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The Gold Stock Strategist analyzes leading junior gold producers and major gold mining companies.

Comments are welcomed!

Monday, September 14, 2009

Barrick De-hedging is Latest Move in a Modern Day "Gold Rush"

The world's largest gold producer, Barrick Gold, announced last Tuesday it intends to pay off its entire book of fixed price gold hedges and a portion of its floating hedges to gain greater exposure to the market price of gold. This move is very bullish for Barrick's share price despite the issuance of new shares and dilution for current investors.

It's also another very strong signal from sophisticated operators who know the gold market best--gold mining company executives. These operators have the most on the line when they move from the certainty of having future production sold at locked-in rates to an environment in which their fortunes are fully leveraged to the price of gold.

Barrick's de-hedging action is the latest move in the modern day "gold rush" by gold producers to reduce or eliminate gold hedges. In the past year, several companies have significantly reduced their gold hedge book including Newmont Mining (NEM), AngloGold Ashanti (AU), Lihir Gold (LIHR), Sino Gold, Newcrest Mining and others. Barrick (ABX) already reduced its own gold hedge book by one million ounces last year.

Barrick’s share price has been lagging peers because of the rising spread between its gold hedge price and the spot market price. As the price of gold continues to rise, opportunity cost is rising because of the increasing spread between the hedge price and the spot market price for gold. De-hedging enables Barrick's future earnings and current valuation to grow with the price of gold.

Barrick had 3 million ounces of gold in fixed price hedges and 6.5 million in floating hedges for a total of 9.5 million ounces of gold hedged—representing 128 percent of Barrick’s annual production for 2009. Barrick’s projected production for 2009 is 7.4 million ounces of gold.

The gold hedges contractually obligate Barrick to sell its production at an average of about $396 per ounce, guaranteeing certainty in cash flow for the company from 2011 to 2019. In a rising price of gold environment, investors see the negative impact on earnings because the company had committed to sell gold production at prices much lower than the current spot price.

Critics of the move point to the dilution caused by the de-hedging, ignoring the boost to future earnings with rising gold prices. The critics would do well to understand two things. First, the market has already priced in this growing hedge book liability. As a result, de-hedging has a positive impact on the company's share price with improved leverage to the price of gold. The hedges were primarily dedicated to the development of the Pascua-Lama project in Chile, the largest green fields gold mining project in the world. As Pascua-Lama comes on line, overall profitability should increase as Barrick sells production at a much higher price than the original hedges.

Secondly, the price of gold is in the middle of a long-run bull market. Extraordinary fiscal and monetary policy measures enacted since the global financial crisis of 2008 are likely to create pressure for higher price inflation in the future. Gold is a traditional hedge against price inflation and likely to increase in value. Gold producers can expect to benefit as a leveraged play on the rising price of gold.

Barrick's initial de-hedging plan was announced on September 8 to raise $3 billion from a share offering at $36.95 a share. Proceeds will be used to pay off the Company's gold hedges. On Thursday, September 10, Barrick released news that underwriters RBC Capital Markets, Morgan Stanley (MS), J.P. Morgan Securities and Scotia Capital exercised an over-allotment option, enhancing the entire agreement to $4 billion. As a consequence of the financing, Barrick's common shares outstanding will increase to roughly 982.7 million from about 874 million currently—a 12.4 percent share increase.

The company will incur debt for the remaining $1.6 billion needed to close out the hedge agreements for a $5.6 billion charge to shareholder equity in the third quarter. The gold hedge contracts will be closed over the next 12 months.

In terms of scale and effect, Barrick's move to de-hedge the fixed price contracts alone (3 million ounces) is equivalent to reducing total annual global production of gold for all gold producers by about 4 percent. The additional floating price hedges (6.5 million ounces) represent an additional 7 percent of annual global gold production for a grand total of 11 percent of annual global production. This is very bullish for gold going forward and a key reason the price ended last week above $1,000 an ounce, the highest end-of-week close ever.

Barrick Gold is more attractive to investors with this action now that the company is increasingly leveraged to the price of gold.

Disclosure: No position


Barrick Gold, already up over 7% since July 31 after an initial recommendation by the Gold Stock Strategist newsletter, has the sixth highest return among the newsletter's overall model portfolio of 9 current and emerging gold producers.

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