09 June 2008

The Gold Value Chain Part I – Mining

Funding

So let’s say you have been lucky enough to find some land with gold in it. You estimate that there is 1 million ounces in it but to get it out you need to build a mine and employ people and to do that you need (paper) money. You can get that either by selling some shares in your new company Goldmine (equity) or by borrowing some cash from your friendly banker (debt). Ideally, the source of funding you would choose would be the cheapest, but you will probably find that there are limits to how much you can get of the cheapest source of funding. For example, a bank is unlikely to lend you the entire amount you need without yourself or other investors putting some cash in. This does seem a bit unfair because they have been stupid enough to lend people 100% of their house price (what happened to the days of 10% deposit) but I think they are learning their lesson (yet again).

As a result Goldmine is probably going to need a bit of debt and equity. Now the equity people accept a bit of risk and understand that they don’t have any guaranteed return on their investment, but they think you are trustworthy and are happy with your projected profitability so are prepared to give you a go. Generally for that risk they are expecting, however, to earn more than the rate they could earn by lending their cash out. Let’s say for simplicity you have calculated that they will earn 10%. The bank however, is not into that sort of risk so they want a charge on the assets of Goldmine or mortgage on your assets but in return they just expect a boring cash return of 5%.

The process I’ve described above is pretty much common to any business, not just mining. Debt is usually cheaper than equity, but it is limited and requires guarantees of some sort. But things are a bit different with gold, however, because Goldmine also has the ability to borrow gold itself, which makes a bit of sense because it is gold that you want to get out of the ground. Why would Goldmine want to borrow gold? Well let’s enter the world of central banks, bullion banks and leasing.

Leasing

One of the first things that struck me when I started in this industry was the fact that you can borrow gold (however in the gold industry they don’t use the word borrowing, but call it leasing). I found it intriguing because you can’t borrow copper or tin or other commodities and also because borrowing is something usually associated with money.

One of the funniest things I think is those commentators who rant about the evils of leasing. The fact that you can borrow gold, and that gold has an interest rate (called the lease rate), is one of the strongest argument that gold is a legitimate form of money. As a result, all people who do not believe in paper money should be supportive of the gold leasing market because it is proof gold is money and in a transition from paper money to hard money you will need a borrowing and lending market to exist for your hard (gold) money. It is pretty hard to set up the infrastructure and systems for borrowing/lending market from scratch, so supporting the existing leasing market means you are ensuring hard money will be ready to “rock and roll” when money = gold?

If you are new to this whole gold thing, you might be asking how did it come to pass that gold (and silver, and to a lesser extent, platinum and palladium) can be leased? My simplistic explanation is that in the good old days of the gold standard, money was gold (or convertible into it). What is interesting is that when countries went off the gold standard and money became just (fiat) paper, gold continued to be borrowed and lent. I suppose that is because central banks were used to treating gold as money and had arrangements and systems that treated gold as money, so just because money wasn’t gold anymore didn’t mean they couldn’t continue on as they had. They still held reserves of it and still wanted to earn a return on their assets, so why stop lending it out if other countries or legitimate businesses wanted to borrow it? Interestingly, it was Australian miners who rejuvenated the leasing market by realising its potential in supporting gold mining.

Before I get back on topic I want to talk about why the industry uses the word leasing instead of borrow/lend? My theory is that leasing implies ownership by the person lending it to you. The thing about paper money is that it is virtual, there is no real thing you have a claim on. The words borrow/lend refer to this virtual liability. In contrast, you can’t borrow a house; you rent/lease a house. You don’t borrow a car, you lease it. In these situations, the word lease is saying that I still own the house or car, but am letting you use it for a period of time for which you pay me a rental or lease fee. After you finish using it, you give the asset back and any gain or loss in the value of the house or car is the owner’s problem, not yours.

Given that gold is a hard asset, not virtual, I don’t think it is just chance that the industry uses the word leasing. It is a way of saying or reinforcing that the physical gold I give you is still mine, I benefit from any increase in its price – you are just “renting” it and can use it but it is mine and I want (the) gold back at the end of the lease period. Of course, in reality it is not possible to get the exact physical atoms back that were leased, so you only need return gold of the same weight and purity (just the same as if you lend your friend $20, you don’t expect the exact same note back with the same serial number on it).

The Lease Rate

So why would your company Goldmine be interested in borrowing gold instead of dollars. Well, because it is cheap, really cheap. Currently you can lease gold at 0.2% per annum, compared to USD cash rates of 2%, or AUD of 8%. Needless to say, as the manager of the company you would be crazy to turn down such a cheap form of funding, because it is going to increase the profit Goldmine makes, and therefore the dividend you can pay your shareholders.

Why is the gold lease (i.e. interest) rate so cheap? Well, basic supply/demand. An interest rate is the “price” of borrowing/lending something. If you have a lot of demand for borrowing and less lending supply, then the price (interest rate) goes up. So a low gold lease rate means there is a lot of lending supply, but not as many borrowers.

So who is on the supply side? Well those who hold gold and want to earn a return on it. As I noted in my last blog, central banks hold approximately 1 billion ounces and they are really the main supply of lent gold. In theory private investors could also lend their gold, but there aren’t any mechanisms in place in the market to deal with small players, so it really is a wholesale market and only accessible by central banks or large institutional holders.

Who is on the demand side, well three groups really – miners, fabricators and short sellers. The fact is there are not a lot in the first two groups relative to supply. In respect of the short sellers, banks (should) be reluctant to lend too much because of the risks involved (that is the topic of a whole other blog). Therefore there is a limited market demand to lease gold, hence the rate is low, and has been low, or lower than cash rates, for a very long time.

Hedging

In a world where money is gold, your Goldmine company would simply borrow gold, use that gold to pay for equipment and wages, get the gold out, have it refined and then use that gold to repay the loan, with hopefully some gold profit left over to distribute to shareholders. However we live in a world where money is paper, so the people selling Goldmine the equipment and the workers want to receive paper dollars instead (crazy some would say). But even though we live with paper dollars, Goldmine could still do the first and last part – borrow and repay gold.

So in practice Goldmine leases just enough gold to cover setup costs and extraction costs. With lease rates at 0.2%, the “interest” bill is much lower than if it borrowed dollars. However it needs dollars, so it immediately sells the gold for dollars and uses those dollars to build the mine and pay workers.

Now the alarmists out there may say “that is not good, Goldmine has short sold and is exposed”. Not so, because the definition of short selling is that you have sold something you don’t own and will have to buy it back in the future. But Goldmine does have gold in the ground, so it has actually just sold gold it already has in advance, not sold short.

Let’s assume for simplicity that all up production costs (equipment and wages) for Goldmine are $300 million, the current gold price is $600 and that the whole 1 million ounces will be mined in one year. To get the $300 million to mine the gold, Goldmine leases 500,000 ounces at 0.2% (interest cost at the end of the year is therefore 1,000 ounces) and sells this at $600 per ounce to generate the $300 million.

Everything goes well and at the end of the year it has mined 1 million ounces. It repays the 500,000 ounce gold lease plus 1,000 ounce interest, leaving 499,000 ounces. This is sold at $600 per oz = $299.4m. Yippe, happy shareholders!

So what about the alternative scenario, where Goldmine just borrows $300m cash? Well at the end of the year it would have 1 million ounces which it sells for $600m. It repays the $300m loan plus $6m interest (at 2%). This leaves $294m cash, $5.4m less than if it leased gold.

What happens if the gold price goes to $900 per ounce at the end of the year? In the leasing example, Goldmine would still have leased 500,000 ounces at the start of the year because the price was $600 at that time. So at the end of year it sells the 499,000 ounces @ end of year price of $900 = $449.1m. Yippe!

Under the alternative method using cash borrowings, Goldmine would sell the entire 1 million ounces for $900m. It repays the $300m loan plus $6m interest (at 2%). This leaves $594m cash, $144.9m more than if it leased gold. 32% extra yippe!

Now you may say that leasing doesn’t look too good anymore. In a stable price market you are slightly better off but with a rising price you are a lot worse off. Correct, but what happens if the price drops below production cost, to say $200 per ounce?

In the leasing example, Goldmine would still have leased 500,000 ounces at the start of the year. So at the end of year it sells the remaining 499,000 ounces @ $200 = $99.8m. Interesting, even though the gold price is below production cost Goldmine still made money. Yippe!

Under the cash borrowings method, Goldmine sells the 1 million ounces for $200m. But it can’t repay the $300m loan plus $6m interest. It is $106m short and your shares are worthless. No yippes!

These examples demonstrate that leasing gold and selling it in advance (or forward selling) is a way of hedging (or protecting) against a fall in the gold price. In the current market where the gold price is well above the cost of mining gold, and is expected to go higher, there is little need to hedge. However if the gold price drops towards the cost of mining, then Goldmine would be crazy not to protect itself.

Hedging (and as a result, leasing, because it is what allows hedging in the first place) is not of itself bad in my opinion. Whether it is reasonable is entirely dependent upon one’s risk profile and assessment of the risk of the gold price declining. Those who say that no miners should be hedging and leasing should not be allowed as just dictators, forcing others to accept the risk/return tradeoff they consider acceptable. I don’t think that there is anything unreasonable about someone saying I’d rather Goldmine hedged so it will not go bankrupt if the price drops below $300 and I’m prepared to trade that off against higher profits if the price goes up.

However, the way gold mining is done is that the investor doesn’t really have control over the hedging decision. You may have a good company with solid management that you like, but a hedging program (or lack thereof) that you don’t like. Or vice versa. Too bad, they both come packaged together. It would be interesting to see a market where miners did capital calls on shareholders to pay cash costs as they occurred and disbursed all gold mined as dividends. Individual investors could then go into a separate retail market where they could enter into arrangements with a bank to forward sell their gold dividends if they thought the price was going to decline or simply sell at spot as they received the gold if they thought the price was going to rise. That suggestion is probably impractical (the company would have to go after those shareholders who got it wrong and couldn’t pay the future capital calls), and inefficient (bulk hedging by a miner with a bullion bank is cheaper than many small shareholders doing it), but the “I’m in control” part I like.

The examples I have went through above about Goldmine leasing gold directly and selling it in reality doesn’t occur. If a miner wants to hedge, they simply go to a bullion bank who offers them some sort of contract, be it a forward sale or option, customised around their unique circumstances and projected production. However, whatever financial instrument is constructed, behind the scenes the leasing of gold and its sale is ultimately involved.

Where’s the gold?

One final thing I would like to cover is the global “balance sheet” for gold in the example I have put forward, because there is a lot of talk about central banks and whether they have the gold or not and whether it is leased out and whether it is doubled counted. Let’s go back to our scenario of Goldmine leasing 500,000 ounces to hedge its production costs. At the beginning, the global gold stocks look like this:

Central bank asset - physical gold in vaults – 1,000 million ounces
Goldmine shareholders asset - physical gold in ground – 1 million ounces
Private investors’ asset - physical gold in vaults – 1,000 million ounces
Total – 2,001 million ounces

After the central bank lends gold to bullion bank who lends to Goldmine who sells it, the situation is:

Central bank asset – physical gold in vaults – 999.5 million ounces
Central bank asset – claim on bullion bank for leased gold – 0.5 million ounces
Bullion bank asset – lease to Goldmine – 0.5 million ounces
Bullion bank liability – lease to central bank – 0.5 million ounces
Goldmine shareholders asset – physical gold in ground – 1 million ounces
Goldmine shareholders liability – lease to bullion bank – 0.5 million ounces
Private investors’ asset – physical gold in vaults – 1,000.5 million ounces
Total – 2,001 million ounces

In this interim stage what has happened is that the central bank has traded physical gold for a claim to future physical gold, plus interest. Via the bullion bank through to the miner, on a global scale the central bank effectively “owns” part of Goldmine’s gold in the ground. However, it is a claim only – the central bank has a counterparty exposure to the bullion bank, which has an exposure to Goldmine. After the gold is mined and all leases repaid and Goldmine’s remaining gold sold the situation looks like this:

Central bank asset - physical gold in vaults – 1,000.001 million ounces
Private investors’ asset - physical gold in vaults – 1,000.999 million ounces
Total – 2,001 million ounces

In the end, the gold in the ground ends up with investors, with the central bank back with its physical metal plus a bonus 1,000 ounces. There is nothing inherently bad about this in my opinion, with the central bank facilitating the mining of gold, a good thing I think we would all agree.

The issue in the real world is does the central bank really know what the bullion bank is doing with the leased gold, does it know if it has been prudently lent out to reputable miners who are not excessively hedging or speculating (e.g. Sons of Gwalia)? The fact that a central bank has leased out gold is not a problem for me, the question is to whom and what have they done with it, and will they be able to repay the loan.

I’m a firm believer in free markets, so I don’t believe in regulating gold in any way and that includes leasing, or hedging or financial derivatives. No one had the right to tell someone else whether they should or shouldn’t lend their gold (or borrow it). But one can’t be half free, so I’m also a believer in free information. So the problem is not so much leasing itself, but that there is no transparency in the gold market in regards to the global gold “balance sheet”, telling us where the real physical is and where the paper claims are.

Next week, how refiners go about converting raw mined gold.

1 comment:

John K said...

In 1990, National Rail did a ten year gold loan where they borrowed gold and sold it into the market at around A$600 to realise the cash. They were thus short gold. The Treasurer's assumption was that he would stay short over a ten year term...and borrow or lease gold to cover the repayments on the gold loan. If gold stayed below A$1000, he was better off over the 10 year period as cost of money was 13% and gold borrowing was consistently though not guaranteed below 1%. The gold price fell and the deal looked fantastic. But Minister responsible for NR forced him to close out the position as NR should not be speculating in gold. Only example I know of gold loan to non mining company (John K)