Hedging FraudulentWhere the Fraud / Double Standard Case Goes Wrong
In earlier papers I have explained that virtually all activities of gold mines that go under the name "hedging" are fraudulent. To the extent hedges go out into the future more than one year, or they exceed the quantity of one year's production, they are naked forward sales, carrying unlimited risk (the risk that the gold price goes to infinity, as it has in the wake of every hyperinflation).
Double standard
Most 'hedged' gold mines are in violation of the important restriction that downstream hedges must not exceed one year's gold output and they must be lifted before the end of the fiscal year. Their practice transgresses not only the limits of prudence, but also the limits of upright business management. A gold mine selling forward in excess of one year's output is guilty of fraud. It is concealing a potentially unlimited liability. The accounting profession, the commodity exchanges, and the government's watchdog agencies have never offered an acceptable explanation for the double standard they apply, one for the gold mining industry, and another one for everyone else. While they allow gold mines to sell forward several years' production, they would immediately blow the whistle if, for example, an agricultural producer tried to do the same.
There is no justification for this double standard. It is scandalous that the government grants legal immunity to gold mines using fraudulent hedges.
- As long as gold can be delivered there is simply no fraud. Fraud would be selling forward more gold than reserves.
- The idea of "unlimited risk" is mistaken. As long as a miner has the gold to sell (or will have it to sell by the time the contract stipulates), where's the risk? The only risk is to potential profit.
- Thus the "unlimited risk" premise is based on the previous falsehood that forward selling is fraud and needs to be covered immediately. Two flaws in logic do not make a right.
- Profit risk is a genuine risk, but that risk actually runs in both directions. That's a point the article does not mention. Let's be honest here: No one really knows what the price of gold will be 5 years from today. And it is because profit risk runs in both directions (based on the future price of gold) that miners hedge for longer terms.
- It may not be smart to hedge long term (more on this a bit later) but it is neither fraudulent, nor inherently risky per se. In fact, a good case can be made that it has a tendency to reduce risk, if done smartly.
- Hedges are disclosed. If one does not like hedged miners, one does not have to buy stocks of hedged miners. In fact, if one believes that hedged miners are a fraud, one should be grateful for the opportunity to short such fraudulent companies.
- Comparing gold, silver, copper, etc, to agricultural commodities and seeing a double standard is simply begging for a rebuttal. Agricultural commodities are hedged from harvest to harvest and new crops have to be planted every year, but gold mine developments have lead times from 5 to 10 years and obviously don't have to be planted every year.
- Agricultural commodities are subject to drought, floods, disease, pestilence, soil depletion, etc., to a far greater extent than miners.
- Agricultural production is subject to far more volume fluctuations than gold production.
- All things considered, there is an obvious "justification" for a "double standard".
And while in myth busting mode, let's refute the theory that reasons "the combined short positions in the futures and derivatives markets on gold greatly exceed monetary gold in existence" as if shorting was done by some mysterious entities to force down the price of gold.
Producers sell gold production. One way is by selling forward gold futures. Gold producers will always be short gold futures. There is no conspiracy there. And for every long contract, there must be a short contract. That is how the futures market works. So if there is a conspiracy by gold shorts, then there is an equal and opposite conspiracy by longs to force up the price of gold greater than known supply.
Simply put, for every long gold future someone must be short a gold future. So where's the conspiracy? All this talk of gold shorts suppressing the price of gold proves is that people do not understand how the futures market works.
Nor was there a conspiracy by the Bank of England (or any other central banks for that matter) to suppress the price of gold. Central bankers tend to be foolish. It's a disease. Yes, holding gold from $800 to $250 and then selling it was stupid. But where's the conspiracy? Stupidity by the Bank of England does not constitute conspiracy.
Nor will there be a mad scramble by gold producers running for cover for the simple reason is all the producers have to do is mine the gold to fulfill the contracts. The idea that gold shorts are going to "have to cover short positions" and that will drive the market higher based on the now discredited idea that hedging over one year constitutes fraud. This is how one bad premise leads to all sorts of subsequent misguided hypothesis.
Besides, if gold shorts were going to drive the market way higher then why complain about it? I think the frustration comes in when the expected event after major price runups never seems to occur but is instead met by profit taking causing still more conspiracy talk.
I am not trying to paint a picture of complete market innocence. But I am attempting to portray a balanced view that suggests conspiracies are not lurking behind every corner nor are conspiracies behind every move up or down in the price of gold.
A Look at Barrick Gold
The FP Trading Desk is reporting Barrick Gold should dehedge completely: Citigroup
Now that Barrick Gold Inc. (ABX/NYSE, ABX/TSX) has fully eliminated its "corporate" hedge book, rendering ongoing operations 100% exposed to spot gold prices, its time Canada's largest gold miner rid itself of the remaining 9.5 million ounces left on its "project" hedge book, according to Citigroup analyst John Hill.Before going any further let me say that I am not a big defender of long term hedging per se, and certainly Barrick has made huge mistakes. Barrick could have and should have unwound hedges anywhere from $300-$400. And yes that is going to cost shareholders profit. But no, those hedges do not constitute "fraud" nor are they "entirely unreasonable".
Mr. Hill believes de-hedging would erase the discount valuation in the stock and add $3 to $5 per share to Barrick's net asset value based on expectations that gold will keep climbing. In fact it could even drive the gold price higher by $30 to $40 per ounce, the analyst added.
Barrick, however, appears reluctant to unwind its "project" hedge, choosing instead to view it as an important financing tool for projects such as Pascua-Lama in Chile & Argentina, Mr. Hill concluded, adding the hierarchy of capital allocation seems to be projects, dividends, buybacks then dehedging.
When gold prices crashed from $800 to $250 many miners went out of business. A very good case can be made that Barrick stayed in business because of its hedges. That said, Barrick over-stayed its hedging welcome by a mile. So what now?
I disagree with Hill that Barrick should cover those gold hedges now at $700. If they did, and the price of gold collapsed to $500, Barrick would be in a world of hurt. In essence, and after failing to cover at $250, $300, $350, $400, etc., Barrick would be betting the farm that prices are heading north of $700 and more importantly will stay north of $700 for quite some time. While that may (or may not) be likely, is it really worth betting the company on?
But those who disagree and think Barrick is being fraudulent and will be forced to suffer "unlimited losses" on account of hyperinflation or "forced covering" have the option of buying physical gold or an unhedged miner like Goldcorp (GG) or Newmont Mining (NEM), and shorting Barrick (ABX) as a paired trade.
No, I am not recommending this play. If anything I would advise against it. I am merely point out a trade for those who believe in fraud and various conspiracy theories.
Is Gold Safe Place To Hide? - Take Two
I received many emails pointing out a "flaw" in my reasoning as presented in Is Gold a Safe Place To Hide?
One idea discussed in the aforementioned article is that that "few seem to look beyond the myth of gold acting as an inflation hedge to the reality that gold is a better deflation hedge." A second idea presented was "Gold does well at extremes. In other words hyperinflation and deflation, and poorly at other times."
The "flaw" that was pointed out by many was that the U.S. was on a gold standard in the great depression but is no longer on a gold standard now. "Since gold is no longer money it cannot be expected to hold value in deflationary times."
The "flaw in the flaw" is that gold has been money for thousands of years and gold is still money today. How do we know that gold is still money? The short answer is that in spite of what any government says, gold still acts like money.
The long answer for why "Gold is Money" was presented in Misconceptions about Gold. That answer was further expounded upon in Why does fiat money seemingly work?
Those looking for reasons to buy gold can find them in A Safe Way to Own Gold and Silver or 10 Reasons To Own Gold. Let's get back to basics and forget about fraud and conspiracies.
Disclosure:
Positions in junior miners and physical gold
No position in GG, NEM, or ABX
Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/
Posts
