Over the Hedge and Underground

When should companies hedge their exposure to financial and commodity risks? Is it always wrong or always right or somewhere in between? This topic arises every now and again when a goldmine is found to have made losses (and we’ll distinguish shortly between different types of “losses”) as a result of gold price increases when gold has been sold forward or they have an effective short position in gold through derivative exposures. Sasol (2) has also been in the news for making apparent losses on hedges put in place.

What is a hedge and how do companies hedge

A hedge can be constructed in several ways.

  • The commodity may be sold forward such that the price is agreed today but the goods are only transferred in future.
  • A future may be sold (or shorted) on the OTC market or on an exchange which achieves a similar overall effect.
  • A put option on the commodity may be purchased such that the company is protected from price decreases
  • Other structures may be created in conjunction with banks, hedge funds or other capital market participants

The net result is usually that disadvantageous price movements (usually price decreases for a commodity producer) result in profits on the hedging instrument that offset losses as a direct result of lower revenue from sale of commodities. When commodity prices decrease, the company doesn’t make as large losses as it would without the hedge. The catch? When commodity prices increase, the company doesn’t make as much profit as it would without the hedge. So the company ends up with lower volatility of earnings.

The problems with hedging

Hedging accurately requires exact knowledge of future volumes and dates of sales. Even the most stable goldmine has some variation in output from month to month. When predicting volumes several years into the future, the uncertainty increases in what is often described as an expanding funnel of doubt. If the hedge is put in place to offset the exposure of 100 units of gold and only 50 units of gold are available to be sold, then the hedge will overcompensate for price changes to the extent that the company will, perversely, likely make a loss when the price rises and a profit when the price drops! Similarly, if there is actually 150 units of gold available to be sold, the company will only have partial protection against commodity price movements.

Secondly, movements in the price of the hedging instrument may not exactly offset movements in the value of the underlying commodities to be sold. This is known as basis risk. An easy example to understand this is with wheat futures – the exact quality, type and transportation costs for the specified future may not be the same as the company’s own crop. Alternatively, if the hedge does not have the same maturity date as the sale date for the commodity, deviations in price for the hedging instrument on the market due to liquidity or other issues could result in differences too.

A more complicated issue reflects accounting rules for hedges and natural resources. IFRS requires derivatives to be carried on the balance sheet at market value in most instances. However, the extent to which gold deposits still in the ground are recognised as an asset depends on several other factors. The scenario can arise where the full loss on the derivative must be taken through the income statement in a particular period, but the increase in the value of the gold deposits in the ground is not recognised because the resources haven’t been proved with sufficient accuracy. This has often been the argument put forward by executives looking to explain accounting losses on hedging transactions. There is also the potential for this to be used as an excuse to hide the real economic losses.

The usual arguments against hedging

The most common argument against companies’ hedging their financial or commodity risks is that there is no need. Investors can more effectively manage their own exposures to various risk factors and adjust their exposure themselves. Many investors, wanting geared exposure to a particular commodity, will look for unhedged, marginal mines that are extremely highly exposed to changes in the price if the underlying commodity. If the gold mining company itself hedges the risk, it is no longer of interest to the investors.

The argument follows that management of a gold mine should worry about mining gold, and that maize farmers should worry about maize farming. Leave the sophisticated financial and derivative decisions up to the experts.

Can hedging be good? Aka why the previous argument is flawed.

There are three clear flaws in the usual argument against hedging.
Firstly, if investors are so adept at adjusting their risk exposures with derivatives and fancy structures, why do so many of them like marginal mines to get their geared exposure? Chat to many resources punters and investors and, while many will stick with the tried and trusted, there is significant demand for marginal gold mines too. If all investors could get the same exposure through derivatives and other hedges, this demand wouldn’t exist.

Secondly, surely the gold miner has the best information relating to the volume and timing of gold sales and can thus hedge more effectively than an outside investor? If the company is hedging 100 units of gold exposure, it is likely that each individual investor is hedging close to 1 or maybe 10 units of exposure. Economies of scale do play a role in getting the best price in hedging transactions (admittedly it can work the wrong way round too). Thus, it is not clear that investors are in a better position to be able to hedge the resources company’s exposure.

Finally, and most importantly, pulling gold of the ground and planting maize require long-term planning. Planning acreage of planting, capital investment, labour quantities and transportation contracts accurately requires solid estimates of future volumes and revenues. For a gold miner to concentrate on mining gold he or she will need to know what rate of return can be expected on sinking a new shaft or reopening an existing shaft, hiring more staff and importing machinery from Canada. This is difficult with the uncertainty of a volatile gold price. How can a farmer choose what mix of crops to plant without knowing what the final revenue from each unit of crop will be? The very argument that advises the natural resource companies to not hedge and stick to their knitting is, in my view, the strongest argument for them to hedge.

The question that needs to be asked is, “Can the company more efficiently focus on its critical success factors by hedging?” If the answer is yes, then hedging is the way forward. If the answer is no, then it might be better left to investors.

This is by no means the final word on whether hedging is appropriate or not. It’s hardly even scratching the surface. However, everytime a journalist or analyst gives a gold mine a hard time about hedging when hedging was the right thing to have done at the time then we discourage our miners from hedging. A little more insight and more carefully thought-through analysis should lead to better decisions overall.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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  1. The price of gold is fixed on a daily basis. Do you know if the fixing has any cap or other limit for a 1 day movement? Or is the price allowed to freely move up or down independent of the prior day’s price fix? I suspect the later and the implications to hedging.

  2. Gold is traded around the world in spot and derivative markets; it’s not even that clear to know what “the” daily price is. Different time-zones will have different market-close prices, but since trading continues around the world there is no reason to favour one closing price over another.

    In general, the movement in the gold price is not limited. Because it is a commodity, traded around the world, it is difficult for exchanges to impose rules that limit how far the price can move. There may be more rules on some of the derivate markets though.

    But these limits only apply in extreme market circumstances. If one is truly hedging the exposure for operational purposes, there should be no need to be trading regularly.

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