The hedging of production, especially by gold and silver producers, remains a highly contentious issue, writes BullionVaults Miguel Perez-Santalla.

Miguel Perez-Santalla&nbsp|&nbsp29 August 2013&nbsp10:27

THERES always a lot of talk about gold and silver miners and their hedging policies.

Selling some future production at current prices raises money today. It can also help the gold or silver miner smooth out changes in the market. That should be to the benefit of the shareholders. Yet the main concern in hedging isnt how to manage this trade. It is the shareholders view of hedging which counts.

Why? Starting in the late 1990s, gold miners suffered major losses when the gold price rallied. This is because they had excessively large hedge positions in place far out into the future. It is imperative that the act of hedging not get confused with the reality of mismanagement of hedging policies.

As gold prices began rising early last decade, investors came to hate the big hedge-book built up by the gold miners during the previous bear market. And simply put, miners need investment money to fuel their business. If the shareholders are not happy with the way they operate their business, then their share price goes down. And if the share price goes down, then the gold or silver miners capitalization also goes down, which then affects their ability to borrow from the banks.

So with hedging both weighing on profits and annoying shareholders a decade ago, the famous leverage to gold prices offered to investors by precious metals miner stocks went missing, even before the financial crisis hit.

An excessively large hedge is in effect a speculation. And I am prepared to concede that we were reckless , said Sam Jonah, the chief executive of gold-miner Ashanti as it faced bankruptcy thanks to a jump in the gold price at the end of the long 1990s bear market.

We took a bet on the price of gold. We thought that it would go down and we took a position.

Why speculate against the very mineral youre in business to dig from the ground? The length and misery of the gold bear market first. But unfortunately, too often companies rely on outside firms to consult on their hedging strategies, too. Such was the case with Ashanti, for instance.

Goldman Sachs had recommended that Ashanti purchase enormous hedge contracts which of course lined the bankers pockets. Derivatives contracts and other structured products offer far greater income to the middlemen than straight buying and selling. But after making easy money at first as the gold price fell further, in the end Ashanti were not hedged. What they had done was to establish a short gold position which brought their own demise.

Lesson learned; do not take advice from outsiders who have no vested interest in your success, not without inside analysis and study.

Because of the poor decisions of some mining companies 15 years ago, hedging is still frowned upon today. The practice is still little understood by shareholders, too. The gold miners speculative hedging was entirely unwound by 2011, ahead of the peak in prices (so far). But the truth is that hedging is not a one-size-fits-all program and should not be static. Hedging should by elastic and managed daily by the mining company, and not by outside firms.

The biggest concern that miners should focus on, and something which I believe they rarely do, is the proper education of their shareholders about their hedging activities and goals. By educating their shareholders about their business model, they can have them participate and support the strategies the firm enlists.

When gold and silver started rising faster in 2005, to the current price levels that we are at today, many of the shareholders of many mining companies were unhappy. They believed they should have participated more in the higher prices. But lower prices were already locked in, and the shareholders blamed their lack of income on hedging. It was not hedging that limited their upside potential, however. It was the management or style of hedging.

Another truth must be told. Because owning stock in gold or silver mining companies should not and is not a vehicle for tracking the price of the underlying commodity. Just like any other stock, an investor is buying into a business whose purpose is to make money. Mining companies purpose is to make money by the extraction of raw materials from the ground.

So upon looking at a mining stock, an investor must first decide if the miner has the ability to be profitable on a stable price platform. If silver were trading at $20 per ounce when considering a mining stock it would make sense to see if they would remain profitable at $15 or even $10 per ounce. In calculating what level the price of the underlying commodity needs to be for the mine to be profitable we would then have a better handle on this specific business model. Once this is established then a mine can be looked at as to how they handle price moves. The question lies in what tools they will use to manage their market exposure.

There are many options to this question, and for that reason it should be imperative that the mining concern have a strong background in the management of commodities in the financial markets.

• Is the price trending higher or lower?
• How is the current industrial and investment market demand?
• How much downside price risk can the company afford from current levels?
• What stance do we need to take to acquire necessary financing?

Obviously, these questions are not exhaustive. They are examples of the thought needed when managing the precious metals price risk.

To hedge or not to hedge, that is the question. The answer can only be found within each individual company of how much and when. A strong analysis of all operating cost factors is a prerequisite to ascertain the bottom line price needed for the commodity. Once this number is ascertained then decisions can be made. However, some decisions are not left to the mining concern itself, especially when they are seeking financing.

Many banks and/or investment houses that lend to the mining sector may demand that they hedge their entire or partial production in order to acquire the financing. But hedging is not cut and dry for the miner. As mentioned before there are different tools used.

The primary tools for hedging, which truly means price protection, are the following:

• Commodities futures and options market ( Comex. NYSE Liffe US);
• Forward trades and options with a bank or trading company;
• Other derivatives, including finance deals with lenders.

Using the commodities futures and options market adds transparency to the pricing model, plus a record of all prices traded when a hedge is placed. Much like BullionVault where private investors trade only physical bullion at fully-paid prices there is complete transparency on live gold market prices. execution and time of trades.

The commodities futures market, which enables the mining company to sell their production at a time in the future, requires margin money which is a deposit. This deposit may need to be increased in the case the contracts are losing money. Because if prices are rising, then the metal that you are waiting to come out of production is gaining in value. Essentially, this kind of hedge is a wash, but until you have the metal out of the ground you do not have the cash to cover the margin calls on your hedges, and this increases the need for more financing.

On the same exchanges, options contracts can also be traded. And there are different reasons for doing so. In a stable or declining market the mining company may determine to sell calls, which also means to write a call option, which earns income from the trader who buys it. (Writing a call option gives the buyer the right to buy the underlying commodity at a specified price.) In a rising market the same mining company may determine to buy put options. (Buying put options gives the buyer the right to sell the underlying commodity at a specified price.) In the case where the company sells calls they earn a premium, and when they buy puts they pay a premium for that right. One decision earns some money, the other is a cost like an insurance policy, where you pay a premium.

The gold or silver mining company can also trade through their banking relationships, using forward trades and options quoted to them by the bank. They may get preferential credit treatment if they already are getting their financing from this bank. The problem with this scenario is that they are limited to trading with this firm because of the relationship. The miner may of course have more than one banking relationship, enabling them to trade elsewhere. This will in turn create a need for more operational controls of the trades being placed.

Such OTC trades are not in the public domain. They are known as over the counter and are conducted privately in what bankers call the physical market, because the deal is for physical delivery of metal, rather than cash settlement as is usual with New York gold futures and options. So there is less transparency, and the result is that operationally transactions need to be confirmed by looking at other markets, on top of confirming each individual trade with the banking entity. The bullion banker, if it is a well-established relationship, may assist and provide services that make going this route the better choice.

Other derivatives are tools based on the standard market products. Option collars, straddles and spreads are some to name a few. To complicate things a market can also go into Backwardation. even while the price is dropping as we have recently seen in the gold market. This would mean that hedging forward or in the future will add costs to the bottom line. This is not so in a regular Contango market where the seller normally receives a higher price to cover financing and carrying costs.

There are other variables as well for a mining company to consider, such as fuel costs and equipment costs, current and into the future. Then they must also consider hedging those commodities that they use as well, such as oil. This is why it is imperative that any mining company have a strong market-experienced team handling their price protection needs.

In the end result, what I have been sharing here is that every company has their own set of costs and prices needed to be successful. Each one of these mining companies must be looked at independently. But hedging should not be a four-letter word. In fact hedging should be an everyday tool for any company that makes a living producing commodities. They must work at optimizing their profits while limiting their price risk.

Otherwise they no longer are a business concern but a speculator. This is because no one knows, at least not on this planet, where the price of a commodity will go for certain.

Miguel Perez-Santalla is vice president of business development for BullionVault. the physical gold and silver exchange founded a decade ago and now the worlds #1 provider of physical bullion ownership online.