a. Explain the value chain for gold mining firms (how can a mine create a competitive advantage relative to its rivals). What are the factors that may explain exceptional performance of ABX relative to the other gold mines?
To create a competitive advantage, a mine has to properly manage its exposure to gold price fluctuations. This is not an easy thing to do since there are so many factors to consider: when, how much, and how to hedge the gold production.
Firms in this industry differentiate themselves based on the risk management strategies they implement. Furthermore, mines should also be able to minimize the cost of gold production along with making large sunk costs. Operating in this sector obliges the companies to make huge investments to create the proper infrastructure to dig and process the ore; therefore, they should be financially stable on order to afford investing large amount of money.
ABX implemented a gold hedging program that quickly became an integral part of its corporate strategy.
This strategy helped it to hedge efficiently against gold price fluctuation. Besides, it allowed it to occasionally sell its gold at prices above those of the market. The exceptional performance of ABX was also due to its annual acquisitions. Luck was an important aspect as well, since gold was discovered in most of its new properties. Moreover, American Barrick generated a lot of cash, which it reinvested to finance its growth.
It was also able to cut its expenses in order to enhance its growing profitability. The management of American Barrick wanted to diversify its activities by listing the company in Toronto, Montreal, and the United States among others. The top managers were very serious about keeping a financial stability and a liquid balance sheet by issuing few debts and hedging against risk. All in all, American Barrick attracted a lot of investors because of its risk management strategies, expected future growth, strong and liquid balance sheet, and finally its efficient management team.
b. Quantify the nature of gold exposure, that is, in the absence of a hedging program using financial instruments, how sensitive would Barrick stock be to gold prices changes? For every 1% change in gold prices, how might its stock price be affected? How could the firm manage its gold price exposure without the use of financial contracts? If American Barrick wanted to protect itself from gold price exposure without the use of financial contracts, it could use natural hedges. One way to hedge against undesired risk is to match cash flows such as revenues and expenses.
In other words, a commodity producer such as American Barrick, which has revenues payables in U.S. dollars and incurs cash outflows in a different currency, will try to match its outflows to its expected inflows in the foreign currency. Another way of hedging against risk is the purchase of insurance to protect against financial loss due to external influences. It is also common to hedge gold investments against fluctuations of the U.S. dollar. It is extremely important for commodity traders to know which currency is correlated with what commodity in order to be able to predict certain market movements; for instance, there is often a negative correlation between gold and S&P 500.
c. What is the stated intent of ABX’s hedging program? What are the arguments for managing gold price exposure? ABX wanted to lock in the price at which it could sell its output in order to avoid seeing the expected value of its projects fluctuate widely. It wanted to differentiate itself from its competitor by choosing the right hedging policy. ABX aimed at being financially stable by protecting itself against the dips in the gold price. It vehemently argued that managing gold price exposure would allow it appropriately forecast its cash flows, rise its production, and offers its investors a clear vision of their future earnings.
d. How would you characterize the evolution of Barrick’s price risk management activities? Are they consistent with the stated policy goals? American Barrick used to use gold financings. Through this way of financing, investors could benefit from both the increase incurred in the volumes of gold to the trust and the gold price. In 1984 and 1985, ABX used forward sales right after a sharp drop in gold prices. This strategy allowed the company to eliminate its exposure to price drops; however, it also limited its opportunities to benefit when the prices rose. This led it to try option-based insurance strategies that could manage the risk but still allow retaining some of the benefits of rising prices. However, as it needed contracts with a longer maturity, ABX shifted to spot deferred contracts. The evolution of Barrick’s risk management activities is characterized by its wish to be fully protected against price declines and still be able to capture benefit from increasing gold prices.
The risk management strategies implemented by American Barrick were consistent with their goals since its positions grew considerably. e. How should a gold mine which wants to moderate its gold price risk compare hedging strategies (using futures, forwards, gold loans, or spot deferred contracts) with insurance strategies (using options)? On what basis should these decisions be made? Once a firm has decided on either a hedging or an insurance strategy, how should it choose from among specific alternatives? A mine that wants to moderate its gold price risk should first analyse the differences between the hedging and the insurance strategies. Indeed, hedging allows eliminating risk by giving up the potential for gain. While an insurance strategy requires a premium to eliminate risk but allows retaining the potential for gain.
The decision should be made based on the cost of the strategy, the maturity of the strategy, and the degree to which the strategy allows to benefit from potential gains. Once a firm has decided on what strategy to follow it should choose among the existing alternatives of each strategy. For the hedging strategy, the company should take into consideration the particularity of each financial instrument. Indeed, forward sales for instance, are usually for relatively short delivery periods of under a few years.
However, a continuous drop in gold prices might negatively affect the opportunity for the firm to sell at higher market prices. On the other hand, spot deferred contracts allow having multiple delivery dates. They enable the firm to profit from increases in the price and yet set a minimum price on its sales. For the insurance strategy, the main problem encountered by the firm is that of the cost. Indeed, the firm should use the premiums received from the sale of calls to purchase puts. That way the cash inflows and outflows cancel out. The firm can also reduce the cost of insurance by adjusting the exercise prices and rations of puts and calls to determine the degree at which it chose to participate in gold price rises.
f. What is a “spot deferred contract”? Explain the mechanics of the contract. Is it an option? A forward contract? Why has ABX chosen to rely on spot deferred contracts relative to other gold derivatives?
As defined in the case, a spot deferred contract is a type of forward sale of gold. At the opposite of a forward where the delivery is set on specified day (maturity), SDC’s are characterized by multiple delivery dates. It is up to the seller to choose on which rollover date they would make the delivery. The seller has the choice to defer the delivery up until the end of the contract. In other words, the seller had flexibility as to when they would like to deliver the quantity of gold.
ABX preferred SDC’s to other gold derivatives for the simple reason that they allowed it to profit from increases in the price of gold and yet set a minimum price on its sales of gold. Therefore, as years have gone by, ABX found itself using more and more SDC’s at the expense of other hedging vehicles.