Gold miners maximized their gold exposure in the bull market, but this has made some miners vulnerable to the metal’s pullback.
John Bridges and Anant Inani of JPMorgan Chase & Co. (NYSE:JPM) believe gold companies have to be shaped to prosper in both up and down gold markets. This probably means that some gold equities will have to be significantly restructured in the next 6 to 12 months. They don’t see gold hedging as a “solution” to the industry’s problem, but do believe that some tactical hedging could be helpful. They hope the tool is not ignored because of prior mistakes. Even though an overdose of painkillers can be fatal, we don’t stop using them when indicated.
Gold hedging can help smooth adjustment
Gold hedging can help smooth adjustment. The gold sector is in a forced transition from a business that was growth focused into one that is necessarily targeting positive free cash flow. While hedging can never substitute for efficient operations, it might be a useful tool to protect revenues while essential changes are made to the mines’ cost structure or to get a miner “over the hump” of a major capital program.
Investor supportive of a cashing out strategy
In JPMorgan Chase & Co. (NYSE:JPM) recent investor survey, 43 percent of respondents were supportive of a “cashing out” strategy. As part of this strategy some might like a gold miner to lock in a gold price and simply distribute free cash flow until all reserves are depleted. One key problem with this policy would be that regulators today require that a large entity backstop the environmental cleanup and rehabilitation of the site after mining. In the past insurance companies offered this service, but today most mining companies commit to rehabilitate their mine sites.
Large, long-term hedges in the 1980/90s were helped by very well controlled mine inflation. As can be seen from the chart below, mine inflation as reported by GFMS was very muted.
More recently, mine costs have been more volatile. This could prevent long-term hedges since once signed the sales prices are fixed and this would add risk if costs were still rising.
The risk of hedging could be falling. The chart below shows the strong correlation between a commodity currency and the cash cost of producing gold in US$. If the A$ continues to weaken, cash costs should fall. However, costs don’t have the technology advantage of the 1980s and 90s, when young, higher grade mines were benefiting from advances in equipment and economies of scale.