Selling Low and Buying High: Hedging by the Gold Miners Part II
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).
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