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Gold's Midas touch leaves banks cold

By Adrienne Roberts
Financial Times
Sunday, November 17, 2002

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Against a backdrop of corporate scandals and
plunging stock markets, the price of gold has
climbed by about 20 per cent in the past 18
months. Mining companies' profit margins have
grown and anyone with a nest egg of bullion
bars is feeling a little safer.

Not everyone in the market is smiling,
however. Business has never been tougher for
the bullion banks and, while investors have a
new-found enthusiasm for gold, the serious
money has bypassed the metal itself, pouring
instead into mining shares.

Meanwhile, the bullion banks, which do
business with the mining groups and central
banks, have seen their profits dwindle. That
is largely because of the fall in hedging
business. When the outlook for gold prices is
uncertain, mining companies might choose to
manage the risk by locking in a future price
for their gold. Bullion banks help make these
forward sales possible, providing derivative
products such as forwards and options.

Hedging was good business for the banks
during the 1990s as they designed
increasingly sophisticated derivative
structures for clients. But producers became
more cautious after 1999 when the gold price
spiked unexpectedly andAshanti Goldfields of
Ghana andCambior of Canada's derivative
positions brought them close to disaster.

"By 2000 the producers were looking at much
more 'plain vanilla'-type business: basic
forwards, basic options," says one mining
executive. "The really lucrative trades
started drying up though there was continued
volume in the bread and butter stuff."

But as gold has pulled out of its decade-long
slump, producers have stopped hedging. Some
are letting contracts expire, others are
buying themselves out of their positions.

Conventional wisdom says this development,
and gold's rally, were begun the US Federal
Reserve. Falling dollar interest rates made
it unprofitable for miners to hedge, or for
speculators to sell the metal short.

For forward sales to make commercial sense,
the cost of borrowing gold must be less than
the cost of borrowing money. In the mid 1990s
one could have borrowed gold at 1 per cent,
sold it and invested the proceeds at 7 per
cent. But falling US interest rates have
narrowed that gap.

Not only is hedging no longer profitable, it
has become anathema to investors seeking
exposure to gold's rally.

Investor sentiment has rewarded the unhedged
miners, putting pressure on the non-hedgers
to increase their price exposure. Shares in
the unhedged South African producerGold
Fields have risen about 160 per cent in US
dollar terms over the past year, compared
with about 70 per cent for rivalAnglogold,
which does hedge (although Anglogold and
other hedgers have significantly reduced
their books).

While producers continue reducing their hedge
books, they continue to support bullion
prices. Ironically, the suppliers themselves
have become a key source of demand for the
metal.

"In 1999, producers were adding around 500
tonnes of gold a year to supply through
hedging. They are now taking back around 500
tonnes through de-hedging," says Andy Smith,
analyst at Mitsui in London.

But once the producers have finished buying,
will there be enough other demand to keep
gold buoyant? Investment demand for bullion
has risen - by 12 per cent in the first half
of 2002 compared with that period in 2001,
according to the World Gold Council. But
recent data show that producer buybacks were
mirrored by a fall in demand from jewellery
makers as prices climbed.

"If you take a very bearish view, once the
crust of producer buying is finished then
prices may slide alarmingly," says a banker.
With US interest rates still low and the
dollar floundering, however, it might be
premature to call the end of gold's run just
yet.