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Hedging Fraudulent
In earlier papers I have explained that virtually
all activities of gold mines that go under the name "hedging" are
fraudulent. To the extent hedges go out into the future more than one year,
or they exceed the quantity of one year's production, they are naked forward
sales, carrying unlimited risk (the risk that the gold price goes to
infinity, as it has in the wake of every hyperinflation).
To understand the motivation to resort to fraud, and
to shoulder unlimited risk to boot, we must remember that the combined short
positions in the futures and derivatives markets on gold greatly exceed
monetary gold in existence. Without compulsively selling paper gold, a short
squeeze and even a corner in cash gold could develop if the longs decided to
call the bluff. Thus any exposure to the short side forces pyramiding to fend
off the danger. On the other hand some shorts, especially bullion banks, have
found the creation of ersatz gold a profitable business. They play a
cat-and-mouse game with the longs. They have fashioned the rules of gold
exchanges and ETF's in their own favor in order to make delivery a cumbersome, expensive,
and time-consuming procedure. As a result the price of gold could be thrown
into a hole so that, whenever it tried to climb out, 'hedgers' and
speculators would rush in and club it down. The shorts can get away with it
because the supply of paper gold (futures and option contracts) as well as unmined gold in the ground is virtually unlimited and can
be mobilized in the anti-gold campaign.
It speaks volumes of the inherent strength of gold
that it could climb out of the hole in 2001 in spite of a
terrible assault to push it back. The 20th century belonged to the enemies of
gold. There is no need to make predictions here about the 21st.
Changing the nature of gold speculation
Significantly, the so-called hedging activity of
gold mines has altered the strategic line-up in the gold market. Speculators
have typically been on the long side. They have photographic memories and recall
the propensity of governments to cry down the value of the national currency
in terms of gold from time to time. The opposite procedure, writing up the
value of the national currency in terms of gold is virtually unknown in the
annals of monetary history. Given mine hedging, so-called, speculators have
changed sides and compete with the mines to sell (paper) gold at the first
sign of a bullish move in the price. The fraternity of
speculators conceive of risk-free profits on the short side of the
market as they attempt to forestall the mines. They have abandoned their
traditional haunt on the long side. Peak Gold is a predictible
consequence. Unhedged gold mines, too, feel
compelled under the threat of a falling gold price to produce gold at
break-neck speed while neglecting prospecting and the development of gold
properties. Once the producing mines get exhausted, the supply of new gold
will decline.
In summary we might say that fraudulent hedging
carries with it its own punishment: Peak Gold. It leads to ruthless
exploitation of gold mining resources, with no prudent provision for
replenishing them through prospecting and new mine development.
It is unfortunate that the perfectly honest and
useful word "hedging" has been allowed to be abused and given a
completely distorted meaning. As the saying goes, 'give a dog a bad name,
might as well shoot him!' It is difficult to explain the distinction between
'hedging true' and 'hedging false' when the connotation of the word 'hedging'
in the minds of the people is unsavory. It turns
them off. Yet the mission of the monetary scientist obliges him to continue
on the path of truth even if it is uphill all the way.
Hedging is a wide-spread practice of producers in
all walks of the economy. To be valid and effective, it must be carried on at
two levels: upstream and downstream. The former refers to the input, the
latter to the output of production. At the input level the producer buys the
resources that go into his final product. At the output level the producer is
marketing his final product. The need for hedging arises as price
fluctuations at either level, especially if they occur faster than
adjustments can be made, may cause losses. Thus, worrying about the
downstream, the producer is anxious to lock-in a favorable
selling price as it may become available for his product prior to the end of
the current production cycle. Worrying about the upstream, the hedger aims at
locking-in a favorable buying price as it may
become available for a major ingredient of his product prior to the beginning
of his next production cycle.
Upstream and downstream hedging
Hedging is most efficient if it is bilateral.
As it has been practiced in gold mining, hedging is unilateral. It involves
forward sales by way of downstream, to the exclusion of the forward purchases
by way of upstream hedging. It is a caricature of hedging. It pretends to
overcome the fluctuation of the gold price as it affects the output of new
gold. I say 'caricature' because it is counter-productive. Rather than
allowing the producer to sell high while preserving the value of his unmined reserves, it forces him to sell low, and sell
it fast, as the message is that the price is going to fall, and any delay
in selling will involve losses.
Yet, if done properly, either type of hedge should
contribute to profitability as well as husbandry. In combination they are a
legitimate form of arbitrage, provided that the hedges are carried in the
balance sheet, and profits (losses) are reported in the income statement. Hedges
carried off-balance-sheet are not legitimate as they
conceal a liability with the result that the income statement is falsified. Shareholders
and creditors are misled. Directors and managers lock themselves into a
fools' paradise. Especially dangerous are downstream hedges carried
off-balance-sheet, for the reason that the short leg (forward sale)
represents an unlimited liability. By contrast the long leg of the
upstream hedge (forward purchase) represents but a limited liability. The
difference is due to the fact that while the price of a commodity can never
fall below zero, there is no identifiable limit above which it may not rise. Another
way of expressing it is to say that the downstream hedge is subject to a
squeeze and possibly to a corner. By contrast, there is no way to squeeze or
to corner a producer with an upstream
hedge.
Capital destruction
I must confess that I cannot understand the utter
lack of business acumen on the part of gold mining executives, still less on
the part of investment bankers that finance their activities, in embracing
such a contradictory and self-defeating strategy of marketing gold. They
should be interested in maximizing the price of their product. Instead, they
engineer a falling price trend. They should be interested in maximizing the
working life of their gold producing property. Instead, their marketing
policy directly contributes to the premature exhaustion of the mines. A lot
of observers jump to the conclusion that the gold mines and the bullion
banks, in partnership with the government, form a conspiracy to club down the
gold price. Theirs is a hidden agenda. The gold mine management is interested
in defalcation, that is to say, to trick their stockholders out of their
equity. The bullion banks think that they can harness perpetual motion in the
artificially induced oscillating movement in the price of gold. Governments
look at the gold price as a messenger with an embarrassing message about the
depreciation of currency. The messenger had better be shot. Governments know
that a steep increase in the gold price will cause panic. Such a panic has
historically served as the harbinger of hyperinflation. It must be prevented
by hook or crook.
I find this reasoning unattractive. Such a
conspiracy can never be proved or disproved. Governments probably use more
subtle methods.
Double standard
Most 'hedged' gold mines are in violation of the
important restriction that downstream hedges must not exceed one year's gold
output and they must be lifted before the end of the fiscal year. Their
practice transgresses not only the limits of prudence, but also the limits of
upright business management. A gold mine selling forward in excess of one
year's output is guilty of fraud. It is concealing a potentially unlimited
liability. The accounting profession, the commodity exchanges, and the
government's watchdog agencies have never offered an acceptable explanation
for the double standard they apply, one for the gold mining industry, and
another one for everyone else. While they allow gold mines to sell forward
several years' production, they would immediately blow the whistle if, for
example, an agricultural producer tried to do the same. It is well understood
that forward sales in excess of one year's production are a predatory
practice designed to hurt or destroy competition. It is also hurting other
market participants downstream.
There is no justification for this double standard. It
is scandalous that the government grants legal immunity to gold mines using
fraudulent hedges. Worse still, the fraud is facilitated by central banks
willing to lease gold which, as the bank well knows, the mine will sell for
cash. Central banks are accomplices in the scheme of fraudulent hedging since
they report gold that has been leased and sold as if it were still sitting in
their vault. It is a form of double-counting gold by modern accounting
techniques.
Selling forward more than one year's output is no
hedging. It is outright speculation on the short side of the market in
anticipation of a decline in the gold price. Not only is such a 'naked bear
speculation' illegitimate as it falsifies the balance sheet and conceals an
unlimited liability, but it also makes the prospectus meaningless. There is
no mention in the prospectus of any intention to indulge in short selling
that inevitably results in the premature exhaustion of ore reserves and in
the dissipation of the most valuable resources of the mine at artificially
low prices. On this ground alone the gold mine is open to class action suit
by the shareholders. (I am grateful to Tom Szabo of
www.silvewraxis.com for pointing
out that the double standard is repeated in case of a number of other
industries, see FASB Statement No. 133. He also mentions that Barrick's Gold Sale Contracts have been exempted, along
with others, from the regulation as "cash-flow hedges" and thus
have no required financial statement inclusion).
Shareholders being hit three times
Furthermore, naked bear speculation makes no
economic sense for the mine. By virtue of its net short positions the gold
mine assumes a vested interest in a lower and falling gold price which
clashes with its main mission of selling newly mined gold at the highest
possible price. Such division of loyalties is inadmissible for a firm
commissioned by its shareholders to convert wealth represented by ore
reserves into wealth represented by bullion in a most advantageous manner. The
managers of the 'hedging' gold mine have a schizophrenic stance as they are
prompted to pray for a higher and a lower gold price all at the same time. No
enterprise with a schizophrenic management team can survive the vicissitudes
of market competition and shareholders' ire for long. Shareholders get hit
three times through the schizophrenic action of the managers. First, income
is shaved every time the gold price is forced lower through short selling. Second,
capital is being destroyed as the falling gold price makes payable ore
reserves to disappear (i.e., become non-payable). Third and most serious is
the fact that the richest ore reserves are being frittered away for a
pittance at the artificially suppressed gold price, thereby materially
shortening the working life of the mine. Naturally, the share price will show
not only the shaving of income and destruction of capital, but the premature
aging of the gold mine as well.
Paper profit no profit
Advocates of this senseless practice, in particular,
the officers of Barrick Gold argue that these
losses are more than compensated for by the extra income the firm generates
from 'investments' made with the proceeds of forward sales. But insofar as
this extra income is encumbered with unlimited liabilities represented by the
fraudulent downstream hedge, it consists of paper profits that should not be
paid out in the form of dividends. In fact, they should not be reported as
profits in the first place. "There's many a slip between cup and
lip", as the proverb says. Hidden liabilities may force the firm out of
business before it has a chance to realize its paper profits. The practice of
window-dressing income statements using unrealized paper profits, especially
as they are encumbered with unlimited liability, is blatant fraud and no amount
of sophistry or government connivance will change that fact. It is the height
of insolence on the part of management to treat shareholders as simpletons
unable to understand the difference between paper profits on an open forward
sale contract, and profits that have been consummated by having them closed
out.
Bilateral hedging
Apologists for the practice of naked bear
speculation by gold mines try to push the blame on to the banks. They point
out that mines could not get financing unless they heeded the bid of banks to
sell forward several years of output as collateral for the loan. Let us leave
aside the fact that the banks in setting conditions involving fraud become
partners in crime. It is possible that they enjoy the same immunity from
criminal prosecution as the mines. Even then the argument is not persuasive.
The banks are not micro-managing the mines. The responsibility for fraudulent
forward sale of several years of output rests with mining management. It
could have used true hedging to satisfy the banks.
In the third, concluding part of this series I shall
describe in full details bilateral hedging. It is proper hedging that gold
mines can practice without harming anyone. It involves upstream hedging that
consists of forward purchases of gold, to compensate for the forward sales of
downstream hedging. This reveals that the compensating long leg of Barrick's straddle is missing. Therefore the so-called
hedges of Barrick constitute no valid arbitrage. They
are merely tools for illegitimate naked short speculation. They invite severe
punishment in a bull market. By contrast, bilateral hedging is for all
seasons. The mine prospers in a bull market as well as in a bear market.
A unilateral short hedge can always be converted
into a bilateral hedge through adding a compensating unilateral long hedge. Forward
sales should be matched by forward purchases. A bilateral hedge is the
combination of a downstream and an upstream hedge. It is a legitimate hedge,
as forward sales are compensated by forward purchases. It never gives rise to
unlimited liability.
For example, an upstream hedge is created by the
gold mine when a sudden fall occurs in the gold price. Since management is on
the look-out for new gold-bearing properties to buy, in order to replace ore
reserves that are being exhausted by its mining activities, the sudden fall
in the gold price represents a godsend. Yet the opportunity is ephemeral. The
falling gold price knocks down the value of gold-bearing properties and that
of the stakes of prospectors. However, the opportunity to buy the property or
the stake at such an excellent price is likely to elude the gold miner who
has to go through the lengthy process of searching the title and checking the
quality and quantity of gold ore in the ground. By the time this process is
completed, the gold price might have surged forward making the opportunity to
add to ore reserves at a reasonable price disappear.
To lock in a favorable
price is possible nevertheless through the forward purchase of gold. The
miner creates a straddle or upstream hedge, the long leg of which is a long
position in the futures market, while the short leg is the gold-bearing
property under negotiation. Care is taken to match the value of the property
with the number of futures contracts to purchase. When the deal is closed out
and the property is bought, the long leg is lifted and the upstream hedge
unwound. The point is that the miner is under
no time pressure to close out the deal prematurely. Even if eventually he is
paying more in consequence of the surging gold price, the miner is
compensated for that by profits on the long leg of his straddle. It is true
that there would be a loss on the long leg if the gold price fell further. This
is no problem, since the lower price paid for the gold-bearing property will
take care of that loss. Adding the upstream hedge converts unilateral into
bilateral hedging. It makes the illegitimate forward sale of several years'
mine output legitimate. The short leg of the downstream hedge is compensated
for by the long leg of the upstream hedge. The forward purchase removed the
unlimited liability that was created by the forward sale of gold. The
fraternity of gold speculators will return to their traditional haunt, the
long side of the gold market. Gold investors are not hurt by the hedging
activities of the gold mines, provided the hedges are proper.
Figuratively we may describe the proper hedges of a
gold mine as a four-legged straddle. Two legs are in the upstream and
the other two in the downstream market. The short leg downstream (forward
sales) is counter-balanced by the long leg upstream (forward purchases) -
just as the long leg downstream (gold in the ground about to be mined)
counter-balances the short leg upstream (gold property about to be acquired).
The gold mine is uniquely positioned to take
advantage of the fluctuating gold price through buying and selling gold
futures virtually risk free. Bilateral hedging may increase the
profitability of a gold mine manifoldly.
Gold Standard University Live
Gold Standard University
Live has just completed its Session Two at the Martineum
in Szombathely, Hungary. Session Three is planned
in Bessemer (nearest airport Birmingham),
Alabama, U.S., in February 2008. It will
feature a one-week course entitled Adam Smith's Real Bills Doctrine. An
advocatus diaboli
from neighboring Mises
Institute will be invited to come and challenge the wisdom of Adam Smith.
The session in Alabama will also feature a blue ribbon
panel discussion on the subject of True Hedging for Gold Mines. Representatives
of hedged and unhedged gold mines will be invited
to participate. The present series
Peak Gold!
is a primer on true hedging, and a book is planned
that would cover the proceedings of the conference.
For the benefit of prospective participants from Europe, Session Three may be repeated at the Martineum in early March, 2008, provided that a
sufficient number register.
This is a preliminary announcement only. Stay tuned.
For more information please contact:
GSUL@t-online.hu.
References
A. E. Fekete, Peak
Gold! (Part One), August 17, 2007
A. E. Fekete, Have
Gold Bugs Been Barricked by the U.S.? July 12, 2007
A. E. Fekete, Gold
Vanishing Into Private Hoards, May 31, 2007
A. E. Fekete, To
Barrick Or To Be Barricked, That Is the Question, August 11, 2006
A. E. Fekete, The
Texas Hedges of Barrick, May, 2002
Charles Davis, So Big It's Brutal, Report on
Business, The Globe and Mail: Toronto,
June 2006, p 64.
Bob Landis, Readings from the Book of Barrick: A Goldbug Ponders the
Unthinkable, www.goldensextant.com, May 21, 2002
Richard Rohmer, Golden Phoenix: The Biography
of Peter Munk, Key Porter Books,
1999
Ferdinand Lips, Gold Wars,
Will Hedging Kill the Goose Laying the Golden Egg? p 161-167, New York: FAME, 2001
Antal E. Fekete, Towards a Dynamic Micreoeconomics,
Laissez-Faire (Universidad Francisco Marroquín,
Guatemala City)
No. 5, September, 1996, pp 1-14)
George Bush's "Heart of Darkness" -
Mineral Control of Africa, Executive
Intelligence Review,
January 3, 1997, see in particular:
Barrick's Barracudas
Inside Story: The Bush Gang and Barrick, by
Anton Chaitkin
George Bush's 10 billion giveaway to Barrick, by Kark Sonnenblick
Bush abets Barrick's Golddigging,
by Gail Billington
See also: http://american_almanac.tripod.com/bushgold.htm
Stop the Press!
There is wild speculation in Newmont stock on rumors that it is a candidate for a hostile takeover by Barrick. Barrick has denied the
rumors; Newmont refused to comment. (Reuters,
August 28). So it boils down to the question whether you can believe Barrick. A penny for my thought? Newmont is worth far
more under its present management that has courageously unhedged
it, than it could ever be worth under the management of Barrick,
which is grieviously
lacking both in courage and vision. Barrick is
still wedded to its idiotic hedge plan, stewing in its own juice as a
consequence. Newmont could introduce bilateral hedging, the only true hedge
plan for a gold mine, to be described more fully in the next instalment of Peak
Gold! I cannot help but think that Barrick is
acting out of desperation, in trying to dilute its hedgebook
through hostile takeover of unhedged mines. For the
latter, it is a kiss of death. Where is Homestake,
the legendary flagship of the American gold mining industry?
Barrick's management
could spend its money far more efficiently if it bought back its hedge book,
rather than buying out Newmont, which has a vision Barrick
is sorely lacking. What are we to make of Barrick's
masochistic prognostocations of a higher gold price
both in the short and long term? Company spokesman Vincent Borg is cheering
shareholders that they can expect to derive further leverage as Barrick will continue to expand margins. The only fly in
the ointment is that it may not be Barrick, but its
successor picking up the goodies from receivership, who
will reap those benefits.
The key risk for Barrick
at this point is in the future course of gold lease rates. This much was
admitted in the company's 2006 Annual Report. It is true that they do have
some lease rate swaps. However, these do not protect them against gold going
into backwardation as a result of gold lease rates significantly exceeding
U.S. dollar interest rates. Another way of saying this is that Barrick would be in a heap of trouble if gold demand
greatly exceeded available lease supply. There is no way to hedge against
this. The key to Barrick's fate can be gleaned from
the second paragraph on page 54 of its 2006 Annual Report. It was this statement
- clinging to the hope of maintaining the status quo on the future
availability of leases - that convinced me Barrick
was going to be in a huge amount of trouble if it did not amend its ways, and
soon. Judging by its insistence on the self-anointed brilliance of the
remaining "Project Gold Sales Contracts" (having closed out, for
the most part, its "Corporate Gold Sales Contracts"), Barrick has earned the title of THE tragic figure of gold
mining: a latter-dayTantalus: hungry and
"tantalised" by the sight of most gorgeous foodstuffs floating by
he mustn't touch.
Barrick has staked its
very existence on a continuing surplus of leasing over hoarding - at best a
dubious assumption. Thus Barrick has made itself
into the corporate antithesis of the monetary ascendence
of gold.
My fears have been sadly confirmed. Barrick does not have and is unable to raise the money to
buy back its hedge book, but it apparently tries to wriggle off the hook
through acquiring more unhedged companies. It would
pay for the acquisition with Barrick stock. No, not
again! Stockholders of Barrick are to be barricked to death!
If the rumors are true,
the takeover drama is not without its humorous aspect. The poison pill of
unilateral hedging that has been swallowed by Big Fish by now it is causing
indigestion and cramps. Now Big Fish wants to feed on fish that have just
regurgitated theirs!
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.
Antal E. Fekete
Professor,
Intermountain Institute of Science and Applied Mathematics, Missoula, MT 59806, U.S.A.
Gold Standard University
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.
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