Bullion Horror! Gold Miner Hedging Returns

Wednesday, 9/02/2015 18:48

Gold bullion is being borrowed and sold into the market, says market chatter...

GOLD BULLION might only have recovered a little from this summer's new 5-year lows, but the cost of borrowing it through London's wholesale market is rising enough to make headlines, writes Adrian Ash at BullionVault.

The cause, according to the Financial Times, is "dealers needing gold to deliver to refineries in Switzerland before it is melted down and sent to places such as India," the world's No.2 gold-buying nation behind China.

But finally catching up with emails from last week's holiday today, I found rumours claiming that gold miners were driving this 'tightness' in bullion borrowing costs. Because they used August's jump in prices to start hedging their production.

Hedging is when a producer sells future output at today's prices. And here in September 2015 – some $800 per ounce below the peak of four years ago – "the selling continues unabated," says one London bullion desk.

Like claims that dealers are borrowing gold to ship to Asia, this note points to action in the Gold Forward curve. It shows the cost of borrowing metal today to return again at some point in the future. Only, this being the professional bullion market, it actually tracks the cost of lending out metal and getting it back some time in the future, putting the cash received meantime on deposit to earn a rate of interest.

Higher levels thus mean lower demand to borrow metal, through higher costs to gold owners wanting to earn interest on cash instead. Whereas right now, the far-forward curve "is getting crushed" says one note – signalling strong demand to borrow metal – and "mainly relates to miners forward hedging."

"This is what is currently holding prices back," another desk reckons. And Monday brought confirmation that at least one smaller gold miner has taken the chance to lock in current prices for some of its future output.

Mid-tier Australian miner Evolution (ASX:EVN) says that it's sold 300,000 ounces forward for delivery between June 2016 and end-2019.

Big news? Several smaller players have already been hedging since the 2013 crash. Overall, the industry was a net de-hedger in the first 3 months of this year. And at just 25 tonnes in total, Evolution's overall hedge book now equals less than 25% of its expected output over the next 5 years.

Maybe one or two other miners are doing the same. But if this is driving the uptick in gold borrowing costs, we are still a long way from the hedging mania which swept the gold-mining industry at the depths of the 1990s' bear market. A very long way away.

Back then, the global gold mining industry built up forward sales equal to well over 12 months of world production. The impact, when prices started to rise in 2001, was dramatic. Because having locked in the lowest prices since the late 1970s, the mining industry suddenly scrambled to buy back its hedges...helping drive the price higher again...forcing more miners to try and buy back their hedges as well.

Shareholders hated it, of course. First because those forward sales seemed to help worsen the bear market. Then because it meant that their equity investments –instead of rising on the back of rising prices after 2001 – were hamstrung by hedging deals struck at lower levels which cost money to close.

For managing cash-flow, a little hedging seems wise in any productive business. Evolution's new move is "eminently sensible" agrees a note from ICBC Standard Bank today. Especially because Evolution – which mines exclusively in Australia – currently enjoys gold prices near 3-year highs in Aussie Dollar terms.

EVN's stockholders seem to like it too, pushing the shares 5% higher on Wednesday and extending the rally from last week's nasty drop to more than 20%.

The big question for gold bullion investors and traders is whether – or when – the big boys start hedging as well.

Arch-hedger and world No.1 miner Barrick (NYSE:ABX) famously locked in prices at the late 1990s' lows, only to buy them back and help push up prices over the next 10 years. Its current chairman, John Thornton, said this May that hedging "just makes sense" to him.

Maybe. Should gold prices keep rising as the US Fed delays its rate hike – and China's slowdown whacks other financial assets – new hedging by miners outside the US could present a headwind to further gains.

But the long-term outlook for gold mining output says annual production is likely to peak this year, and then start slipping from these record-high levels. Some analysts put known reserves still below-ground at 20 years of production. And as Societe Generale's bullion desk notes, the American Chemical Society includes gold – like silver – on its Periodic Table of Endangered Elements facing serious supply problems in future.

Expecting a boom in recycling, 'Buy refiners, not miners' is SocGen's quick off-the-cuff conclusion.

Naturally, 'buy gold' would be ours here at BullionVault.