American Barrick Resources Corporation.

2. Sensitivity of gold price changes and stock effects

1. 1% change in gold prices and its stock affects

In order to check the sensitivity of share price of ABX compared to gold price changes we calculated the net income two times: one time including hedging policy (see table 1992 a) and the other time without hedging (see table 1992 b). Furthermore, in 1992 c we increased the gold price by 1% and recalculated the net income based on the corresponding revenues.

Result: A 1% increase in gold price leads to a 3.56% increase in net income, given no hedging strategy in place.

Underlying assumptions:

• Only revenue changes
• No demand changes due to differences in gold price
• No changes in the number of outstanding shares
• Tax rate: We used the average tax rate from 1986 – 1992, which was 21.8%, as Barrick operates in a specialized industry and in several tax jurisdictions, its income is subject to varying rates of taxations.
• P/E ratio constant
• The influence of the reserves (still in the ground) is already included in the share price and since the P/E ratio is assumed to be constant, the influence of these reserves is not included here.

2. How could the firm manage its gold price exposure without the use of financial contracts

The gold market is risky as it is impossible to predict the direction of price fluctuations. The greater the range or dispersion of the price changes, the greater the risk involved (market or price risk). When building a risk-management strategy, the firm will start by looking at its operational management to see if it can find ways of reducing the risks it is taking. It will try to ensure that the inflows and outflows are balanced in nature, by currency, and interest-rate sensitivity and so forth, thus creating internal hedges matching by costs and revenues.

Operational hedging involves the firm changing sources of supply, the location of manufacturing, adjustment of production etc. in order to reduce the impact of economic factors.

Unfortunately, there are many problems associated with operational hedging. Changing suppliers disturbs existing business relationships, may lead to production and/or quality control problems and is slow to implement. ABX might consider operational business decisions which involve considerable long-term investment which, probably have significant `exit cost´ elements. ABX could face considerable costs in altering operational procedures as a risk management tool and would hence not use strategic risk management as their primary means of controlling their macroeconomic exposures.

The four significant disadvantages over financial hedging are:

• They do disturb existing business relationships
• They are slow to implement
• Transaction costs are quite high
• Hedge cannot be cheaply reversed if no longer appropriate

Another effective, though illegal way to manage gold price exposure would be collusion. By “signing” contracts with competitors, supply of gold could be reduced, thus, given similar demand,  the overall gold price would rise.

3. Instruments

1. Instrument “Gold financing”

Barrick-Cullaton Gold Trust, marketed in Canada and Europe. Figure 1 shows the payout diagram for the investor (right hand scale) and the costs to ABX (left hand scale). The gold trust paid investors 3% of the mine’s output when the price of gold was at or below $399 per ounce, rising to 10% of production when gold was at $1’000 per ounce. ABX totally raised $17 million trough this trust.

The trust represents indirect equity comparable to preferred stock. Trust holder have a right on interest payments (can be seen as dividends) but no voting rights. The payoff for ABX was that it limited the cost of this equity to 3% (of the firms output) when the gold price was at or below $399 and at the same time offering its investors a substantial upside potential of 10% of the mines output when the gold price would reach $1,000 per ounce. This limited potential cost of debts to 10% for ABX.

In addition, ABX had the possibility to buy the trust back if gold prices and production rose significantly in their favour. By doing so, they could protect themselves from paying large amounts of interests. The characteristic that the payout was tied to the mines output helped further to reduce cost of debt when the gold price was at an unfavourable level and thus stabilized the net income. This instrument does not hedge ABX gold price risk on the sales side but on the cost side.

Figure 1 Profit diagram of Barrick-Cullaton Gold Trust

2. Bullion Loans

ABX entered a bullion loan contract with Toronto Dominion Bank in which it received 77,000 ounces of gold that ABX sold immediately on the sport market for $25 million ($324.68/ounce). Over the next 4 years ABX had to repay in monthly gold ounce instalments incl. 2% annual interest. The assets of the mine (value  $54.2 million) and a guarantee issued by ABX collaterized the loan. Additionally, ABX was required to make accelerated deliveries equal to 50% of the cash flow from the mine after deducting capital expenditures and mandatory deliveries.

Figure 2 ABX value diagram with a gold price of $325 at the contract begin

Figure 2 shows the ABX firm value diagram for the bullion loans. ABX locked the price when it sold the gold on the spot market for $325 over the next 4 ½ years. ABX would suffer from forgone profits if the gold price rose above $325 because they could sell it on the spot market for a higher price. On the other hand, if the price would fall, ABX is better off at a price of $325. Additionally, ABX was contractually committed to make accelerated deliveries equal to 50% of the mines cash flow. That means, with high cash flows ABX was in a position to quicker pay back its debt in ounces of gold. This resulted in lower forgone profits (slope decreased as depicted in Figure 2.

The characteristic of the repayment and especially accelerated repayment is shown in figure 3. The dotted lines indicate accelerated repayment of gold that can vary depending on the level of cash flows that the mine produced.

Figure 3 Characteristics of the repayment of gold with possible scenarios of accelerated repayments (dotted line)

3. Gold-indexed Eurobond

ABX raised $ 50 million in 2% gold-indexed notes. Investor paid $1’308 per note and received $26.16 annual interest payments (2%) and the right to redeem the note between February 88 and February 92 with an linearly increasing amount of gold as depicted in figure 5. At expiration the note had to be redeemed. At a prior redemption date, earliest February 88, the investor could chose whether to receive cash or gold bullion whose value equalled 3.2150 ounces at the first redemption date and 3.3804 ounces of gold at expiry. There was no collateration.

Figure 4 Payoff diagram until February 1988 (first redemption option)

Figure 5 Characteristics of redemption options

Figure 4 shows the payoff for ABX for the first redemption date. The payoff for ABX was limited at the cost of the index-note of 2% plus the premium of the call option at the redemption date. The major payoff for ABX was the low debt financing costs of only 2%. On the other hand, the note holder was attracted by the fact they could participate in the raising gold price.

 

4. Forward sales

ABX had to deliver a specified quantity of gold at specific date for a price fixed at the beginning of the contract. The parties were free to close out their positions through a negotiated settlement. Forward sellers receive a premium above the current gold price called contango. The contango rate was set according to the difference between the interest rate of $ (7%) and the lease rate of gold (2%). This resulted in a contango premium of 7% - 2% = 5%.

Figure 6 Payoff diagram for ABX with a contango of 5% at a forward price of $367.50

ABX logged the gold prices for the future production and therefore insured the risk of price fluctuation between now and the specified delivery date of the contract. This allowed ABX to exactly predict their revenues, and with its stable production costs, its cash flows.  

5. Options and Warrants (collar strategy)

ABX sells and buys simultaneously a call (sell) and a put (buy) option on gold. The exercise price of the put is below that of the call. No cash outflow occurs as the premium received form the sale of the call is used to purchase the put.

Figure 7 The collar with an put and a call option with different exercise prices x1 and x2

By setting the exercise price of put and call ABX can determine the degree of gold price risk they want to take. ABX can adjust the exercise of new puts / calls according to new market prices. By following this strategy ABX is able to stabilize its revenues without the cost for financial instruments.

6. Spot deferred contracts

This is like a forward contract with rollover option (find detailed description in chapter 4). By following this strategy ABX was able to profit from increases in the price of gold and at the same time set a minimum price of gold to protect them if the gold price would fall.

Figure 8 depicts roughly the contango for varying rollover dates.

Figure 8 Principal characteristics of spot deferred contracts

4. Spot deferred contract

Spot deferred contract (SDC) is a forward contract with multiple delivery dates. The final delivery date can be up to 10 years after initiation of the contract. The seller has the choice at which of these rollover dates he will deliver and he has the right to defer delivery until the end of the contract.

At the beginning of a contract with 1-year delivery rollover dates, the price to be paid for delivery is set only for the first rollover date. The price is based on the 1-year forward price. After the 1st period ABX has the following choices comparing the contract price (1-year forward) with the spot price.

1. Closing: If the spot price is lower than the contract price ABX will deliver and close the contract.
2. Rollover: If the spot price is higher ABX sells on the spot market and rollovers over the contract for another year. Thus no money or gold is changing hands. The price for delivering at the next rollover period is set based on the prior contract price plus the prevailing contango premium on the next rollover date.  

Using this instrument ABX could always profit from an increase in the gold price (roll contract over) and on the other hand lock in a minimum price for its production/sales (closing) then.

Figure 9 Profit diagram for ABX if the spot market price is always higher than the forward price x until expiry of contract at S

 

Based on their good financial position and its large reserves in gold ABX could sign agreements with 10-year delivery options.

The spot deferred contract is a mixture of a forward and an option contract because ABX has the right to either close or rollover the contract. This mechanism is shown in figure 9. If the forward price is at x0 and the spot market price is at x1 then ABX would make a rollover and paying a contango, which is depicted with the dotted line. If the spot market price continuous to raise above the new forward price x2  ABX would again roll over until the expiration of the contract. In this case the profit diagram as shown with the solid line would apply. If the spot market price at any time would be below the forward price ABX would close the contract. In this case ABX would profit from the difference between the forward price and the lower spot market price.

The objective of ABX was to realise a minimum average price of $400 per ounce until 1994. Additionally, if the gold price rose they had the option to sell at higher spot market prices. ABX would be better off if this price difference was bigger than the contango premium to be paid. Compared to other gold derivatives they were able to choose the most profitable solution based on the specific market condition at that time.  This increased on average the realized gold price per ounce.