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Producer Hedging

A hedge is a transaction that acts to manage the risk of adverse price movements in an asset such as gold. Gold producers typically enter into hedging contracts for one of three reasons. The first is in order to secure a forward premium in price. The second reason is to seek to protect revenues against falling gold prices, while the third is as part of the terms of a financing package. The simplest method of hedging is the forward sale, whereby a producer enters into a contract in which it can receive a fixed payment for a certain amount of gold at a predetermined date in the future. Regardless of any price movement between entering into the contract and its expiration, the producer will realize this guaranteed price on delivery.

There are three main parties involved in a basic gold hedge contract: the producer; the bullion bank, which acts as the producer’s dealer; and a central bank. To place a hedge, the producer advises its dealer that it wishes to forward sell, for example, 1 tonne of metal. The dealer then immediately borrows this amount from a central bank (paying a leasing fee), which it immediately sells into the spot market, agreeing to return the 1 tonne by a certain date. The proceeds from this sale are then placed in a high-yielding cash account (subtracting the dealer’s fee and the leasing fee on the borrowed gold), usually generating a premium for the producer. The producer is obliged to return 1 tonne of gold to the bullion bank by the preagreed date. At the time of implementation, the action of the bullion bank of borrowing gold and selling it into the spot market increases the supply of gold to the market. However, when the gold is returned, usually by delivering mine production from the producer’s account, supply reaching the market is correspondingly constrained. Hedging activity therefore represents an acceleration of supply to the market, but the overall balance of supply and demand is maintained over the lifetime of the transaction.

Hedging and de-hedging activities are thus important in the wider gold market. To give a historical perspective, the 1990s were largely characterized by unrelenting downward pressure on the gold price, which led to steadily increasing levels of hedging undertaken by producers who were seeking revenue protection from further declines. In 1995, hedging had a particularly noticeable impact, reaching 475 tonnes and thus accounting for about 13% of total supply. By September 1999,however, the gold price had made an abrupt change of direction and started to climb. Many hedged producers were caught off-guard and were unable to take advantage of soaring spot prices. On the back of this crisis, the year 2000 was the first year since the late 1970s when the global producer hedge book did not expand. There has since been a protracted period of de-hedging, in which producers have both delivered into and also prematurely closed out their hedge contracts. This is accomplished either by bullion purchases from the market, delivered to the bullion bank,or through delivering their own production into contracts before they mature. De-hedging posted a record level of 447 tonnes in 2007, representing just over 11% of total gold demand. Expectations for higher gold prices and investors’ associated anti-hedging sentiment were the chief reasons for this.

It can be seen that, pre-1999, producer hedging activity was a significant supply component in the gold market, whereas post-1999, hedging activity became a significant demand component of the market. Today, many more exotic and complex financial derivatives and option structures exist, in addition to the humble forward sale, through which producers can hedge. The effect of these more complicated contracts is, however, ultimately the same: hedging activity by gold producers affects the timing of mine supply reaching the market.