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There
is a fundamental difference between speculation and arbitrage. The speculator
deliberately takes large risks in the hope of large profits. The arbitrageur is
not interested in increasing risks, in fact, he wants to reduce them. His
main instrument is the straddle with two legs: a long leg
representing purchase in one market, and a short leg representing a
compensating sale in another. In closing out the straddle both legs must be
lifted simultaneously, otherwise the arbitrage is turned into speculation.
The activity of the arbitrageur is also known as hedging, and another name
for a straddle is a hedge. As the objectives of speculation and arbitrage are
diagonally opposite to one another, it is a bad mistake to confuse the two,
as is the case all too often. This confusion is epitomized by the story about
the Texas rancher. When it was pointed out to him that the long positions in
cattle futures he was affectionately calling "me hedges" were in
fact no hedges at all because they lacked the short leg, he proudly answered:
"them are Texas hedges". The title of this paper suggests that the
hedges of Barrick are no hedges at all because they lack the long leg.
Limited
versus Unlimited Liability
Worse still, the Texas hedges of Barrick represent an unlimited
liability, in contrast with those of the rancher which represent but a
limited liability. This difference is due to the fact that while the price of
a commodity can never fall below zero (thus limiting risks involved in a
forward purchase), there is no identifiable limit above which it may not rise
(thus making risks involved in a forward sale unlimited). Another way of
expressing the same fact is that Barrick's Texas hedges are subject to a
short squeeze and, possibly, a corner. By contrast, there is no way to
squeeze or to corner the rancher on account of his net long position. It is a
fundamental fact of commodity markets that only the bears can be squeezed and,
if the worst comes to the worst, cornered. Bulls are immune.
Total
net short sales must never exceed one year's output. If Barrick and its
epigoni limited their forward selling activities to one year's output, then
one could argue that their hedges were legitimate. But the hedging program of
Barrick and its imitators call for the forward sale of several years' output.
The justification for limiting net forward sales to one year's output is that
a hedge larger than that is programmed to self-destruct within a year. Mine
output is sold and the long leg lifted by the end of the fiscal year, so the
short leg must be moved forward to the next. If the open short leg is
profitable, paper profits are paid out in the form of dividends. Paper
losses, if any, are suppressed. This exhausts the concept of a fraud. The
practice transgresses the bounds of prudence and integrity. A gold mine
selling forward in excess of one year's output is concealing a potentially
unlimited liability. The shareholders and creditors are misled.
Barrick's
Apology
Barrick argues that all its hedges are proper, regardless whether one or more
years' output is sold forward. In either case there is a long leg, namely,
gold in the ground owned by the company.
The
apology is lame. In case the hedge plan is limited to one year's output the
gold sold forward is no longer in the ground but already in the production
pipeline. It is gold on the move. It will reach the market and be sold
to the cash-paying customer in less than a year. It is very different economically
from gold sold forward under an unlimited hedge plan, which is tied up in ore
bodies deep down below surface. It is gold that is not moving. It
cannot be considered as a proper long leg for hedging, nor as a proper
collateral for gold loans. The company may go bankrupt before it can be dug
up and put into marketable form. Borrowing gold short-term against such a
phoney collateral in the hope that the gold loan can be rolled over several
times until many years later the borrowed gold is replaced out of mine
production is gambling, not hedging.
Spot-Deferred
Contracts
This also exposes the fraud involved in Barrick's much-vaunted spot-deferred
contracts. These can be characterized as a forward sale with margin calls
swept under the rug. Barrick has the option of either delivering the newly
mined gold into the hedge book, or selling it in the open market. It is in
its interest to do the former if the gold price is below the forward sale
price; otherwise it will do the latter. This sounds too good to be true, as
normally an embarrassing and financially onerous margin call would be in
order whenever gold was trading above the forward sale price. But we are told
that there would be no margin call (mind you, we are not allowed to read the
small print in the contract). After all, what goes up must eventually come
down, mustn't it? Margin calls are for the financially weak, who cannot ride
out storms. The financially strong can. They just wait until the gold price
comes down to make the forward sale profitable again. Barrick boasts
that the final settlement of its spot-deferred contracts can be put off as
much as 15 years. But what if the gold price stays up for 15 years? Come,
come, don't be ridiculous. The chart for the past 15 years clearly shows that
every time the price goes up, sooner or later it will come down, returning
the spot deferred contract to profitability. But gold has been around a lot
longer than 15 years. Wouldn't it be advisable to examine charts covering a
longer period? Barrick is not interested: history started when Barrick was
established.
Jamie Sokalsky,
Senior Vice President and CFO, is on record as saying that Barrick has the
unique flexibility to defer settlement on its contracts up to 15 years, which
is ample time for the high-flying gold price to return to earth. "If the
price of gold shot up to $600 and stayed there for 15 years, we would still
realize every cent of that increase." Every cent? Bob Landis is
pondering the unthinkable (see References below). Assuming that annual production
stays at the same level of 6 million ounces, Barrick's proven and probable
ore reserves of 82 million ounces would be more than exhausted in 15 years.
The situation would then be as follows. The 82 million ounces have been sold
in the open market. Barrick would have zero ore reserves left, and a
liability to return 18 million ounces of borrowed gold to the owners. I may
add a small correction to the study of Bob Landis: Barrick's proven and
probable reserves would actually be larger at $600 gold than they are now.
But his point is well-taken: the cost of liquidating the liability of owing
18 million ounces of gold, if the gold price goes to more than $600 and never
drops below it for 15 years, is so huge that it may well ruin the company
financially. This cost cannot even be estimated as we haven't got a clue
about the cost of replacing ore reserves when gold is selling above $600, nor
about where Barrick's liability, to restore to the owners 18 million ounces
of gold it hasn't got, would take the gold price.
The prospect of
gold going past $600 never ever to fall below it, so that the spot-deferred
contract can never ever be closed out profitably even if Barrick gets
perpetual deferral, cannot be ignored. Rather than being a wonderful flexible
marketing tool, doesn't the spot-deferred contract look more like an
invitation to bankruptcy?
Margin call by
another name
On May 8, 2002, at its Annual Meeting, Barrick made an important
announcement. It is simplifying its Premium Gold Sales Program. It will close
its book on gold call option writing and variable price sales, to go back to
the simple spot deferred program, in order "to be better positioned to
take advantage of rising gold prices". But there is also a change in the
spot deferred program. The company will no longer invest part of the proceeds
from the spot deferred contracts in the bond market, but "will instead
leave all proceeds invested with its bank counterparties".
This gives the
lie to earlier boastful statements that margin calls are for the financially
weak, but not for Barrick. Lo and behold, the modest recent gains in the gold
price have resulted in a margin call on options written by Barrick, forcing
it to close them out. But, more surprisingly, there is a margin call, if by
another name, on the cherished spot deferred contracts, too. The "bank
counterparties" no longer allow Barrick to do as it may see fit with the
proceeds from the spot deferred sales. They are put in escrow, pending on
performance on the delivery schedule of newly mined gold into the hedge book.
Nice try,
Barrick, to put a positive spin on the margin calls you have been innocent so
far. But it won't work, because your shareholders are not stupid. They know
that there is no margin call on short sales in a declining market. But they
also know that it will hit you with full force in a rising one.
The bullion banks
had an easy time to lead the mining executives of developing countries into
temptation and to their destruction with their sweet siren song. As the
shareholders of Barrick may realize, somewhat belatedly, Jamie Sokalsky is no
Odysseus. He, too, allowed himself to be tempted by the siren song and, as a
result, Barrick may go the way of Ashanti and Cambior.
Hedges off
balance sheet are fraudulent
No wonder that it is off balance sheet where Barrick keeps its Texas hedges.
They could not suffer the light of day. They cover shady deals that may
benefit management, but certainly not the shareholders. As a matter of
principle all hedging activity should be reported openly and fully on the
books. It should be transparent, and everybody should be able to see for
himself that the hedges remain profitable after both legs have been lifted
and the hedge unwound. But this is impossible for a contract that has 15
more years to run. So off balance sheet we go. Never mind that hiding an
unlimited liability constitutes a fraud.
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 for everyone else. They
allow mines to sell forward several years' gold production, but they would
immediately blow the whistle if, for example, an agricultural producer tried
to do the same in selling forward several years' grain production. There is
no justification for this double standard. It is a scandal 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, will end up being sold for cash and which, for that
reason, the borrower may never be able to replace. Central banks are
accomplices in the scheme of fraudulent hedging as they report gold that had
been sold as if it was still sitting in their vaults.
To recapitulate,
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. Such a 'naked bear' speculation is not only illegitimate as
it falsifies the balance sheet and conceals an unlimited liability. It also
makes the prospectus meaningless as no mention in it has been made of any
intention to indulge in short selling that will inevitably result in the premature
exhaustion of the ore reserves and in the dissipation of the most valuable
resources of the mine at an artificially low price. On this ground alone
Barrick is open to class-action suits by the shareholders.
Competitive Short
Selling
Furthermore, naked bear speculation makes no economic sense. By virtue of its
short position Barrick assumes vested interest in a lower and falling gold
price, which clashes with its main mission to sell newly mined gold at a
higher and rising 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 Barrick 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 schizophrenic managers can survive the vicissitudes of market
competition and the shareholders' ire for long. Shareholders get hit three
times through the schizophrenic action of the managers of the mine they own.
Firstly, income from the mine is shaved every time the gold price is forced
lower through short selling. Secondly, capital is being destroyed as the
falling gold price makes payable ore reserves to disappear (i.e., to become
non-payable). Thirdly and most seriously, the richest and most valuable ore
reserves are squandered for a pittance at the artificially suppressed gold
price, thereby materially shortening the working life of the mine. The share
price will ultimately show not only the shaving of income and destruction of
capital, but the premature ageing of the mine as well. The Texas-type hedging
policy of Barrick gives rise to competitive short selling every time the gold
price may be ready to break out of its coffin. This is extremely damaging to
the interest of the shareholders. No producer with such an inflexible and
self-defeating marketing strategy can, or deserves to, survive.
Paper Profit is
No Profit
The officers of Barrick argue that these losses are more than compensated by
the extra income the firm is generating from 'investments' made with the
proceeds of forward sales. But insofar as this extra income is encumbered
with unlimited liabilities represented by the Texas hedges, that is to say,
naked short positions masquerading as legitimate straddles, this income
consists of paper profits that should never be reported as profits, let alone
paid out in the form of dividends. "There's many a slip between cup and
lip", says the proverb. Hidden liabilities may force Barrick to go out
of business before it has a chance to realize its paper profits. The practice
of window-dressing the firm's financial statements using unrealized paper
profits, especially as they are encumbered with a potentially unlimited
liability, is blatant fraud and no sophistry or government connivance will
change that fact. It is the height of insolence on the part of Barrick to
treat its shareholders as simpletons unable to understand the difference
between paper profits on an open short position, and profits that have been
consummated by closing out a short position.
That you can
never fool all the people all of the time is borne out in the case of
Barrick. Shareholders are voting with their feet. From the bottom in November,
2000, the XAU index of gold stocks rallied about 73% while the stocks of gold
mines without a hedge book on average rallied a remarkable 185%. Meanwhile
Barrick hardly managed to add a paltry 33% during that 17 month period. This
repudiates the absurd claim of Barrick's officers that they could con the
market by selling gold at prices well above the highest price the market has
been able or willing to quote during the year under purview.
The Bearish Case
Market sentiment turned decidedly bearish when Barrick introduced its
Texas-type hedge program some fifteen years ago, and a large part of the
industry mindlessly followed the leader. Although the scheme was hailed as
proper arbitrage for the benefit of the shareholders, in reality it was naked
bear speculation on the gold price enormously harmful to shareholder
interest, and most detrimental to the mines as their working life was
drastically shortened and their best ore reserves frittered away.
Speculators have
traditionally been bullish on the gold price. They were well aware that the
irredeemable currency in which the price of gold is quoted is historically
nothing more than a dishonored promise to pay a fixed quantity of gold. After
the default it could be exchanged only for diminishing quantities. That is,
to be precise, until no gold whatever would be offered in exchange for it by
anybody, anywhere. At that time the banker responsible for issuing the
promise would feel compelled to leave the scene of his business (usually in
disguise and under the cover of the night). Speculators knew this, and were
willing to keep a cushion under the price of gold.
However, the
cushion was removed as speculators started abandoning the long side of the
gold market in droves. Who can blame them? They were not the first to betray
the yellow metal. When producers of gold join the bearish camp, the
speculator who tries to eke out a living by trading gold has no choice but to
become active on the short side of the market. As a consequence, there was
competitive selling every time the price of gold showed the slightest sign of
life. Gold miners and speculators were falling over each other while rushing
in to club down the price of gold as it was trying to climb out of the hole.
Thus was every single budding rally beaten back in the gold market for the
past fifteen years, in consequence of the hare-brained scheme of Texas
hedging.
Speculators were
not the only ones to be alienated from gold. Investment demand has
practically dried up. Not very long ago every Swiss banker advised his
clients that common prudence dictates to keep 5 to 10 percent of one's assets
in gold or gold-related investments. Today no Swiss banker will make a loan
on gold collateral security. The consensus is that the so-called hedging
program of the gold mining industry has effectively capped the price of gold.
Worse still, the central banks' selling and leasing policy has opened up an
abyss. Into this, in the opinion of many, the gold price must ultimately
fall. Gold has been demonetized, they say, first by governments and then by
the market as well. By now it has become scrap metal which central banks are
still foolish enough to spend a fortune to store. It would make better sense
to sell it if need be at scrap values, the doomsayers insist, and invest the
proceeds in earning assets such as government bonds, or even common stocks
— as the president of the Bundesbank has recently suggested.
The Bullish Case
The fraud involved in Texas hedges carries with it its own punishment. It may
not be immediate, but it is certainly coming. Barrick and other gold bears
are digging the very ditch in which the gold bulls will trap them. Don't ask
the question when; the bulls won't tell you. But the grand squeeze is coming
with the same certainty as day follows night. When the first signs of the
squeeze appear, market sentiment shall suddenly change. Alienated gold
speculators will abandon the short side of the market and will return to
their traditional spot on the long side. They are alive to gold's continuing
monetary role. They have not been taken in by the silly propaganda about gold
demonetization. Speculators are keenly aware of the fact that paper
currencies of the world are but dishonored promises to pay gold. They
understand full well that fluctuations in the gold price, far from
representing an uncertain value for gold, reflect the uncertain value of
fast-depreciating irredeemable paper currencies. Speculators make it their
business to know that the value of everything, including that of paper money,
approaches the marginal cost of production — which is just a polite way
of saying that ultimately all fiat money is destined to become worthless, so
colorfully demonstrated by history. When it happens again the monetary
metals, gold and silver, will be the only refuge for the hapless citizen
trying to secure a financial future for himself and for his family.
Mene Tekel
The investment demand for gold will, Phoenix-like, rise from its ashes. As
the bearish bias created by Texas hedges disappears, friends of the precious
yellow (alias gold bugs) will be rewarded for their patience and
perseverance. The bogey-man of central-bank gold sales will be exposed as a
scarecrow. At any rate, it could scare unsophisticated crows only. People
with an analytic mind did always see through the cheap trick. They understood
that the threat of central bank gold sales was empty gesture. A central bank
selling gold can in no way strengthen its balance sheet. Quite the contrary,
it weakens it gravely, perhaps fatally, with incalculable consequences to the
value of its bank notes. The central bank gives up the best possible monetary
reserve in the asset-column: gold that is nobody's liability as it never
enters the liability-column of the balance sheet of another central bank, in
exchange for the worst: the irredeemable promises of devaluation-happy
governments. It discards a default-proof asset and replaces it with a default-prone
one.
It is not known
whether or not officers of Barrick see the Biblical writing on the wall that
reads: "Mene tekel upharsin" (you have been put on the scale
and found wanting). It can be allegorically interpreted as an admonition,
relating to the value of irredeemable currencies. It is possible that these
officers are 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.
Barrick, the hit
man
But it is also possible that they are not free agents. Barrick could be a
front, that is, a hedge fund masquerading as a gold mine, set up in order to
promote the aims of another conspiracy, far bigger in scope. We are referring
to the conspiracy of bond speculators to drive the rate of interest down to
zero in order to pocket capital gains on their immense bond (and derivatives)
holdings. Don't laugh. Bond speculators in Japan already succeeded in
achieving that goal. Moreover, the mechanism to drag down American interest
rates in the wake of Japanese is already in place. It is called the yen-carry
trade. The $100 trillion derivatives monster expanding exponentially may give
you a foretaste of the power of bond speculators. That monster serves one
purpose only. The purpose is to make the super-fast breeding of long
positions on bond futures possible, well beyond the limits set by the amount
of bonds in existence. (Goodness knows dollar debt is being created by
fast-breeders, but this is still not fast enough for the bond speculators!)
It appears likely
that the big American and Japanese banks are the faceless leaders of this
conspiracy to drive down the rate of interest to zero. For the Japanese this
is a matter of life and death, so badly do they need capital gains from the
bond portfolio to mend the enormous holes in their balance sheets. The big
American banks know, they have been there, and they have mended theirs by the
same techniques. The gold-carry trade is just a small albeit indispensable
part of this global conspiracy. As long as gold can be shut out as an
investment vehicle, there will be a captive market for government bonds. This
captive market is indispensable for the elimination of risks facing the bond
speculating conspiracy. (I have written in greater details about this in the
paper "Revisionist View of the Great Depression", see References
below).
According to this
script Barrick was hired by the bog banks as the hit man, trying to hold the
gold price in perpetual check. If the price of gold could somehow escape from
the coffin whose lid was nailed down with Texas hedges, then the investment
demand for gold would turn the bond market into a "killing field".
Field where the big banks are slaughtered, and the value of the dollar is
wiped out. Those are the stakes. It appears that the hit man carries on his
shoulder the entire $ 100 trillion derivatives monster, as Atlas used to
carry the ancient universe on his.
Corner by another
name
Thus the fate of the conspiracy to plunge the world into another Great
Depression by driving interest rates to zero boils down to this question: Can
the hit man do the job? This takes us back to the question of squeezes and
corners.
Scholarship
on corners is scant. Most experts agree that historic corners were successful
only in the light of superficial analysis. A deeper understanding shows that
a true corner is an historical rarity. Economic theory also suggests that
corners are no longer possible, certainly not in the 21st century
economy supported, as it is, by instant telecommunication and next-day
door-to-door delivery, world-wide.
But is it really
a fact that there have been no true corners in the past and, as far as the
future is concerned, no commodity can ever be cornered in peacetime? Well,
whatever can be said of other commodities, there is certainly one for which
it is not true. At least one commodity is exceptional in that it could
be cornered, next-day delivery notwithstanding. Never mind that the
corner does not come about by design, but is brought about spontaneously, by
gut reaction and fear.
Gold has been
cornered several times in the past. There is no reason to believe that it
could not be cornered again in the future provided that conditions are ripe.
Consider the following scenario. The Federal Reserve is desperately trying to
combat deflation brought about by bond speculators out in force to drive the
rate of interest to zero. The Fed is printing dollars working the presses
overtime, but these dollars are snapped up by the bond speculators even
faster than they come off the presses. So the process must accelerate, and
will start spinning out of control. At one point the bond speculators will
get scared and decide to cut and run. As they dump the bonds, they trigger a
credit collapse. The government's credit will be ruined. Interest rates will
go to outer space together with the price of marketable commodities. There
will be a fast, fatal, and irreversible loss in the purchasing power of the
dollar. In short, a runaway inflation. A runaway inflation is but a corner
in gold by another name. It is rather naive to believe that the Texas
hedges of Barrick can stem the tsunami of the coming gold corner.
Antal
E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
Read
all the other articles written by Antal E. Fekete
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
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. THE CONTENT OF THIS LETTER 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. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright © 2002-2008 by Antal E. Fekete - All rights reserved
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