THE CRITICS ARE SILENT: LAC’s innovative hedging is now industry

LAC Minerals was criticized at the turn of the 1980s for “speculating” on the gold price by hedging gold production. For the mining industry back then, this was a true innovation — and heresy. Hedging by contracting with a bank or gold dealer to deliver a certain amount of gold production at a fixed price and at a fixed date in the future simply was beyond the pale for most old-line companies. The rationale being that to hedge was to relinquish the potential upside if gold prices continued rising. For example, the hedged gold miner who has to deliver its gold at, say, $US400 an oz. when the metal has shot up to $500, has lost the opportunity for those greater earnings, in the neighborhood of $100 per oz. Thus it was viewed as a speculative act. However, blue bloods of the gold sector were to learn different. Hedging in a falling market is a conservative strategy.

Ironically, pioneering LAC lost money on those early series of hedges. But according to Allen, the gold spike to US$850 was not its chief undoing. No, the delayed Bousquet No. 1 opening was the true villain. “We couldn’t deliver against contracts and the banks didn’t let you roll over your contracts (establishing a later delivery date at a new, negotiated price).”

So Allen and his financial guru at the time, Rolando Francisco, were pioneers in the gold industry and, says Allen, “sacrificial lambs.” However, the real roasting as the 1980s unfolded befell the companies who clung to the old ways. Today, every “modern” gold miner hedges.

Gordon Maw, senior vice-president and chief financial officer, is now steering hedging activities for LAC. He is a well-rounded veteran of corporate finance whose rise to the executive suite began in steel (Stelco in the 1960s), progressed to forest products (Abitibi Price) and finally landed him in the glammer metal, gold. Maw’s hedging expertise encompasses commodities, but his specialities are interest rates and currencies.

Hedging, like insurance, he says, merely protects “against catastrophic events. It prevents the extremes from damaging the business.” To Maw, it’s just good business practice, not voodoo finance. But a gold company must set out a clearly defined hedging strategy. “This often is a board-level issue,” Maw said. Between the two extremes of pure insurance and pure speculation, senior management, with approval from directors, will nail down the company’s hedging strategy. After the level of risk exposure is determined, the only ponderables then are the choice of hedging vehicles, the length and duration of coverage (delivery dates), prices, the extent of coverage (70% of a years production, 90% or 100%) and so on.

In the days before gold hedging came into common use, there were few hedging vehicles. It was, says Maw, just “standard vanilla,” take it or leave it. Today, there is choice. The following are preferred vehicles for gold hedgers:

1. Forward sales: a contract that is entered into by a producer and dealer or bank where the producer agrees to sell gold at a future date to the dealer at a fixed price.

2. Spot Deferreds: similar to a simple forward contract, except that the producer has the option to extend the contract, or roll it over. Delivery is deferred if the spot price on the delivery date is higher than the contracted price.

3. Options: buying put options gives the producer the option to sell its gold at a contracted price on a future date. The purchase of put options are often financed by selling call options at a higher strike price than the put options. Thus, a floor price, established by buying puts, and a ceiling price, set by selling calls, is established(Min/Max program).

4. Gold Loans: a financing vehicle (and, in effect, a hedge) in which the lender, usually a bank, advances gold to the borrower, the mining company, which then sells the gold on the spot market and uses the proceeds for capital requirements. When loan payments are due, the borrower pays the lender in gold from production.

In the decade just passed, producers were wise to hedge. The price of gold was in long-term decline, but hedged producers were capturing prices above the slipping spot price. A research report prepared by Egizio Bianchini for Nesbitt Thomson Inc. says Canadian producers will benefit from their current signed forward contracts to the tune of $US513 million if gold stays near the $US360 level. No one knows what might befall gold prices in this decade. But according to Maw, the future vicissitudes of the gold price should not dictate hedging practices.

“If you, as a producer, need the stability of pricing that hedging can give you to carry out your plans (either operating or capital projects), then hedging is a logical extension of that policy.

“To ensure guaranteed price, it should be done in good times and in bad,” Maw said.

If prices rise dramatically, the fully-hedged producer misses the opportunity to earn extra money. To Maw, that should be acceptable to shareholders as long as they understand why the company was hedging in the first place. Such can be the price of insurance for gold producers.

LAC’s current hedged position is a rolling program with various prices and delivery dates through to 1993. A total of 1.3 million oz. are hedged through 1991, 1992 and 1993 at an average price of slightly more than $US400.