Sinclair explains why U.S. government will want a higher gold price


Gold hedge fever

Hedging gold price risk may allow a producer
to make greater profits, and may depress the
price of gold in the process. Is that any
reason to sue?

By Martin Murenbeeld
National Post, Canada
Friday, December 20, 2002

The practice of hedging gold price risk by
selling gold "forward," as done by Barrick
and other mining firms, generates an extreme
amount of controversy. Barrick's hedging
contracts have been called "fraudulent ... an
invitation to bankruptcy" by no less than a
professor emeritus at the Memorial University
of Newfoundland, and Barrick's officers
"blockheads wrapped up in their own glory who
do not understand the very nature of the
product they help bring up from the bowels of
the earth."

In a legal action brought forward by Reginald
Howe on Dec. 7, 2000, an action supported by
the Gold Anti-Trust Action group (GATA),
Barrick, along with the Federal Reserve and
major banks, was charged with suppressing the
price of gold. It was claimed "Barrick has
material non-public knowledge of [a] gold
price-fixing scheme which they have used to
their advantage."

The Howe case was thrown out of court, but
that hasn't stopped the attacks. On
Wednesday, Dec. 18, 2002, Blanchard and
Company, a supporter of GATA, filed in a
Louisiana court the charge that Barrick and
JP Morgan Chase Co. had "unlawfully combined
to actively manipulate the price of gold."
Indeed, Barrick's hedging program "involves a
unique step whereby Barrick, and the bullion
banks with which it operates in combination,
can flood the market with central bank gold."
That Blanchard did not also name all gold-
lending central banks as co-defendants is a
curious oversight!

What is one to make of all this?

For my part, not only is the practice of gold
hedging perfectly defensible, but having had
a close look at Barrick's hedging program I
can say that there is nothing to suggest that
the aforementioned attacks are even remotely
on the mark.

Hedging is defined as the process of reducing
exposure to an event that could be costly to
a firm. It is the opposite of speculation,
which is generally defined as the process of
increasing exposure to an event that could be
profitable to a firm. Its origins go back to
agricultural economies where farmers would
commit to sell their output to a middleman in
order to avoid the volatility of future
produce prices. (Commodity exchanges -- for
grain, hogs, etc. -- are among the oldest
exchanges.) These farmers would transfer the
risk of a price decline, to which they were
"exposed" and which could be ruinous to them,
to a middleman -- a "risk-taker" (who could
very well be a speculator who hoped to
benefit from a future price rise). In the
event the price of the farmer's output turned
out to be higher than what had been
contracted, the farmer would suffer an
opportunity loss -- but he would experience
no direct cash loss.

Producers who hedge the gold price are
transferring the risk of a future price
decline to a counter party -- typically a
bullion bank. When gold is sold forward, a
price on future output is secured today;
regardless of what happens to the gold price,
the producer will receive the contracted

It is not strictly necessary for management
to have a view of the future price of gold,
furthermore. Management needs to know the
degree to which the company (i.e. the board
and shareholders) will accept adverse price
outcomes. With the help of different gold-
price scenarios, management can construct a
financial profile for the company and act to
mitigate the worst outcomes. Management
cannot control the gold price, but management
can control the impact of an adverse price
outcome on the company. That is the essence
of "hedging."

Hedging isn't "costless." If Barrick
contracted to deliver gold at $340 per ounce,
but the eventual price on delivery day is
$375, Barrick will incur an opportunity loss
-- the "opportunity" to receive the extra $35
per ounce. An opportunity loss is not a cash
loss, however. The company remains in
business; it just wasn't as profitable as it
might have been.

Of course, were the gold price to fall to
$300 by delivery day, Barrick would receive
$40 per ounce more than the market would have
given it. Indeed, over the last 58 quarters,
Barrick has made an extra $2-billion in this
fashion. Some of this $2-billion was used to
find more gold reserves and purchase gold
assets (ergo, Blanchard's claim that by
"manipulating" the gold price Barrick was
able to make an "[unprecedented] leap from
obscurity to dominant global enterprise").

Barrick's hedges are spot-deferred hedges, as
are the hedges of some other producers. This
means they can be deferred into the future.
In the example above, Barrick may choose to
postpone delivery for another year(s) when
gold rises to $375, and simply sell the gold
it was prepared to deliver under the $340
contract directly into the market for $375.
No opportunity loss will then be booked.

Will continual deferment lead to problems?
Provided that Barrick will always be able to
deliver against its contracts, it can only
ever incur an opportunity loss. And it may
not incur any opportunity loss if the gold
price on final delivery day is below the
contract price. If Barrick runs out of gold
reserves, however, and it had continually
postponed delivery, and the gold price
skyrockets, there will be a nasty day of
reckoning. But shareholders, seeing Barrick's
depleting reserves, will have long abandoned
the company to its deserved fate.

Over the last year, the market has "punished"
gold hedgers; their share price has not risen
to the extent the share price of non-hedgers
has. Investors tend to prefer unhedged
producers when the price of gold is expected
to rise, because of the lower risk of
opportunity losses. Barrick's share price
outperformed when the gold price was falling,
on the other hand. With gold price scenarios
more bullish than bearish currently, Barrick
and other "hedgers" are scaling back their
hedging activities. The perceived risk of a
bad gold price outcome has lessened.

Has hedging depressed the gold price? Yes,
according to our models of the gold price. We
have calculated that all hedging -- of which
Barrick hedges are only a small part -- has
depressed the average yearly price of gold by
US$9.40 per ounce since 1983, when the
practice first commenced. This estimate
follows from the fact that when a producer
hedges the gold price risk, its counter party
borrows gold from a central bank and sells
the gold in the spot market. (The gold is
returned to the central bank when the
producer delivers against the contract.) It
is this selling in the spot market that lies
at the root of the animosity towards
"hedgers." Gold companies that do not hedge
receive a lower price for their output than

However, now that "hedgers" are delivering
against past hedge contracts, and not
initiating new contracts, the price of gold
will be higher on average than otherwise. The
knife cuts both ways.

The practice of hedging cannot be stopped.
Hedging occurs in all markets where the
financial technology has made it feasible to
do so. Currency exposure is hedged with great
regularity, for example. Should Ford Motor
Company of Canada Ltd. file suit against
Barrick when Barrick hedges its Canadian
dollar exposure, because it raises the price
of the Canadian dollar and therefore may hurt
Ford's exports to the United States? This
line of logic can lead to ridiculous outcomes
in a hurry!

Hedging price risk is a normal business
practice. In the gold market, it has allowed
some "hedgers" to realize greater profit than
otherwise in the heretofore-declining gold
market. Our economic system would abort
quickly if we barred companies from using all
legal means to gain profit and potential
advantage over their competitors. My guess is
that Blanchard and Company has not profited
to the degree it might have hoped these last
years in the gold market. Too bad, but that
is what a market is all about!


Martin Murenbeeld, PhD, is an economist with
M. Murenbeeld & Associates Inc. He can be
reached at