Tuesday evening we learned that gold producing giant Barrick Gold (ABX) has decided to issue $3 billion in new common equity shares in order to buy back all of its remaining gold hedges, which are currently in the red to the tune of $5.6 billion.
In the company’s press release Barrick explained that investors have expressed disappointment that the company has hedged 9.5 million ounces of production below market values. Barrick claims such a fact has put pressure on its share price, and therefore seems to have concluded that lifting their hedges is good for shareholders.
The press release also included reasons why the outlook for gold was positive (as would have to be your view if you decided to lift out-of-the-money hedges), but is this really the best time to be lifting hedges? I’m skeptical about the timing of this decision and therefore am glad that I am not a shareholder in Barrick.
As you may have seen, gold prices have risen sharply in recent weeks (chart below) and now trade near $1,000 an ounce for the third time over the last couple of years. The metal never seems to stay over $1,000 for long, even in the depths of the credit crisis. Barrick has decided, seemingly based entirely on pressure from shareholders, to go 100% long on gold just as the metal is nearing its all-time high. I thought we were supposed to buy low and sell high?
Barrick is going to pay $5.6 billion to lift its hedges, which is the mark to market loss it has on the books right now. On 9.5 million ounces, that means the company is underwater by $589 per ounce and must pay that much to get out of them. That means Barrick is partially hedged at $411 per ounce with gold at $1,000.
Now, I am not saying that hedging gold at $411 per ounce makes a lot of financial sense in current times. I certainly understand that investors want to see them lift those hedges. After all, if you are long ABX stock, you clearly think gold is going to rise in price, and therefore would want to benefit if that view proves correct. Still, from a financial management perspective, Barrick is essentially buying at the top of the market.
Why not wait for gold to drop to $800 or $900 before lifting the hedges? That would be a “buy low” type of move and even buying at $900 per ounce would save the company $1 billion in cash, versus making this move right now.
The converse argument would be that gold might not trade back down to $900 or lower, but that seems unlikely. The chart above shows us that gold prices couldn’t even stay above $1,000 during the worst credit crisis we have ever faced. In fact, gold traded at $700 less than twelve months ago, at $800 earlier this year, and at $900 just a few months ago.
Gold is typically seen as an inflation hedge as well as a flight to safety when fear is the paramount emotion on Wall Street. We have clearly already lived through the scariest part of this recession. In addition, inflation is unlikely to rear its head anytime soon because firms have little or no pricing power with such a weak economic situation (consumers and corporations are cutting back whenever possible, and demanding low prices, thereby rendering near to intermediate term inflation risks mute).
This $5.6 billion long bet by Barrick Gold with the metal trading at $1,000 an ounce looks like a bad idea to me and I would not be buying gold investments right now. Unfortunately, it appears that the company was forced to act by its shareholders, who likely have a biased view of exactly where gold prices are going to go from here.
If I were running Barrick Gold I would tell my shareholders, “look, we understand where you are coming from, and will look to lift the hedges when it makes sense, but not when prices are approaching all-time highs. Maybe on a pullback we will take swift action.”
Time will tell whether this move pays off for Barrick’s investors or not. In the meantime I believe it is a good time to be cautious on gold.
Full Disclosure: No position in ABX at the time of writing, but positions may change at any time.