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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.
References:
• Gold Wars, by Ferdinand Lips: Will Hedging Kill
the Goose Laying the Golden Egg? pp 160-167, New York (FAME), 2002.
• Revisionist View of the Great
Depression by A. E.
Fekete
• Readings from the Book of Barrick: A goldbug ponders the unthinkable, by Bob Landis, http://www.goldsextant.com
Antal E. FEKETE
aefekete@hotmail.com
May 20, 2002.
_________________________________________________________
Antal E. Fekete is Director of Research and Education at the Ferdinand
Lips Institute, Zurich, Switzerland. . Born and educated in Hungary, he emigrated to Canada after the Hungarian Revolution in 1956
and taught for 35 years in the field of mathematics. Over the years, he has
been a visiting professor or Fellow at Columbia University, Princeton
University, and Trinity College of Dublin. He worked in the Washington office
of Congressman W.E. Dannemeyer on monetary and
fiscal reform for five years in the nineties; and in 1996, he won first prize
in the prestigious International Currency Essay contest sponsored by Bank
Lips Ltd. of Switzerland. He is the author of Gold and Interest and Monetary
Economics 101. In addition, his scholarly articles have appeared on
numerous Internet sites throughout America.
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