Updated essay on Barrick by Reg Howe
12:45a EST Friday, December 17, 1999
Dear Friend of GATA and Gold:
Reginald H. Howe, Harvard-trained lawyer and former
mining company executive, explains in detail here the
hedging situation of Barrick Gold. Howe argues that
Barrick's hedge is twice as risky as an ordinary hedge,
that the big move in gold that is the dream of the gold
bugs is really Barrick's worst nightmare, and that such
a move has happened before in this century.
CHRIS POWELL, Secretary
Gold Anti-Trust Action Committee Inc.
* * *
YOU BET YOUR LIFE:
BARRICK VS. THE GOLD BUGS
By Reginald H. Howe
December 17, 1999
The hedge book debate has produced another strange
twist: Barrick Gold disparaging its natural shareholders,
the gold bugs.
Arthur Hailey, the well-known author and former Barrick
shareholder, is trying to instigate a shareholder
revolt against Barrick's gold hedging program. Vince
Borg, Barrick's point man for investor relations,
accuses Hailey and other gold bugs of being irrational
extremists blinded by conspiracy theories about the
gold market. (See P. Kaihla, "Gold bugged," Canadian
Business, Nov. 26, 1999 -- www.canadian
Barrick, a major gold producer, expects to produce more
than 3.5 million ounces of gold in 1999 at a total cash
cost of $137/oz. and total cost, including
depreciation, of $240/oz. It has 51.5 million ounces of
proven and probable reserves and an "A" credit rating.
As currently set forth at its web site
Barrick's hedge book includes 14 million ounces (435
metric tons) sold forward under spot deferred contracts
as well as written call options for another 4 million
Two critical points emerge from an analysis of
Barrick's hedge book: 1) Its forward contracts are not
simple forward contracts but rather gold loans combined
with forward contracts; and 2) Its spot deferred
program is predicated on the assumption that "gold has
never consistently risen in price and stayed there."
The latter assumption is demonstrably false, and the
practice of combining forward contracts with gold loans
is much more risky than a program of simple forward
Twice in this century the gold price moved quickly to a
new, permanently higher level as a result of
disruptions in the international monetary system. In
1933-34, gold moved in about nine months from
$20.67/oz. to $35/oz., which became the official price
for the next 37 years. Within two years from the
closing of the gold window in 1971, gold moved over
$100/oz., never again to fall significantly below this
level, although it would rise much higher. More
generally, the history of all paper currencies is one
of long-term depreciation against gold until the paper
eventually expires worthless.
Barrick asserts that it would not be subject to any
margin calls on its hedge book unless gold rises to
more than $600/oz. This figure represents slightly more
than a doubling of the gold price from current levels,
or a rate of appreciation between that of 1933-34
(about 70 percent) and 1971-73 (more than 150 percent).
Spot deferred contracts at $385/oz., the price Barrick
claims to have locked in through 2001, will not look so
smart if gold moves to $600 quickly and stays there.
What is more, $600/oz. is not far from the price that
some claim is even now about the equilibrium price for
gold in a truly free physical market.
Fundamentally, Barrick's spot deferred contracts are a
bet on continued stability of the dollar and the
existing international monetary order. And so sure is
Barrick of this relatively benign future that it has
effectively doubled its bet by combining its spot
deferred contracts with gold loans. That is, Barrick
has not simply sold future gold production forward,
thereby locking in a future price and capturing the
contango. Rather, it has BORROWED the gold that it has
sold forward, effectively doubling the contango that it
earns, but seriously reducing its ability to close out
its forward contracts should future market developments
An example will help. Assume spot gold at $300/oz.,
one-year gold lease rates at 2 percent, and one-year
dollar interest rates at 6 percent. The one-year
forward rate, or contango, will be 4 percent, and gold
for delivery one year forward will be about $312/oz. A
producer can lock in this price by entering into a
simple or spot deferred forward contract and earn the
But what Barrick typically does contains an extra
Assume the same facts. Barrick not only sells an amount
of future production forward but also simultaneously
borrows the same amount of gold and sells it at spot.
Thus for each ounce sold forward, Barrick has $300 cash
to invest. It pays the 2 percent lease rate and,
assuming it matches maturities, earns the 6 percent
interest rate, giving it a positive spread of 4
percent, the amount of the contango. At the same time,
it earns the contango on its forward contract. Thus, by
borrowing the gold it sells forward, Barrick can
effectively double the amount of contango earned.
But the price of this extra return is additional risk
and reduced flexibility.
Suppose in the example given that spot gold declines to
$250/oz. after six months. With the same forward rate,
gold for delivery six months out would be $255. Thus
both a company with a simple forward contract and
Barrick would be showing a paper gain equal to $57/oz.
($312-$255) on forward contracts.
Now suppose that something happens to suggest that the
price of gold will not go much lower and might well
rise sharply. The company with the simple forward
contract can go to its counterparty and offer to close
out the forward contract for cash, perhaps even
offering a small incentive such as being willing to
take an amount slightly less than $57/oz. In short, its
paper gain is likely to be realizable.
On the other hand, Barrick has no such simple means of
realizing its paper gain. It has borrowed physical
gold, which it must repay. Thus to close out its
forward contract it must go into the market and buy
gold, which is not difficult in a physical gold market
with good liquidity or for small forward positions. But
for large positions in an illiquid physical market, the
situation is quite different. Any effort to buy gold to
cover is likely to drive up the price and reduce (or
eliminate) the paper gain.
In short, Barrick's approach runs a much higher risk of
being locked into a deteriorating forward position than
a simple forward sale.
This is, of course, the position that Barrick is in
today. With 435 metric tons borrowed and sold forward,
an amount in excess of the Bank of England's total gold
sales program of 415 tons, Barrick cannot cover its
short position in today's tight physical market without
driving gold much higher. A position that the company
claims is a paper gain is in fact a huge potential
liability, exacerbated by written call options covering
another almost 125 tons. If Barrick KNEW that within
one year gold would move to a new, permanently higher
level with $600/oz. as its floor, almost anything that
it might do to defend itself would just accelerate
There is no mystery to the falling out between Barrick
and the gold bugs. Fulfilment of the gold bugs'
sweetest dreams represents Barrick's worst nightmare.