART ONE: THE GROWTH IN MINE UTILISATION OF
PART ONE: BORROWED GOLD
The mining industry over the past 10-15 years has emerged indis-
putably as the major utiliser of borrowed gold. Whereas in the early
1980s, producer hedging probably absorbed no more than 200-300
tonnes, by the end of the decade activity had accelerated so rapidly
that this sector’s requirement for borrowed gold exceeded the 1,000
tonne level. During the 1990s the pattern of growth has continued, but
somewhat more erratically than in the previous ten years. Never-
theless, boosted by some exceptionally large transactions in 1995, and
a record level of activity during the past year, the overall total of gold
borrowing to fund hedge transactions had risen to an estimated
2,550 - 2,650 tonnes by the end of 1997.
What were the underlying factors which enabled the market to
sustain this rate of expansion over a fifteen year period? This question
is best answered by examining the situation which existed in the early
1980s, and recognising that conditions were especially opportune for
the rapid development of hedging.
First, the gold mining industry had recently received an enormous
boost from the surge in gold prices during the previous decade, as a
result of which both production and exploration for new sources
were set on an expansionary course. Second, advances in the tech-
nology of extraction, especially the introduction of heap leaching,
had opened up the prospect of many new commercially viable
projects. Third, within the industry itself, previous perceptions of
risk were being re-evaluated. As a direct consequence, mining compa-
nies already aware of the uncertainties associated with exploration,
discovery and exploitation of new deposits, began to look favourably
at strategies which would protect the market value of assets in the
ground against future price fluctuations.
The producers were ably assisted in pursuing their newly found
strategies by the bullion dealing banks, operating with the enlisted
support of the central banks. Initially the dealers had been able to
draw on their own captive sources of liquidity, consisting essentially
of unallocated gold accounts held by private investors. These had
been steadily built up during the years in which gold had proved a
highly successful investment vehicle. It had quickly become apparent
however that this base of liquidity would soon be insufficient to satisfy
the longer term needs of a burgeoning demand from producers for
gold borrowing, especially as the amount of gold held in unallocated
accounts was itself beginning to decline. Investors were switching
out of gold into other higher yielding instruments. More gold was
being redistributed into the physical markets in order to satisfy
emerging consumer demand in the Middle East and Far East, thereby
1112
RESERVE
CHANGES IN INTERNATIONAL GOLD STOCKS AT THE NEW YORK FEDERAL RESERVE
600
400
200
0
Tonnes (end year)
-200
-400
-600
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 *1996 *1997
Source: New York Federal Reserve *Estimatebecoming no longer available to fund gold borrowing transactions.
The solution was to bring into play the enormous reserves held
by central banks and other monetary authorities, thus transforming
the potential scale on which future hedging business could be funded.
On a practical level, this process of mobilisation frequently necessitated
the transportation of gold physically from its former location, (e.g.
The Federal Reserve Bank in New York) to London, the pivotal market
for gold borrowing transactions, with upgrading where necessary to
meet current trading standards. Much of this work was undertaken by
the bullion banks themselves, as a means of building relationships
with the providers of liquidity. The innate caution of official institu-
tions towards this new sphere of activity was gradually overcome by
the attractive prospect of being able to demonstrate for the first time
a practical utilisation of a proportion of their reserves, which could
yield interest, and hence generate a regular annual income.
The bullion dealers’ second, and equally important contribution
to the expansion of mine hedging, was to adapt techniques and strate-
gies already used in other financial markets to meet the specific needs
of the gold mining industry. In particular, imaginative use was made
1
of the forward contango , a characteristic of the gold market which
over the years has offered enormous benefits to prospective hedgers,
and provided opportunities for the pricing of future production which
do not exist in most other metal markets. Such innovation has been
the main driving force behind the continued expansion of gold
borrowing into the 1990s, and a more detailed description of these
strategies and their application is given in a subsequent section of
this study. In broad terms however, the major developments have
been a significant extension of the range of hedge products, coupled
with a growing tendency to ‘tailor ’ solutions to meet the specific
needs of individual companies. Additionally there has been a consid-
erable lengthening of the time horizon for hedge transactions, in
some instances to as much as 12 years. As a result, mining compa-
nies now have the possibility to hedge much larger quantities of
future production should they so desire.
1
The contango or forward premium exists because of the size of the pool of liquidity,
relative to annual market supply, which is potentially available from long term
holders. It is this reserve which provides the capacity to fund forward hedging, and
which sets gold apart from other metal markets.
1314
THE CASE FOR HEDGING
Given that the hedging of commodities can be traced back far more
than a century, and that the bullion dealing banks have been offering
an ever increasing range of hedging facilities to gold mining compa-
nies during the past 25 years, it is perhaps surprising that the principle
of hedging is still the subject of much forceful debate, and that having
assessed all the arguments, mining companies can still differ dramat-
ically from each other in pursuing their declared policies.
At least it is possible now to regard some of the issues previously
the subject of hot debate as somewhat academic. For example it was
frequently argued that if mining companies did not hedge the price
would be higher, because there would be no impact on the market
from ‘accelerated supplies’ – i.e. gold sold but not yet produced.
Equally it has been suggested that if only the central banks would
desist from lending their gold to the market, the essential liquidity
which is needed to finance hedging would be denied to the
producers, and hence the temptation to sell forward, with its price-
damaging consequences, could not be realised in practice on any
significant scale.
Such viewpoints, whilst they may have some validity, have
nonetheless been overtaken by events, as the market has continued to
evolve. Mining companies operate in a highly competitive environ-
ment, and need to employ all means at their disposal, including
hedging, where they believe it to be advantageous for their business,
in order to maintain profitability. In the case of central banks, many
have concluded that whilst gold remains a part of their reserve port-
folio it should be actively managed alongside other assets. Lending
gold is just one option available, but as more official institutions,
including some very large holders, enter the market as a result of
careful consideration, it is apparent that such steps once taken are
unlikely to be easily reversed.
For some time certain commentators and analysts tried to deny
that forward sales had any effect on the spot price of gold, arguing
that any gold hedged in this way would eventually be delivered at
contract maturity, therefore no net impact on overall supply resulted.
Others have suggested that forward gold purchases from producers
by the bullion banks could somehow be fitted into a complex ladder
of existing transactions, utilising gold already available from within the
system, in such a manner as to nullify or at least to dampen any influ-
ence on the spot market. Adherents to such views however would
appear to be diminishing in number in recent years, possibly as a
result of acquiring a clearer understanding of the way in which bullion
banks offset potential price risk on forward transactions through their
use of the inter-bank market for spot gold. In addition, having exam-
15ined gold’s disappointing performance over the past ten years, it
would be difficult to conclude that the continued expansion of
producer hedging had not in some way been a contributing factor
to the overall trend in prices.
Given that a number of positive arguments can be put forward in
favour of hedging, it is nevertheless apparent that individual mining
companies need to be selective in adapting the basic principles to fit
the needs of their particular operations.
Certain advantages are readily discernible. For example budgetary
control is greatly enhanced by the pricing of a proportion of forward
production, since it increases the certainty of future revenue. Explo-
ration of new sources, the financing of projects, especially in the early
stages, and further expansion of existing operations all require
working capital, and through the appropriate use of hedge strate-
gies mining companies have the opportunity to generate ‘acceler-
ated income’, thereby facilitating the management of cash flows.
Finally in the event of a prolonged period of adverse market condi-
tions, revenue from previously established hedge transactions can
assist in meeting the cost of either closing an uneconomic operation,
or placing it on a care and maintenance basis.
The most commonly voiced concerns regarding hedging are the
potential impact of additional selling on the gold price, and the possi-
bility that shareholders, especially those investing in marginal mines,
will view adversely actions which might reduce the company’s capital
appreciation potential, expressed through its share value. Such consid-
erations probably account for much of the diversity among producers
in attitudes to hedging, ranging from the active, where as much as
10 times annual production may be hedged at any one time, to the
passive, where a stated policy of non-hedging exists.
On the first point, the significance of ‘accelerated selling’ cannot
be entirely discounted, but nevertheless it needs to be placed in the
context of a dynamic market in which a number of participants
including investors, speculators and central banks may equally act
as sellers at a given time or price. Mining companies operating in
such an environment have adopted a pragmatic approach, recog-
nising that their individual actions are insufficient to exert other than
a marginal influence on the market, given its current size. They have
consequently devoted primary consideration to the profitable manage-
ment of their operations, through appropriate use of the forward
markets.
With regard to the second concern, there are justifiable grounds
for individual companies to assess their particular place within the
cost spectrum, and to consider possible shareholder motivations.
However in practice, no unarguable case has been made which
suggests that producers with hedging programmes in place actually
suffer adverse shareholder sentiment as a result. In fact some mining
16companies have made direct reference to the extent of their hedge
programmes as a positive factor for shareholder consideration. More-
over the advent of more sophisticated option strategies has made it
much more possible for companies if they so desire to protect the
downside risk associated with assets in the ground which have yet to
be produced, whilst still retaining the potential to capitalise to a
considerable extent on any future market appreciation.
To summarise it is apparent that in today’s market there is a
growing consensus in favour of some form of hedging, and that many
of the differences within the industry revolve around such issues as
the degree of hedging which is appropriate and the type of strate-
gies to be deployed. Nevertheless it should be emphasised that the
decision making process for producers of gold has been greatly simpli-
fied by the continued presence of a contango market in each of the
currencies of the major producing countries. It is this factor above all
others that has ultimately proved decisive in persuading much of the
industry that hedging is beneficial for their business.
1718
MINE HEDGING: ESTIMATED GOLD BORROWING REQUIREMENTS
3000 450
430
2500
410
390
2000
370
1500 350
Goldprice, US $/oz
Gold borrowing, tonnes
330
1000
310
290
500
270
0 250
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Source: Ian Cox Options Forwards/spot deferred Loans Annual Average Gold PriceHEDGING INSTRUMENTS – THEIR DEVELOPMENT AND USAGE
In the early 1980s when the gold mining industry first began to
develop an increasing appetite for hedging, the menu of available
products was distinctly limited. Loans made available by the bullion
dealing banks were for a relatively limited duration – 2-3 years was
generally the maximum term which could be negotiated – and
forward sales also were transactable only for similar periods. At that
time the gold options business was relatively undeveloped, and
confined to a small group of operators. The premiums payable
reflected both high underlying volatility and low market liquidity,
rendering such instruments more suitable for speculators than
producers seeking price protection for future output.
Whilst equity markets proved the preferred route for financing
much of the gold mining industry’s expansion through the 1980s,
gold loans also were extensively utilised as a means of funding explo-
ration and new project development. A relatively low interest cost,
paid in gold from future output, was viewed as advantageous when
compared with borrowing money, particularly in view of the high
interest rate environment which prevailed at that time.
Towards the end of the 1980s hedging activity began to accelerate
rapidly. Australian producers were very much in the forefront of this
development, although North American business also expanded in
conjunction with a sharp rise in output. The introduction into finance
departments of managers with a broad range of previous experience
in handling risk exposure helped to promote a greater awareness of
the opportunities presented by a combination of a spot market which
in late 1987 had briefly touched $500/oz, high domestic interest rates
in the major gold producing countries, and a newly developed depth
in the options market as more bullion banks began to offer a dealing
service.
A greater emphasis on derivatives business brought direct bene-
fits to mining companies seeking to increase their hedging
programmes, and many of the strategies were developed in co-oper-
ation with the bullion banks with the objective of meeting specific
needs. A common feature among many of the products was an inbuilt
flexibility which enabled the producers to manage their hedge
throughout its contract life, and to respond to signals marking a
change in interest rates, gold borrowing rates and currency parities.
Analysis of the hedging patterns which occurred during the 1990s
indicates that whilst volumes hedged maintained a broadly expan-
sionary trend, producers regularly shifted from one product to
another at different times, in seeking to maximise their returns, and
also to secure adequate protection against adverse price movements.
In the section which follows, a more detailed examination is made
1920
GEOGRAPHIC VARIATIONS IN ESTIMATED MINE HEDGING ACTIVITY
50
45
40
35
30
25
20
% of Total Producer Hedging
15
10
5
0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Source: Ian Cox
Australia North America South Africa Otherof some of the more popular hedge strategies followed by gold mining
companies within the major producing regions, and the differences in
approach prompted by considerations of movements in local interest
rates and currencies.
1. Australia During the initial period of worldwide resurgence in gold mining in
the early to mid 1980s, Australia followed a pattern of hedging
which was similar to that of other regions, deploying a mixture of
gold loans to finance new projects, and forward sales to lock in
future price returns. However the producers soon began to seek
more sophisticated products. A major benefit to be exploited arose
directly from the prevailing high level of domestic interest rates,
which at one point touched 18%, and which exceeded 14% for
lengthy periods. Despite the existence of double-digit domestic
inflation at that time, the industry took the view that after allowing
for the cost of borrowing gold, a net contango of around A$60/oz per
annum presented a hedging opportunity not to be missed. Since the
beneficial effects of high forward premiums became even more
apparent in the longer maturities, a concerted drive was made to
extend the boundaries for forward hedging beyond the normal 3-4
year maximum into the 5-7 year range. In fact this process has
proved to be ongoing, and despite a less favourable price
environment and much reduced contangos during most of the
1990s, some companies currently have established positions with
maturities as far out as 10-12 years.
During the period immediately preceding January 1991, Australian
producers were actively engaged in optimising returns ahead of the
imposition of a profits tax. Whilst undoubtedly this provided addi-
tional motivation at the time, nevertheless the clear benefits arising
from the extensive hedging undertaken in the run up to 1991 have
tended to reinforce the arguments for maintaining a sizeable hedge
programme relative to annual output, and the region has continued
to offer a lead in terms of volumes hedged as a ratio of annual produc-
tion, and also in the length of contract maturities.
Active utilisation of options has been another notable facet of
Australian hedge business. The existence of a sizeable contango in
Australian dollars price terms provided the opportunity to sell call
options at strike prices above the money and to utilise the premiums
to buy protective put options on a favourable ratio at zero cost. In
this way producers were guaranteed an eventual selling price within
a prescribed band, irrespective of the actual level of spot prices at
maturity.
A further imaginative use of the high contango led to the devel-
opment of the flat-rate forward contract and other variations based on
the same principle. In this instance the producer contracted for a
series of equal deliveries over a given period. Whereas under normal
21circumstances, each sale would progressively have yielded a higher
price for the longer maturity, the producer in practice received an
enhanced premium at the earlier stages, foregoing a portion of the
contango which would normally have been due for the later deliv-
eries. Such arrangements had the benefit of yielding enhanced cash
flow during the early life of the mine.
Options have continued to provide the most flexible medium for
the more active approach to price risk management, and the
Australian producers perhaps more than other mining groups have
proved especially receptive to the introduction of so called “exotic”
options, which became fashionable in the early 1990s. Many of these
products were cost effective through the employment of variations on
the barrier principle, whereby certain pre-set conditions were trig-
gered only if the underlying spot price of gold reached a certain level.
Other products which have also found extended use as hedging
tools include spot deferred contracts, where the seller retained flexi-
bility with regard to the actual delivery of physical metal, and floating
rate contracts, where the spot basis for the sale is fixed, but either the
gold borrowing rate or the currency interest rate is priced on an
agreed formula at fixed intervals during the life of the contract. These
arrangements have appealed especially to Australian producers
because of the scope which they offer for continuous hands-on risk
management, with the facility to anticipate movements in currencies
and interest rates.
2. North Whilst there have been periods of opportunity for North American
America producers, notably towards the end of the 1980s, when US$ interest
rates briefly touched 10%, in general terms the background scenario
has been less favourable for hedging than that available to their
major competitors.
The incentive offered to Australian producers in the years imme-
diately preceding 1991 produced an added surge in activity which
fortuitously coincided with a peak in spot prices and contangos. US$
interest rates have subsequently remained consistently below those
prevailing in either Australia or South Africa, and the returns achieved
by US producers, being measured in US$, have been denied the bene-
fits arising from currency depreciation. In other major producing
regions this factor has helped to sustain acceptable price levels for
forward hedging despite the general downtrend in gold prices during
the 1990s. Taking such factors into account, it is not altogether
surprising to find that compared with Australia the North American
producers are less extensively hedged, measured in terms of volume
relative to annual output, and also in the length of forward maturities.
Many of the hedging strategies operated by North American
producers have been dictated by the constraints of operating in a
forward market where US$ premiums have been relatively unat-
22tractive for prolonged periods. The effect has been to produce a much
greater bias towards the use of spot deferred contracts, and also a
more extensive deployment of option strategies. Whereas in some
instances calls have been sold to finance the purchase of puts, in other
cases, the call option premiums have been generated purely to provide
an added stream of income.
Active management of the hedge book risk has been a notable
feature of some of the largest producers in the region and strategies
have often been geared towards range trading – previously estab-
lished transactions regularly being closed out with the intention of
repositioning at a more favourable level. Finally there has also been a
tendency towards managing directly the cost of borrowing gold,
which proportionally has a greater impact on the net yield from
forward sales than in the regions which have the benefit of a higher
contango in their local currency.
3. South At first sight it would appear that many of the domestic financial
Africa circumstances which have combined to produce hedging
opportunities for Australian producers could equally well apply to
South Africa. However the world’s largest producer has tended over
the years to lag behind its competitors in hedging activity, especially
when the volume of business is compared with annual output.
Because of the restrictions imposed by the Reserve Bank on hedging,
the producers historically were limited in the scope available to them
for price protection. Eventually however these restrictions were
removed, enabling the industry to compete on more equal terms with
its rivals. The major mining companies were then able to view the
total spectrum of hedging opportunities in much the same terms as
their Australian counterparts.
A more conservative approach to hedging was not entirely the
consequence of domestic controls. During the 1980s Rand depreciation
against the major currencies acted as a corrective mechanism, making
the case for forward sales far less clear cut than in other gold
producing regions. Operating costs were heavily geared to the local
currency, particularly in respect of labour costs, a major component in
deep mining activities.
From around 1990 onwards however it became apparent that the
major mining companies were beginning to take a more aggressive
stance on hedging and the next few years involved something of a
catch-up process. One important difference at that time however was
that despite the existence of high contangos in Rand terms, the
volume of hedging was conducted for relatively short maturities,
chiefly in the two year time span.
In 1995 however two transactions took place which firmly estab-
lished South Africa in the major league of gold hedging, and
temporarily placed pressures on the borrowing markets which led
23to a sharp rise in rates, until corrective forces began to take effect.
The hedge programmes, although differing in certain elements, were
initiated for essentially the same purpose, primarily to secure a major
part of the funding associated with long-term expansion of production
at specific areas. The size of the transactions and their duration were
also features which set them apart from any previously negotiated
– Gengold’s Beatrix development involved 90 tonnes of gold, whilst
JCI’s expansion at the South Deep section of Western Areas required
a hedge covering no less than 227 tonnes, and operating over an
1
8 /2 year period.
The deal structures incorporated several techniques which had all
been utilised previously, but they provide an illustration of the
progress which has been made in tailoring a hedging product to suit
the requirements of a particular situation. First, the entire planned
production of the JCI project was sold forward in regularly spaced
increments. However the prices negotiated involved an element of
enhanced cash flow in the early stages, offset by a correspondingly
reduced return towards the end of the contract. Second, call options
were purchased for 55% of the volumes sold, in order to preserve
some degree of upside potential for returns in the event of a rise in
gold prices. Third, Rand call options were purchased for 45% of the
maturing gold forward sales value, in order to protect against the
possibility of a sharp depreciation of the Rand which would impact
directly on operating costs.
Transactions such as described above are likely to occur only rarely,
but they nevertheless highlight some of the background factors which
can result in a use of hedging techniques which goes far beyond the
simple objective of fixing the price of future production.
24GOLD’S PRICE DECLINE IN 1996/97 – ITS IMPACT ON
HEDGING STRATEGIES
In December 1997 the spot price of gold touched $283/oz, the lowest
for eighteen years, and the culmination of a downtrend which began
almost two years previously, producing an overall decline of almost
32% measured in US dollar terms. Whilst many market commentators
might have cautioned against over optimism in February 1996, when
the price had almost reached $415/oz, speculative buying was nearing
a peak, and prices had become detached from levels which had been
regularly supported by physical demand, nevertheless few observers
would have been bold enough to anticipate an impending collapse
even to below $350/oz.
The various factors which led to gold’s step by step retracement
have been well documented. During that time producers were forced
to react constantly to adverse circumstances, and to reformulate their
existing hedge policies. Risk management skills of the financial officers
of gold mining companies were tested to a far greater extent than in
any of the three years preceding.
During 1994 and 1995, whilst the market had encountered resis-
tance when approaching the $400/oz level, nevertheless the constant
reappearance of support from the physical markets had assisted in
producing a relatively narrow and stable trading range. Many
producers had enhanced the returns on their hedging programmes
by successfully anticipating and utilising these parameters to their
advantage. The series of events therefore which commenced in late
1996 and unfolded at regular intervals throughout 1997 required a
drastic reappraisal of previously held conceptions. The gradual real-
isation that through a combination of market factors gold prices were
on an extended downward path led to an accelerating pace in
hedging activity as the year progressed. In total an estimated 500
tonnes of additional market supply resulted, of which a significant
proportion, about 200 tonnes, was attributable to the delta-hedge
component of options transactions, most of which were put related.
Despite gold’s steep decline during 1997, currency considerations
partly mitigated the fall in some major producing regions. For example
whereas the difference between the high and low over the year in
US dollars was approximately 23%, weakness in the Australian dollar,
exacerbated by the growing financial crisis in Asia, restricted the
downturn to less than 9% in Australian dollars. In the case of South
Africa there was a much smaller currency depreciation, and prices
measured in Rand fell by around 20% over the year.
Of course at price levels of around $300/oz the gold producing
industry is facing a range of problems which goes far beyond the
question of whether to continue with hedge programmes and if so
25in what form. Nevertheless some new patterns are beginning to
emerge, which provide an indication of likely responses. One crucial
difference between the situation currently and that of a year earlier is
that pricing decisions taken now could well have a bearing on the
continued survival of very many more operations, whereas a year
ago success of a hedge programme was in most instances an added
benefit to be assimilated into the overall level of profitability of the
company.
One particular consequence of the drastic fall in prices is that the
industry faces a period of considerable rationalisation. Also it is
inevitable that many of the projects due to come on stream over the
next few years will be at the very least postponed, pending a degree
of recovery in prices. Both of these developments will have implica-
tions for hedging activity – the first being of greater impact short-
term, the second having more medium-term implications.
For those gold producers which had built up an established book of
hedge transactions there has been an opportunity to close out prof-
itable forward positions, thus providing immediate benefit to the
cash position of the mining company. However, taking such action
inevitably creates a fresh exposure to future spot price fluctuations,
and whatever the inner convictions of individual producers regarding
the prospects for recovery in the market, few are in a position to take
an extensive gamble on the price, given the events of the past year.
Accordingly exposure in almost all cases has been restructured
with a greater emphasis on options which serve as protection against
a worst-case scenario, but which tend not to lock in the producer too
tightly at current levels. Such strategies provide a degree of assur-
ance to shareholders, and at the same time will tend to relieve some
pressures on the spot market, because the net effect of these trans-
actions is a lower overall delta associated with the underlying hedge,
and hence a reduced funding requirement in terms of borrowed gold.
This factor coupled with the likelihood of delays and reductions in
the volume of new gold projects, which under normal circumstances
would have initiated additional hedge programmes, suggests that in
the short term at least the sum total of gold borrowing needed to
finance producer hedging could be somewhat reduced, and taking
1998 as a whole, the 500 tonnes of accelerated supply initiated by last
year’s producer hedging is unlikely to be repeated on the same scale.
Longer term however the situation could well be rather different.
Notwithstanding the earlier comments regarding new projects, the
search for, and successful implementation of low-cost gold projects
continues. This will eventually bring new volumes of hedging to the
market, especially as providers of project finance will be closely
concerned with ensuring the success of the operation in the early
years. In parallel with this development, gold producing companies
are also making strenuous efforts to reduce operating cost levels, and
26success in this direction over a period of time will not only create a
lower cost base across the industry, but would then make possible
opportunities for profitable hedging at lower market prices than
might be considered acceptable at present. Given the considerable
uncertainties which currently exist as to the future intentions of some
of the larger holders of gold in the official sector, and bearing in mind
recent experience of the extent to which gold prices can react to
events, it may well be that should more favourable conditions re-
emerge at a future date, some mining companies will seek to protect
a greater proportion of their future production than has been the
case to date. At the present time, despite the considerable differences
that exist within the industry, the volume hedged in relation to annual
output represents little more than one year’s production, averaged
across the market worldwide.
If the mining companies’ hedging activities and the demand for
borrowed gold continue to expand along the lines suggested above,
it becomes relevant to examine the question of whether such devel-
opments have any implications for the future risk profile of the
market. This issue is discussed in greater detail in the second part of
the study.
2728
PART TWO: THE SUPPLY OF LEASED GOLD AND BANKING RISKS
IN THE GOLD FORWARD MARKET
THE MARKET SUPPLY OF GOLD TO LEND: PRIVATE INVESTORS
AND THE CENTRAL BANKS
Over the past ten years use of the gold forward market by producers
has expanded at a rapid pace. Demand for gold loans was also strong
in the early phase of expansion of mine output during the 1980s, but
has subsequently declined, as repayments outweighed new business.
More recently, options have been utilised on a wider scale than previ-
ously and the delta component of all producer-based transactions
currently absorbs approximately a fifth of the total quantity of gold
borrowed to finance mine hedge business.
As has already been described in part 1 of this study, the expan-
sion of the market for gold loans, forwards, and options has been
greatly facilitated by the existence of a liquid gold lease market. Coun-
terparties have been able to finance their activities through the avail-
ability of low cost borrowing, which in turn has been responsible for
the maintenance of a contango on forward prices. A progressively
increasing contango makes the forward market very attractive to
mining companies seeking to hedge future production. This
structural feature of the gold forward market has proved possible
only because of the gradual entry into the market of central banks,
supplementing the previously existing supply of liquidity available
from private holdings. In today ’s market, the bullion banks have
come to depend almost entirely on the official sector to fund total
borrowing demand (of which producer hedging is by far the largest
component) and to meet any future growth in requirements. The
attitude of central banks towards the risks entailed by their gold loan
and swap activities is therefore of crucial importance to the future
development of the market.
Potential Despite continuing net official sales of gold in the last ten years,
Supply and central banks, excluding the IMF and EMI, still hold around 28,000
Likely Future tonnes. The distribution between countries largely reflects the
Availability position which obtained when gold’s official monetary role ended.
Consequently there exists a considerable diversity in the level of
gold holdings expressed as a percentage of total reserves. Given that
the present level of central bank lending is thought to be
somewhere in the region of 3,600 – 3,700 tonnes, (approximately
90% of the total liquidity available to the gold borrowing market),
the requirement for funding is unlikely to reach 20% of aggregate
2930
REPORTED CENTRAL BANK AND INTERNATIONAL AGENCY GOLD RESERVES
END 1997, TONNES
Over 500 200-499 100-199 50-99 10-49
United States 8140 Spain 486 BIS 194 Brazil 97 Slovak Republic 40
IMF 3217 Belgium 477 Algeria 174 Canada 96 Norway 37
Germany 2960 Russia 463 Iran 151 Indonesia 96 Peru 35
EMI 2782 Taiwan 422 Sweden 147 Romania 93 Afghanistan 30
Switzerland 2590 India 397 Saudi Arabia 143 Australia 80 Bolivia 29
France 2546 China, Peop. Rep. 397 Philippines 135 Kuwait 79 Poland 28
Italy 2074 Venezuela 356 South Africa 123 Thailand 77 Syria 26
Netherlands 842 Lebanon 287 Turkey 117 Egypt 76 Jordan 25
Japan 754 Austria 250 Libya 112 Malaysia 73 UAE 25
United Kingdom 573 Greece 107 Pakistan 64 Morocco 22
Portugal 500 Chile 58 Nigeria 21
Kazakstan 56 Neth. Antilles 17
Uruguay 54 Zimbabwe 16
Czech Republic 52 El Salvador 15
Denmark 52 Cyprus 14
Finland 50 Ecuador 13
Argentina 11
Colombia 11
Ireland 11
Korea 10
Luxembourg 10
Source: IMF, International Financial Statisticsreserves for some considerable time, even allowing for continued
rapid market growth. Clearly therefore no immediate constraint on
potential supply exists. However, in assessing the question of
availability, it becomes necessary to examine the motivations which
have drawn central banks into the lending market, and to assess the
likelihood that either those which are already active will commit
more of their reserves in the future, or alternatively that others
currently on the sidelines will follow their example.
The Return Fundamentally, the central banks have been attracted into gold
on Gold lending for one reason – the prospect of earning a return on assets
Lending and which would not otherwise generate any income. From a study of
the Change the fluctuating pattern of gold lending rates over the past ten years
in the it is apparent that at least a portion of central bank lending has been
Perceived available to the market even at quite low rates of around 0.5% per
Risk/Reward annum. More recently, however, the growing requirement for
Ratio liquidity to fund a steadily increasing volume of producer hedge
transactions has necessitated a gradual increase in the returns
available for gold lending, in order to attract the required volume of
supply. Since mid-1995 rates have tended to fluctuate around a
mean of 1.5%. This has produced the desired response from the
official sector, especially as the yield on competing financial
instruments has been falling in response to a general decline in
inflation within OECD countries. Thus the bullion banks have been
instrumental not only in encouraging a greater level of participation
from the existing pool of official lenders, in response to improving
rates of return, but have also offered a more challenging prospect to
those central banks which continue to operate a policy of inactive
ownership. The trend gradually emerging throughout 1997 strongly
reinforces the view that the number of lenders from the official
sector (currently estimated to be in excess of 60) is still expanding
and can continue to do so in the future.
Central banks are commonly regarded as risk-averse institutions,
and the process of overcoming the innate caution which governs
many of their actions has been a lengthy one, starting in the early
1980s. Some institutions still follow the preferred route of channelling
their gold lending through another official intermediary such as the
Bank of England as a means of ensuring greater security. The majority,
however, have developed direct relationships with the bullion banks
which in turn redistribute the liquidity supplied into the various
sectors which require funding. These banks are not only well capi-
talised, with high credit ratings, but are also supported by a depth
of experience in gold market dealings, and a diverse portfolio of finan-
cial activities. They are unlikely therefore to be unable to meet their
obligations to repay gold borrowed as a result of unforeseen shocks
from within either the gold market itself or the wider financial system.
31There has been one significant default with direct consequences for
certain central bank gold lenders, that of Drexel Burnham Lambert
in 1990, but this event, although entailing some initial losses of gold,
resulted in only a short-term contraction in official lendings. Lending
subsequently resumed in force, following the absorption of appro-
priate lessons, namely a closer attention to the credit rating of the
potential bullion bank counterparties and the greater exposure
incurred with loans as opposed to swaps.
Whilst the sudden collapse of Barings in 1995 may also have
provided central banks with an unpleasant reminder that commercial
banks are potentially vulnerable to the consequences of risks under-
taken on their behalf, authorised or otherwise, the scale of operations
in gold lending by the official sector, although not insignificant at
2
approximately US$ 35 billion , represents a small proportion of the
total spectrum of financial transactions in which central banks
regularly engage. Central banks are increasingly becoming more pro-
active in their approach to reserve asset management and have
educated themselves more thoroughly regarding the pitfalls and
opportunities in the market. As a consequence, many have decided
that lending a part of their gold holdings can be justified on a
risk/reward basis.
Legal The potential conflict between the central banks’ newly found
Political and appetite for increasing the returns on assets and at the same time
Institutional fulfilling their primary role of providing monetary stability and
Constraints financial order, finds expression in a number of possible
impediments to gold lending: legal, political and internal
considerations may each limit a central bank’s freedom.
Some official institutions are still prevented by law or by their arti-
cles of association from lending gold reserves, as is the case, for
example, in respect of the USA, holding 8,140 tonnes and the IMF, a
non-central bank official institution, but with assets of 3,217 tonnes.
Legal requirements, nevertheless, are not immutable and whilst
changes are not always easy to bring about, as instanced by the
continued opposition encountered by the IMF in seeking support for
proposals to sell a relatively small proportion of its gold to help in
financing debt write-offs and by Germany in attempting to revalue its
gold reserves prior to entry into EMU, there are indications that
central banks are beginning to re-examine more critically previously
long-established practices and policies, and to institute processes of
change where appropriate. In this regard there could be no more
influential example than that of the Swiss National Bank, which
during the past year has set out far reaching proposals which, if
approved through a referendum, will lead to a programme of sales to
2
This guideline figure has been calculated using the following assumptions:
1) Central bank lending estimated mean 3,650 tonnes
2) Gold price reference point $300/oz – $9,645/tonne
32provide an endowment for its Solidarity Fund. In the meantime it
has taken the necessary steps enabling it to commence gold lending
operations in November 1997.
Such actions as described above have understandably created an
atmosphere of anticipation in the market, especially as some recent
initiatives are emanating from the larger holders of gold reserves,
opening up the possibility that other countries will similarly review
existing policy. Nevertheless, public sensitivity to the management
of national reserves is still a factor to be recognised and may prove to
carry a greater weighting in some countries than others, especially
where severe monetary dislocation has occurred within living
memory.
Other political considerations may limit a central bank’s freedom to
lend gold. Gold loans may entail holding the metal beyond a country’s
territorial jurisdiction and, where there is reason to fear the possi-
bility of sanctions by other governments, physically relocating the
gold to London may be perceived as posing an unacceptable risk. A
number of countries, therefore, some holding quite sizeable reserves,
still prefer to retain direct control of their gold and accordingly are
prepared to forego the potential earning capability of the asset.
Finally, internal considerations will play a major role in deter-
mining a central bank’s attitude to lending, and in particular the
chosen mode of participation, in order to limit risk whilst still retaining
acceptable returns. Ideally, official institutions would prefer to deal
with only the most creditworthy of the commercial banks, but as the
market continues to expand in volume, the question of raising dealing
limits with counterparties in order to accommodate new business
could potentially pose constraints. Certainly there would appear to be
an opportunity for banks with high credit ratings, but which have
not yet engaged in gold lending activities, to enter the field so as to
widen the scope for the placing of official business.
In other areas central banks have traditionally sought to limit risks
– for example gold swaps might be considered preferable to loans,
since in the event of a default the potential deficiency to the central
bank would be related to the value of its forward purchase obliga-
tions, measured against the market price, rather than the total under-
lying value of the gold, as in the case of a loan. Equally many central
banks have restricted their loan or swap horizons to within either a
three or six months period, despite the bullion banks’ obvious
appetites for longer lending in order to more closely match producer
hedge business maturities. Nonetheless, some central banks in seeking
the higher yield which is generally available for maturities beyond
one year, have reassured themselves that such a policy is justified
despite the additional risk incurred. The proportion of longer-term
lending secured from the official sector, although it still remains small
in relation to the overall total, is therefore continuing to increase.
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