A Primer on True Hedging,
Antal E. Fekete
Gold Standard University Live
Sep 10, 2007
In earlier papers I have explained
that virtually all activities of gold mines that go under the
name "hedging" are fraudulent. To the extent hedges
go out into the future more than one year, or they exceed the
quantity of one year's production, they are naked forward sales,
carrying unlimited risk (the risk that the gold price
goes to infinity, as it has in the wake of every hyperinflation).
To understand the motivation
to resort to fraud, and to shoulder unlimited risk to boot, we
must remember that the combined short positions in the futures
and derivatives markets on gold greatly exceed monetary gold
in existence. Without compulsively selling paper gold, a short
squeeze and even a corner in cash gold could develop if the longs
decided to call the bluff. Thus any exposure to the short side
forces pyramiding to fend off the danger. On the other hand some
shorts, especially bullion banks, have found the creation of
ersatz gold a profitable business. They play a cat-and-mouse
game with the longs. They have fashioned the rules of gold exchanges
and ETF's in their own favor in order to make delivery a cumbersome,
expensive, and time-consuming procedure. As a result the price
of gold could be thrown into a hole so that, whenever it tried
to climb out, 'hedgers' and speculators would rush in and club
it down. The shorts can get away with it because the supply of
paper gold (futures and option contracts) as well as unmined
gold in the ground is virtually unlimited and can be mobilized
in the anti-gold campaign.
It speaks volumes of the inherent
strength of gold that it could climb out of the hole in 2001
in spite of a terrible assault to push it back. The 20th century
belonged to the enemies of gold. There is no need to make predictions
here about the 21st.
Changing the nature of gold speculation
Significantly, the so-called
hedging activity of gold mines has altered the strategic line-up
in the gold market. Speculators have typically been on the long
side. They have photographic memories and recall the propensity
of governments to cry down the value of the national currency
in terms of gold from time to time. The opposite procedure, writing
up the value of the national currency in terms of gold is virtually
unknown in the annals of monetary history. Given mine hedging,
so-called, speculators have changed sides and compete with the
mines to sell (paper) gold at the first sign of a bullish move
in the price. The fraternity of speculators conceive of risk-free
profits on the short side of the market as they attempt to forestall
the mines. They have abandoned their traditional haunt on the
long side. Peak Gold is a predictible consequence. Unhedged gold
mines, too, feel compelled under the threat of a falling gold
price to produce gold at break-neck speed while neglecting prospecting
and the development of gold properties. Once the producing mines
get exhausted, the supply of new gold will decline.
In summary we might say that
fraudulent hedging carries with it its own punishment: Peak Gold.
It leads to ruthless exploitation of gold mining resources, with
no prudent provision for replenishing them through prospecting
and new mine development.
'Give a dog a bad name, might as well
It is unfortunate that the
perfectly honest and useful word "hedging" has been
allowed to be abused and given a completely distorted meaning.
As the saying goes, 'give a dog a bad name, might as well shoot
him!' It is difficult to explain the distinction between 'hedging
true' and 'hedging false' when the connotation of the word 'hedging'
in the minds of the people is unsavory. It turns them off. Yet
the mission of the monetary scientist obliges him to continue
on the path of truth even if it is uphill all the way.
Hedging is a wide-spread practice
of producers in all walks of the economy. To be valid and effective,
it must be carried on at two levels: upstream and downstream.
The former refers to the input, the latter to the output of production.
At the input level the producer buys the resources that go into
his final product. At the output level the producer is marketing
his final product. The need for hedging arises as price fluctuations
at either level, especially if they occur faster than adjustments
can be made, may cause losses. Thus, worrying about the downstream,
the producer is anxious to lock-in a favorable selling price
as it may become available for his product prior to the end of
the current production cycle. Worrying about the upstream, the
hedger aims at locking-in a favorable buying price as it may
become available for a major ingredient of his product prior
to the beginning of his next production cycle.
Upstream and downstream hedging
Hedging is most efficient if
it is bilateral. As it has been practiced in gold mining,
hedging is unilateral. It involves forward sales
by way of downstream, to the exclusion of the forward purchases
by way of upstream hedging. It is a caricature of hedging. It
pretends to overcome the fluctuation of the gold price as it
affects the output of new gold. I say 'caricature' because it
is counter-productive. Rather than allowing the producer to sell
high while preserving the value of his unmined reserves, it forces
him to sell low, and sell it fast, as the message is that
the price is going to fall, and any delay in selling will involve
Yet, if done properly, either
type of hedge should contribute to profitability as well as husbandry.
In combination they are a legitimate form of arbitrage, provided
that the hedges are carried in the balance sheet, and profits
(losses) are reported in the income statement. Hedges carried
off-balance-sheet are not legitimate as they conceal a liability
with the result that the income statement is falsified. Shareholders
and creditors are misled. Directors and managers lock themselves
into a fools' paradise. Especially dangerous are downstream hedges
carried off-balance-sheet, for the reason that the short leg
(forward sale) represents an unlimited liability. By contrast
the long leg of the upstream hedge (forward purchase) represents
but a limited liability. The difference is due to the fact that
while the price of a commodity can never fall below zero, there
is no identifiable limit above which it may not rise. Another
way of expressing it is to say that the downstream hedge is subject
to a squeeze and possibly to a corner. By contrast, there is
no way to squeeze or to corner a producer with an upstream hedge.
I must confess that I cannot
understand the utter lack of business acumen on the part of gold
mining executives, still less on the part of investment bankers
that finance their activities, in embracing such a contradictory
and self-defeating strategy of marketing gold. They should be
interested in maximizing the price of their product. Instead,
they engineer a falling price trend. They should be interested
in maximizing the working life of their gold producing property.
Instead, their marketing policy directly contributes to the premature
exhaustion of the mines. A lot of observers jump to the conclusion
that the gold mines and the bullion banks, in partnership with
the government, form a conspiracy to club down the gold price.
Theirs is a hidden agenda. The gold mine management is interested
in defalcation, that is to say, to trick their stockholders out
of their equity. The bullion banks think that they can harness
perpetual motion in the artificially induced oscillating movement
in the price of gold. Governments look at the gold price as a
messenger with an embarrassing message about the depreciation
of currency. The messenger had better be shot. Governments know
that a steep increase in the gold price will cause panic. Such
a panic has historically served as the harbinger of hyperinflation.
It must be prevented by hook or crook.
I find this reasoning unattractive.
Such a conspiracy can never be proved or disproved. Governments
probably use more subtle methods.
Most 'hedged' gold mines are
in violation of the important restriction that downstream hedges
must not exceed one year's gold output and they must be lifted
before the end of the fiscal year. Their practice transgresses
not only the limits of prudence, but also the limits of upright
business management. A gold mine selling forward in excess of
one year's output is guilty of fraud. It is concealing a potentially
unlimited liability. 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 one for
everyone else. While they allow gold mines to sell forward several
years' production, they would immediately blow the whistle if,
for example, an agricultural producer tried to do the same. It
is well understood that forward sales in excess of one year's
production are a predatory practice designed to hurt or destroy
competition. It is also hurting other market participants downstream.
There is no justification for
this double standard. It is scandalous 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, the mine will sell for cash. Central
banks are accomplices in the scheme of fraudulent hedging since
they report gold that has been leased and sold as if it were
still sitting in their vault. It is a form of double-counting
gold by modern accounting techniques.
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. Not only is such a 'naked bear speculation' illegitimate
as it falsifies the balance sheet and conceals an unlimited liability,
but it also makes the prospectus meaningless. There is no mention
in the prospectus of any intention to indulge in short selling
that inevitably results in the premature exhaustion of ore reserves
and in the dissipation of the most valuable resources of the
mine at artificially low prices. On this ground alone the gold
mine is open to class action suit by the shareholders. (I am
grateful to Tom Szabo of www.silvewraxis.com
for pointing out that the double standard is repeated in case
of a number of other industries, see FASB Statement No. 133.
He also mentions that Barrick's Gold Sale Contracts have been
exempted, along with others, from the regulation as "cash-flow
hedges" and thus have no required financial statement inclusion).
Shareholders being hit three times
Furthermore, naked bear speculation
makes no economic sense for the mine. By virtue of its net short
positions the gold mine assumes a vested interest in a lower
and falling gold price which clashes with its main mission of
selling newly mined gold at the highest possible 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 the 'hedging' gold mine 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 a schizophrenic
management team can survive the vicissitudes of market competition
and shareholders' ire for long. Shareholders get hit three times
through the schizophrenic action of the managers. First, income
is shaved every time the gold price is forced lower through short
selling. Second, capital is being destroyed as the falling gold
price makes payable ore reserves to disappear (i.e., become non-payable).
Third and most serious is the fact that the richest ore reserves
are being frittered away for a pittance at the artificially suppressed
gold price, thereby materially shortening the working life of
the mine. Naturally, the share price will show not only the shaving
of income and destruction of capital, but the premature aging
of the gold mine as well.
Paper profit no profit
Advocates of this senseless
practice, in particular, the officers of Barrick Gold argue that
these losses are more than compensated for by the extra income
the firm generates from 'investments' made with the proceeds
of forward sales. But insofar as this extra income is encumbered
with unlimited liabilities represented by the fraudulent downstream
hedge, it consists of paper profits that should not be paid out
in the form of dividends. In fact, they should not be reported
as profits in the first place. "There's many a slip between
cup and lip", as the proverb says. Hidden liabilities may
force the firm out of business before it has a chance to realize
its paper profits. The practice of window-dressing income statements
using unrealized paper profits, especially as they are encumbered
with unlimited liability, is blatant fraud and no amount of sophistry
or government connivance will change that fact. It is the height
of insolence on the part of management to treat shareholders
as simpletons unable to understand the difference between paper
profits on an open forward sale contract, and profits that have
been consummated by having them closed out.
Apologists for the practice
of naked bear speculation by gold mines try to push the blame
on to the banks. They point out that mines could not get financing
unless they heeded the bid of banks to sell forward several years
of output as collateral for the loan. Let us leave aside the
fact that the banks in setting conditions involving fraud become
partners in crime. It is possible that they enjoy the same immunity
from criminal prosecution as the mines. Even then the argument
is not persuasive. The banks are not micro-managing the mines.
The responsibility for fraudulent forward sale of several years
of output rests with mining management. It could have used true
hedging to satisfy the banks.
In the third, concluding part
of this series I shall describe in full details bilateral hedging.
It is proper hedging that gold mines can practice without harming
anyone. It involves upstream hedging that consists of forward
purchases of gold, to compensate for the forward sales of downstream
hedging. This reveals that the compensating long leg of Barrick's
straddle is missing. Therefore the so-called hedges of Barrick
constitute no valid arbitrage. They are merely tools for illegitimate
naked short speculation. They invite severe punishment in a bull
market. By contrast, bilateral hedging is for all seasons. The
mine prospers in a bull market as well as in a bear market.
A unilateral short hedge can
always be converted into a bilateral hedge through adding a compensating
unilateral long hedge. Forward sales should be matched by forward
purchases. A bilateral hedge is the combination of a downstream
and an upstream hedge. It is a legitimate hedge, as forward sales
are compensated by forward purchases. It never gives rise to
For example, an upstream hedge
is created by the gold mine when a sudden fall occurs in the
gold price. Since management is on the look-out for new gold-bearing
properties to buy, in order to replace ore reserves that are
being exhausted by its mining activities, the sudden fall in
the gold price represents a godsend. Yet the opportunity is ephemeral.
The falling gold price knocks down the value of gold-bearing
properties and that of the stakes of prospectors. However, the
opportunity to buy the property or the stake at such an excellent
price is likely to elude the gold miner who has to go through
the lengthy process of searching the title and checking the quality
and quantity of gold ore in the ground. By the time this process
is completed, the gold price might have surged forward making
the opportunity to add to ore reserves at a reasonable price
To lock in a favorable price
is possible nevertheless through the forward purchase of gold.
The miner creates a straddle or upstream hedge, the long leg
of which is a long position in the futures market, while the
short leg is the gold-bearing property under negotiation. Care
is taken to match the value of the property with the number of
futures contracts to purchase. When the deal is closed out and
the property is bought, the long leg is lifted and the upstream
hedge unwound. The point is that the miner is under no
time pressure to close out the deal prematurely. Even if eventually
he is paying more in consequence of the surging gold price, the
miner is compensated for that by profits on the long leg of his
straddle. It is true that there would be a loss on the long leg
if the gold price fell further. This is no problem, since the
lower price paid for the gold-bearing property will take care
of that loss. Adding the upstream hedge converts unilateral into
bilateral hedging. It makes the illegitimate forward sale of
several years' mine output legitimate. The short leg of the downstream
hedge is compensated for by the long leg of the upstream hedge.
The forward purchase removed the unlimited liability that was
created by the forward sale of gold. The fraternity of gold speculators
will return to their traditional haunt, the long side of the
gold market. Gold investors are not hurt by the hedging activities
of the gold mines, provided the hedges are proper.
Figuratively we may describe
the proper hedges of a gold mine as a four-legged straddle.
Two legs are in the upstream and the other two in the downstream
market. The short leg downstream (forward sales) is counter-balanced
by the long leg upstream (forward purchases) - just as the long
leg downstream (gold in the ground about to be mined) counter-balances
the short leg upstream (gold property about to be acquired).
The gold mine is uniquely positioned
to take advantage of the fluctuating gold price through buying
and selling gold futures virtually risk free. Bilateral
hedging may increase the profitability of a gold mine manifoldly.
Gold Standard University Live
Gold Standard University Live
has just completed its Session Two at the Martineum in Szombathely,
Hungary. Session Three is planned in Bessemer (nearest airport
Birmingham), Alabama, U.S., in February 2008. It will feature
a one-week course entitled Adam Smith's Real Bills Doctrine.
An advocatus diaboli from neighboring Mises Institute
will be invited to come and challenge the wisdom of Adam Smith.
The session in Alabama will
also feature a blue ribbon panel discussion on the subject of
True Hedging for Gold Mines. Representatives of hedged
and unhedged gold mines will be invited to participate. The present
series Peak Gold! is a primer on true hedging, and a book
is planned that would cover the proceedings of the conference.
For the benefit of prospective
participants from Europe, Session Three may be repeated at the
Martineum in early March, 2008, provided that a sufficient number
This is a preliminary announcement
only. Stay tuned. For more information please contact: GSUL@t-online.hu.
A. E. Fekete, Peak Gold!
(Part One), www.321gold.com
, August 17, 2007
A. E. Fekete, Have Gold
Bugs Been Barricked by the U.S.? www.gold-eagle.com,
July 12, 2007
A. E. Fekete, Gold Vanishing
Into Private Hoards, www.gold-eagle.com,
May 31, 2007
A. E. Fekete, To Barrick
Or To Be Barricked, That Is the Question, www.321gold.com
August 11, 2006
A. E. Fekete, The Texas
Hedges of Barrick, www.goldisfreedom.com,
Charles Davis, So Big It's
Brutal, Report on Business, The Globe and Mail: Toronto,
June 2006, p 64.
Bob Landis, Readings from
the Book of Barrick: A Goldbug Ponders the Unthinkable, www.goldensextant.com,
May 21, 2002
Richard Rohmer, Golden
Phoenix: The Biography of Peter Munk, Key Porter Books,
Ferdinand Lips, Gold
Wars, Will Hedging Kill the Goose Laying the Golden Egg?
p 161-167, New York: FAME, 2001
Antal E. Fekete, Towards
a Dynamic Micreoeconomics, Laissez-Faire (Universidad
Francisco Marroquín, Guatemala City) No. 5, September,
1996, pp 1-14)
George Bush's "Heart
of Darkness" - Mineral Control of Africa, Executive Intelligence Review,
January 3, 1997, see in particular:
Inside Story: The Bush Gang and Barrick, by Anton Chaitkin
George Bush's 10 billion giveaway to Barrick, by Kark Sonnenblick
Bush abets Barrick's Golddigging, by Gail Billington
See also: http://american_almanac.tripod.com/bushgold.htm
Stop the Press!
There is wild speculation in
Newmont stock on rumors that it is a candidate for a hostile
takeover by Barrick. Barrick has denied the rumors; Newmont refused
to comment. (Reuters, August 28). So it boils down to the question
whether you can believe Barrick. A penny for my thought? Newmont
is worth far more under its present management that has courageously
unhedged it, than it could ever be worth under the management
of Barrick, which is grieviously lacking both in courage and
vision. Barrick is still wedded to its idiotic hedge plan, stewing
in its own juice as a consequence. Newmont could introduce bilateral
hedging, the only true hedge plan for a gold mine, to be described
more fully in the next instalment of Peak Gold! I cannot
help but think that Barrick is acting out of desperation, in
trying to dilute its hedgebook through hostile takeover of unhedged
mines. For the latter, it is a kiss of death. Where is Homestake,
the legendary flagship of the American gold mining industry?
Barrick's management could
spend its money far more efficiently if it bought back its hedge
book, rather than buying out Newmont, which has a vision Barrick
is sorely lacking. What are we to make of Barrick's masochistic
prognostocations of a higher gold price both in the short and
long term? Company spokesman Vincent Borg is cheering shareholders
that they can expect to derive further leverage as Barrick will
continue to expand margins. The only fly in the ointment is that
it may not be Barrick, but its successor picking up the goodies
from receivership, who will reap those benefits.
The key risk for Barrick at
this point is in the future course of gold lease rates. This
much was admitted in the company's 2006 Annual Report. It is
true that they do have some lease rate swaps. However, these
do not protect them against gold going into backwardation as
a result of gold lease rates significantly exceeding U.S. dollar
interest rates. Another way of saying this is that Barrick would
be in a heap of trouble if gold demand greatly exceeded available
lease supply. There is no way to hedge against this. The key
to Barrick's fate can be gleaned from the second paragraph on
page 54 of its 2006 Annual Report. It was this statement - clinging
to the hope of maintaining the status quo on the future availability
of leases - that convinced me Barrick was going to be in a huge
amount of trouble if it did not amend its ways, and soon. Judging
by its insistence on the self-anointed brilliance of the remaining
"Project Gold Sales Contracts" (having closed out,
for the most part, its "Corporate Gold Sales Contracts"),
Barrick has earned the title of THE tragic figure of gold mining:
a latter-dayTantalus: hungry and "tantalised" by the
sight of most gorgeous foodstuffs floating by he mustn't touch.
Barrick has staked its very
existence on a continuing surplus of leasing over hoarding -
at best a dubious assumption. Thus Barrick has made itself into
the corporate antithesis of the monetary ascendence of gold.
My fears have been sadly confirmed.
Barrick does not have and is unable to raise the money to buy
back its hedge book, but it apparently tries to wriggle off the
hook through acquiring more unhedged companies. It would pay
for the acquisition with Barrick stock. No, not again! Stockholders
of Barrick are to be barricked to death!
If the rumors are true, the
takeover drama is not without its humorous aspect. The poison
pill of unilateral hedging that has been swallowed by Big Fish
by now it is causing indigestion and cramps. Now Big Fish wants
to feed on fish that have just regurgitated theirs!
OF THIS ARTICLE IS SOLELY FOR YOUR INFORMATION AND ENTERTAINMENT.
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. HE HAS NO POSITION,
LONG OR SHORT, IN BARRICK STOCK, NOR DOES HE INTEND TO ACQUIRE
ONE. THE CONTENT OF THIS ARTICLE 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.
September 10, 2007
Memorial University of Newfoundland
Professor Antal E. Fekete was born and educated
in Hungary. He immigrated to Canada in 1956. In addition to teaching
in Canada, he worked in the Washington DC office of Congressman
W. E. Dannemeyer for five years on monetary and fiscal reform
till 1990. He taught as visiting professor of economics at the
Francisco Marroquin University in Guatemala City in 1996. Since
2001 he has been consulting professor at Sapientia University,
Cluj-Napoca, Romania. In 1996 Professor Fekete won the first prize
in the International Currency Essay contest sponsored by Bank
Lips Ltd. of Switzerland. He also runs the Gold Standard
Copyright ©2005-2010 by A. E. Fekete<