When is this gold bear market going to end?
There’s a question to which we’d all like to know the answer.
I actually have gold and gold stocks on a short-term buy signal at the moment. They’re bouncing from oversold levels, as I suggested last week they would.
But today we consider a much longer term perspective by looking at one of the most controversial practices of the gold mining industry – hedging.
How hedging saved the gold mining industry
Between 1971 and 1980 gold enjoyed a bull market that took it from $35 to $850 an ounce. But on the way, between 1975 and 1976, it experienced a two-year, 50% correction.
There are those who hope that today’s correction (three years, 40% and counting) is similar. Gold will soon resume its uptrend and rise to some stratospheric number that reflects global debt levels in excess of $100trn and the incredible amount of fiat money that has been created.
And there are those who think this bear market isn’t over by a long chalk.
Between 1980 and 2001, there were rallies and bumps. But it was mainly grind, as gold slid from $850 to an eventual low of $250 an ounce.
Talk to the bears and they’ll tell you gold is in another such secular bear market now.
So how did gold mining manage to survive that previous 20-year secular bear market?
The harsh reality is, much of it didn’t. Mines were closed, development projects halted, exploration budgets disappeared.
But some producers did manage to survive. And one of the ways they stayed afloat was by selling gold they had not yet been mined.
Let’s say it’s a bear market. Gold is trading at $500 an ounce. It was $600 last year. It costs Company X $450 an ounce to produce. So Company X goes into the futures markets and sells next year’s production now.
It knows it will make $50 an ounce next year, the market knows it will make $50 an ounce, the shareholders know it will make $50.
Next year, the gold price falls another 20%. Gold is now $400 an ounce. But Company X has already sold all that year’s production for $500. It has not only beaten the market, it has ensured its survival. If it hadn’t sold that gold forward – if it hadn’t ‘hedged’ – it would be badly underwater.
Meanwhile, in this falling gold price environment, the company has streamlined its practices, cut back on costs, it’s high-grading (ie only mining the highest quality rock) and it’s managed to get its cost of production down to $380.
With the gold price now at $400, it sells next year’s production. The gold price goes on to fall another 20% to $320, but the company has managed to break even. And so it lives to fight another year.
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The great hedging conspiracy theory
Hedging is a company-saver during a bear markets.
Things got so bad in the late 1990s, that by the end of the decade some companies were hedging more than a year’s production ahead.
The gold price got as low as $250 an ounce. Global production was around 2,500 tonnes. Around 3,200 tonnes – something like 125% of annual supply – had been hedged.
Central banks were also big sellers at this time – including Switzerland and, most famously, Gordon Brown (against the Bank of England’s advice). In fact, so much gold had been sold forward by the miners, that senior gold producers – especially Barrick (the world’s largest producer) – were accused of working in collusion with central banks to suppress the gold price.
We’ll never really know if that’s true or not until America audits its gold, which it steadfastly refuses to do.
In any case, 1999-2001 marked the peak of hedging. It also marked the low in gold. Below, courtesy of Nick Laird at Sharelynx, we see the GFMS global goldmine hedgebook in blue, the gold price in gold, and annual gold production in black.
The end of hedging – and the end of the gold bull market
Of course, hedging might work in a bear market, but it’s an absolute disaster in a bull market.
With the gold price at $500, and production costs of $450 an ounce, if Company X sells next year’s production at $500, but the gold price rises 20% to $600, Company X has only made $50 an ounce, when it could have made $150. Its profits are a third of what they might have been.
This is what happened during the bull market of the 2000s. The gold price was rising by 20% a year. But because they were hedging, many of the senior producers were missing out on the profits.
The larger companies were the slowest to react. Many – Barrick, in particular, where the bear market mentality had become almost institutionalised – became a laughing stock.
Meanwhile many new mines were being funded and built. Shareholders demanded that these new producers stayed unhedged. They wanted pure exposure to the gold price. The chief executives complied, often even boasting of their strategy in the PR.
As a result, their share prices were rising by greater magnitudes than the gold price, while the likes of Barrick’s were anaemic. At one stage, The New York Times said the biggest liability to Barrick’s stock price was its hedging book.
Finally, in September 2009, with the gold price now at about $1,000, Barrick threw in the towel.
It said its “gold hedges and floating contracts were adversely impacting the company’s appeal to the broader investment community and hence, its share price performance.”
It announced a public offering. With the money it raised, it planned to eliminate all of its “fixed gold price contracts”. Within 12 months Barrick’s 21-year-old practice of hedging was over.
And as it ended it – in late 2010 – the explorers peaked. The juniors followed a few months after that in February 2011. Gold itself peaked in September 2011 along with the large producers.
In other words, loosely speaking, the end of hedging marked the peak of the gold bull market.
Time is running out for the bull to take back the reins
Mining companies – like so many of us – have been slow to react to the current bear market. The practice of hedging has not truly reared its head. Currently, it seems about 40 tonnes (annual production is just over 3,000 tonnes) is hedged – less than 2% of annual supply.
That’s not surprising. It was some ten years after the 1980 peak that hedging really got going. By then the bear market mentality was entrenched. After the ridicule that mining chief executives suffered for their hedging in the ‘00s, it may be a while before they dare risk it again.
But if the gold price keeps falling and their survival depends on it, they will have no choice. You can bet they’re all discussing it in boardrooms right now. One will lead and the rest will follow.
Hedging is just one long-term, contrarian indicator – there are plenty of others to consider before making your investment decisions – but it is one that nobody else I’ve seen is thinking about. If it is one to go by, then this bear market might not be over until hedging once again exceeds global production. And we are a long way from that.
It all depends, of course, on whether this is a secular bear market – or just a mid-bull-market correction, a la 1975-76. But if it is the latter, time is running out for the bull to take back the reins.