Peak Gold!
A Primer on True Hedging,
Part Three
Antal E. Fekete
Gold Standard University Live
Sep 19, 2007
Double standard in gold hedging?
This is in answer to Mike "Mish"
Shedlock's rejoinder Double
Standard in Gold Hedging? (September 11, 2007) to my
Peak Gold! - Part Two
(September 10, 2007). Mr. Shedlock challenges my claim that unilateral
hedging by a gold mine, in particular, the practice of selling
forward longer than one year, or quantities in excess of one
year's mine output is, in effect, a naked short sale, involving
unlimited risk. I have suggested that unilateral hedging and
forward sale of several years' output are imprudent, fraudulent,
and should not be allowed by the exchanges - as they certainly
are not in case of agricultural producers.
At this point I would like
to remind my readers that the series Peak Gold! has not
been concluded as I have not yet fully discussed what true
(or bilateral) hedging as opposed to fraudulent (or
unilateral) hedging is. But before I do that I feel it is necessary
to answer the points raised by Mr. Shedlock, which I now do point
by point in the same order he raised them.
Unlimited risk is for real
- There is fraud involved in
the practice of unlimited forward selling of gold beyond one
year precisely because it may not be possible to deliver the
gold as contracted. One year is the logical production cycle
for gold. There is a difference between selling forward gold
already in the pipelines moving towards the market, and selling
forward gold still locked up in ore bodies. It is safe to assume
that gold already in the pipelines will make it to the market.
By contrast, gold locked up in ore bodies may not. The oft-quoted
dictum that "there's many a slip between cup and lip"
applies. Ore has to be extracted, pulverized, processed, and
refined. The company may not be there to do it if it goes bankrupt
in the meantime - for example, as a result of its foolish unilateral
hedging policies.
.
- The idea of 'unlimited risk'
involved in naked forward sales is real. The miner does not have
the gold in hand. He has only a bird in the bush. In addition
to the risk to potential profits there is the risk that the company
will be foreclosed on its naked forward sales and go into receivership.
Mr. Shedlock simply ignores the dynamics of the gold market.
He ignores, for example, that forward sales as practiced by Barrick
rely on gold lease rates remaining stable - a fact admitted arrogantly
in its last Annual Report. Perhaps Mr. Shedlock doesn't realize
lease rates are nothing more thaín the fulcrum upon which
the dollar-rate of interest and the future price of gold teeter
in balance. But what if no more gold were available for leasing,
as will surely happen when the central banks finally empty their
cupboards? Lease rates would explode as one piece of gold in
hand would be worth severalin the bush. I am grateful to Tom
Szabo of www.silveraxis.com for pointing out to me that this
could and would happen if the demand for gold becomes greater
than the lease supply. There is no way to hedge against this
risk. The fact is that gold could go into backwardation so
fast as not to allow time for the company to take defensive action.
It will matter little then that Barrick claims a great deal of
flexibility in its gold contracts since the very thing it has
egreed to receive in exchange for gold - U.S. dollars - will
have lost all of its value. Does Barrick have enough capital
to deliver the "hedged" gold for nothing, and will
it be given much time to do so? This is where Barrick would fing
that backwardation poses a serious obstacle to its survival as
the value of future gold production, and thus that of a gold
mine, is but a fraction of the same amount of gold when held
in the hand.
.
Bullion bankers are, no doubt, a nice bunch of people when they
coax the gold miner into the trap of unlimited risk. They will
not be nearly so nice when they get ready to make their margin
call and take their pound of flesh, as any Shylock worth the
name would.
.
- Sure, profit risk runs in
both directions. This is exactly why true hedging must
be bilateral involving forward purchases to complement forward
sales. This is exactly why unilateral hedging is false
hedging. It fails to be symmetric. Bullish sentiment is nipped
in the bud, while the bearish variety is cheered on. It pretends
to market a product at the best price available, but all it does
is ruining its own market by inviting competitive short
sales from other gold mines and speculators. Profit risk
running in both directions is the whole point of my series on
Peak Gold!, a primer on true hedging, if you just have
the patience to hear me out. I wonder if Mr. Shedlock has read
the section in Part Two on bilateral hedging, namely,
how a downstream short leg (forward sale) of a hedge ought to
be complemented by an upstream long leg (forward purchase) representing
down payment on gold bearing properties that the gold mine is
in the process of acquiring. Bilateral hedging works with four-legged
straddles, a short and a long leg downstream, plus a long and
a short leg upstream. Unilateral hedging tries to get by with
one-legged straddles: the only leg being the short one downstream.
I ask you: which is going to win the race?
.
- A gold mine can never be smart
enough to outsmart speculators who make it their business to
forestall other market participants. It is outright stupid to
pursue a market strategy of long-term forward selling, given
the fact that in the futures markets nimble speculators make
split-second decisions to turn from a buyer into a seller. By
the time the gold mine, a dinosaur in comparison, has made its
long-trumpeted forward sale, the speculators have run away with
the best of the pick. Unilateral long-term forward selling of
gold could work, but only if governments or central banks
have underwritten the losses that are almost certain to accrue.
.
- It is not a question of liking
or not liking hedged mines. The demonstrable fact is that the
leading hedger takes unfair advantage of all the other mines,
hedged or unhedged, by forcing them to sell ahead of schedule
at lower prices. Unilateral long-term forward selling is a predatory
practice which enables the big fish to gobble up the small.
No fair play is possible as long as the practice is allowed.
For this reason the suggestion that if you don't like hedged
mines you should short them is puerile. Shorting a predator may
be suicidal.
.
- It is true that every production
process has its production cycle. As Mr. Shedlock remarks, for
agricultural commodities it is typically from harvest to harvest,
or one year. Although for gold it is not so sharply delineated,
it is reasonable to make the fiscal year to play that role. Once
a year shareholders meet, elect new directors and there may be
changes in management. Important decisions are made about acquiring
new gold-bearing properties, prospecting, exploration, mine development.
In this sense, yes, you plant in the first quarter to reap in
the fourth, typically the busiest season for the gold mining
concern.
.
- It is true that, as far as
its fundamentals are concerned, gold production is far more stable
than the production of agricultural commodities or, for that
matter, the production of any other good. This is what makes
gold such a superb monetary metal. It is foolish to suggest that
gold, as a result of its 'demonetization', has ceased to have
stable value - fluctuating gold price notwithstanding. What the
fluctuating gold price shows is not the lack of stability in
the value of gold; it is the lack of stability in the value of
paper currencies, issued by devaluation-happy governments, in
which the price of gold is quoted. It is certainly not indicative
of a mysterious disappearance of stability in the value of gold.
.
- The fluctuating price of gold,
as well as fluctuating forex and interest rates, are not nature-given
as are the fluctuating prices of agricultural products. They
are man-made. They have deliberately been inflicted upon
the people by governments in betrayal of their sacred mission
to protect them. The fluctuating gold price and gyrating bond
prices are the instrument of the most vicious exploitation the
world has seen since chattel slavery. The government in regulating
futures trading has approved "double standards" in
an effort to create a practically infinite supply of ersatz
gold, including paper gold (such as gold futures that can be
sold greatly in excess of physical gold in existence), and unmined
gold locked in ore bodies below ground (which can then be sold
forward), in the hope of keeping the price of cash gold in perpetual
check. This is not a myth. This is a well-established fact admitted,
at one time or another, by many a government in its more sober
moments.
Niagara-on-Potomac
The world-wide regime of irredeemable
currency would have come to a sorry end decades ago if it weren't
for gambling casinos foisted upon the world by governments hell-bent
to keep the game of musical chairs going non-stop. Governments,
in the best tradition of casino owners, want people to gamble
in gold, bond, and forex futures. The futures markets in gold,
bonds and forex serve a purpose, and one purpose only: to provide
an outlet for the Niagara-on-Potomac, money supply gushing forth
from the Federal Reserve that could drown the entire world in
a hyperinflationary deluge. If it hasn't, that's because excess
money has been soaked up by the gambling casinos. So far. People
scramble for the excess because they could use them as chips
at the gaming tables. But as growth in the derivatives markets
(the size of which doubles every other year and by now exceeds
half a quadrillion dollars or $500,000,000,000,000) shows,
this is not a stable process secured with proper checks and balances.
This is a runaway train on which the brakes (i.e., natural limitation
on gold production) have been deliberately disabled. Fraudulent
hedging of gold mines, and double standards in regulating futures
trading are part of the sabotage. This is a world disaster waiting
to happen.
Hedge fund masqerading as a gold mine
Mr. Shedlock has missed my
point. We may honestly disagree on the question whether long-term
unilateral hedges are prudent or fraudulent. But there is no
ambiguity about the fraudulent nature of a hedge fund masquerading
as a gold mine. If it is the world's biggest gold mining concern,
then the masquerade assumes cosmic proportions.
I repeat the verdict: the gold
carry trade is criminally fraudulent. In more details: to lease
gold, to sell it for cash, to invest the proceeds like a hedge
fund, and to report the income from these investments as profit
to shareholders, as if they were profit from gold mining operations,
constitutes fraud. Paper profit is no profit. It is encumbered
with a contingent liability, the extent of which cannot be ascertained
until the hedge is lifted and the hedgebook closed. The trouble
is that by that time management will have spent the 'profit'
taken out of the corporate treasury fraudulently.
The practice of window-dressing
income statements using unrealized paper profits, especially
as they are encumbered with unlimited liabilities, is a blatant
fraud dealt with by the Criminal Code.
Are Barrick's officers masochistic or incompetent?
In Peak
Gold! Part One I mentioned that Barrick President Greg
Wilkins and Executive Vice President and CFO Jamie Sokalsky announced
extremely optimistic predictions about the gold price for the
next five to seven years in a conference call that has been widely
publicized. These predictions are based on a study of gold fundamentals
commissioned by Barrick. (Reuters, August 3, 2007.)
Here is my parting shot to
Mr. Shedlock. He says that he disagrees with Citigroup analyst
John Hill, who publicly called on Barrick to rid itself of the
remaining 9.5 million ounces left on its 'project' hedge book.
According to Shedlock Barrick should not cover those hedges
now at $700. "If it did and the price of gold collapsed
to $500, Barrick would be in a world of hurt... Barrick would
be betting the farm that prices are heading north of $700...
and will stay there for quite some time... Is [this contingency]
really worth betting the company on?"
I ask Mr. Shedlock what makes
him think that Barrick's actual bet (namely, that the price of
gold will collapse to $500) is a more worthwhile contingency
to bet the company on? Who is Messrs. Wilkins and Sokalsky trying
to fool in making prognostications potentially very damaging
to the financial health of the company - in view of its hedgebook
deeply under water? Are they masochistic? Do they think that
they have been hired by the shareholders to run the company aground?
Why did they not lift all their so-called hedges, as John Hill
suggested and Newmont has done, in good time, before
releasing such a devastating report putting the company in jeopardy?
This is what common sense would seem to dictate, to lift the
hedge first, and make the announcement afterwards, is it not?
If they did not have and could not raise the money to do it,
at the very least they should have suppressed the optimistic
prognostication on the gold price, in order to soften the blow
to shareholders who are going to suffer one way or another the
consequences of gold breaking above $700, due to Barrick's insane
hedging policy.
It is understandable that Barrick's
officers are reluctant to admit publicly that they have made
the most colossal blunder in the history of mining, by committing
their company to the policy of unilateral downstream hedging
through unlimited forward sales of gold. Such an admission would
be hard on the ego. They may hope against hope that their blunder
will be quietly forgotten, and the shareholders will buy the
desperate propaganda-line that a higher gold price is good for
them, hedgebook or no hedgebook.
But you cannot keep kicking
garbage upstairs to the attic forever, because it will keep rotting
there until something gives and the accumulated garbage will
come crashing down.
I have issued a public challenge
to Barrick to explain why they ignored my warning ten years ago
that unilateral downstream hedging is a dangerous trap they should
avoid. I also pointed out to the top brass how their hedge plan
could be made bilateral, a winning combination. Had they listened
to my advice, they would have avoided having to carry the yoke
of a millstone-size hedgebook around their neck. I take this
opportunity to report that Barrick has so far ignored my challenge.
I am not sold on the conspiracy
theory according to which Barrick is a front set up by governments
to keep the gold price in perpetual check. Not yet anyhow. But
then, the only conclusion is that the officers of Barrick are
incompetent bunglers whose name will go down in ignominy in the
annals of mining.
DISCLAIMER
AND CONFLICTS
THE PUBLICATION
OF THIS ARTICLE IS SOLELY FOR YOUR INFORMATION AND ENTERTAINMENT.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS
HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A
RECOMMENDATION TO BUY OR SELL ANY SECURITY. HE HAS NO POSITION,
LONG OR SHORT, IN BARRICK STOCK, NOR DOES HE INTEND TO ACQUIRE
ONE. THE CONTENT OF THIS ARTICLE IS DERIVED FROM INFORMATION
AND SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO
REPRESENTATION THAT IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD
NOT BE RELIED UPON AS SUCH.
September 19, 2007
Professor
Emeritus
Memorial University of Newfoundland
email: aefekete@hotmail.com
Professor Antal E. Fekete was born and educated
in Hungary. He immigrated to Canada in 1956. In addition to teaching
in Canada, he worked in the Washington DC office of Congressman
W. E. Dannemeyer for five years on monetary and fiscal reform
till 1990. He taught as visiting professor of economics at the
Francisco Marroquin University in Guatemala City in 1996. Since
2001 he has been consulting professor at Sapientia University,
Cluj-Napoca, Romania. In 1996 Professor Fekete won the first prize
in the International Currency Essay contest sponsored by Bank
Lips Ltd. of Switzerland. He also runs the Gold Standard
University.
Copyright ©2005-2010 by A. E. Fekete<
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