sep 112002

M. Murenbeeld &Associates Inc.

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P.O. Box 6187, Depot #1Victoria, British ColumbiaCanada V8P 5L5Tel: (250) 477-7579Fax: (250) 721-3524www.murenbeeld.com

In Defense of Gold Hedging The Case of Barrick

August 2002


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In Defense of Gold Hedging The Case of BarrickINTRODUCTION

Not a day goes by without some comment on the newswires or gold com-mentary sites that gold hedging is a scourge on the gold market, and that thegold price would be much, much higher were it not for hedgers Invariably,Barrick is mentioned as the leading miscreant among hedgers, and devotedto suppressing the gold price lest its outstanding hedges are overtaken by arising gold price.

A sample of the commentary I have collected serves to highlight the vitri-olic nature of the criticism levied at Barrick - criticism tantamount to slan-derous, and which a company smaller than Barrick might otherwise findprofitable to litigate. Among the worst commentaries is a piece written byAntal Fekete, entitled The Texas Hedges of Barrick, which can be foundon a number of gold-related web sites, including www.gold-eagle.com. Thecommentary starts with the nonsensical claim that [hedge] sales must neverexceed one years output and that the hedges of Barrick represent an un-limited liability. It deteriorates from there. Barricks spot-deferred con-tracts are fraudulent, may well ruin the company financially, and are anan invitation to bankruptcy. This will leave Barrick open to class-actionsuits by the shareholders, and the officers of Barrick are blockheadswrapped up in their own glory who do not understand the very nature of theproduct they help bring up from the bowels of the earth.

Those who claim the existence of a conspiracy to suppress the price ofgold, directed by no less than the US Federal Reserve, also finger Barrickamong the conspirators. In an official Complaint (dated December 7, 2000and undertaken by one Reginald Howe supported by GATA, the Gold Anti-Trust Action group) point number 13 claims that an examination of the goldhedging activities of the worlds two largest gold mining companies,AngloGold Ltd. based in South Africa and Barrick Gold Corp. based inCanada, suggest that both companies have material non-public knowl-edge of the gold price fixing scheme which they have used to their advan-tage.

What is the gold investor to make of all this? Indeed, the claimants ofBarricks fraudulent behavior come with impeccable credentials. AntalFekete, for example, is Professor Emeritus at Memorial University of New-foundland.

Yet, impeccable credentials do not imply that such charges againstBarrick and its officers are remotely accurate. I have a Ph.D. from Berkeley,


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0

500

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1500

2000

2500

3000

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85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02

With Gold

With TSE Precious Minerals Index

With XAU

RATIO BARRICK SHARE PRICE :Month endDec 1985 = 100

California, and was on staff at the Faculty of Management Studies at theUniversity of Toronto during the 1970s. I am currently an Adjunct Professorat the Faculty of Business at the University of Victoria. I can say honestlythat not every professor is up to snuff. Indeed, one of the motives for thisarticle is my affront as a part-time academic by the diatribe that passes forargument from those with impeccable credentials.

This paper presents a defense of the practice of gold hedging, and a de-fense of Barricks hedging program specifically. The paper will start with asomewhat detailed explanation of hedging. It will then highlight the costsand benefits of hedging before delving briefly into the debate about hedgingunder the section The Costs to the Industry. The paper will conclude withan analysis of Barricks hedging strategy in order to highlight the costs andbenefits of this strategy to the Barrick shareholder.

The informed reader may skip any section except the last, withoutloss of continuity.

It is worth noting right at the outset that we have found nothing inher-ently dangerous or ill-conceived in Barricks hedging strategy. It is astrategy that has provided Barrick with cash flow well in excess of the mar-ket over the last 58 quarters, and which has therefore benefited Barrickshareholders despite very difficult market conditions.

Just how well it has served the shareholder can be gleaned from thechart below, which compares the Barrick share price with the gold price, withthe TSE Gold and Precious Minerals Index (which includes Barrick), and


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with the Philadelphia XAU index (which also includes Barrick). The rise inthe Barrick share price attests to just how much it has outperformed thesebenchmarks over the last 17 years. Clearly the blockheads at Barrick havebeen doing something right.

THE THEORY AND MECHANICS OF HEDGING

The Theory of Hedging

Hedging is defined as the process of reducing exposure to an eventthat could be costly to a firm. Speculation is defined as the process ofincreasing exposure to an event that could be profitable to a firm.

By definition, hedging is the opposite of speculation. (Antal Fetekewrites about Barricks arbitrage activity, but arbitrage is the process ofprofiting from buying in one market and selling in another something quiteunrelated to hedging.) It follows that if the event turns out opposite to whatwas expected there will be costs opportunity costs (in the case of hedgers) orcash costs (in the case of speculators).

The origin of hedging goes back to agricultural economies where peasantfarmers would commit to sell their output to a middleman in order to avoidthe volatility of future produce prices. (Ergo, commodity exchanges grains,hogs, etc. are among the oldest exchanges.) These farmers would transferthe risk of price declines, to which they were exposed and which could beruinous, to a middleman - a risk-taker (possibly an outright speculator whohoped to benefit from a future price rise). The farmer was risk-averse,meaning he would prefer the certainty of a fixed price at which to sell his out-put. Obviously, in the event the price of his output turned out to be higherthan what he contracted for with the middleman the farmer would suffer anopportunity loss but he would experience no direct cash loss.

The farmer would not typically contract to sell next years production for-ward, because the vagaries of weather and other variables left him uncertainas to the size of his harvest a year out. He recognized that if he was unable todeliver produce that was sold forward, and market prices were higher thancontracted, he could be ruined.

This basic need to transfer risk has, over the years, spawned whole in-dustries. In the financial industry it has led to the development of numerousderivative markets and instruments, each instrument having very specificrisk-transference characteristics. The management of risk has also become ahighly specialized field within the general field of business management. In-


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deed, there are probably very few managers still working in major corpora-tions today who have not at one time or another had to transfer a specific riskby way of some derivative instrument.

Gold price hedging, or the process whereby the risk of a future gold pricedecline is transferred to a risk-taker(s), also developed naturally. I was anadvisor to Lac Minerals in the early 1980s when that company (since mergedwith Barrick) began to apply risk management techniques developed in theforeign exchange market to the gold market. (It is an interesting aside thatback then a gold company might very well hedge its Canadian Dollar expo-sure, but not its gold price exposure. The prevailing view was that you didnot hedge the gold price risk if you did you were speculating that the goldprice would not go up. No such double-think was applied to currency hedg-ing however.)

In gold hedging it is not strictly necessary for the risk manager tohave a view of the future price of gold. A good risk manager needs toknow the degree to which the company will accept adverse price outcomes; arisk manager needs to know the risk profile of the company, in other words.Once someone like myself a gold price analyst - lays out different gold pricescenarios for the future (remember, no one knows what the price of gold willbe in the future) the risk manager can construct a profit and loss profile forthe company and act in accordance with the companys risk profile to miti-gate the worst outcomes.

The point is, a good risk manager is not directly taking a bet on thegold price! The manager is managing the risk of adverse outcomes; he/she ismanaging the companys exposure to events that have cash cost implications.It does follow, however, that when all the gold price scenarios are bullish i.e., when there is a low perceived probability that gold prices will decline the risk manager will typically hedge the price risk less than when all thegold price scenarios are bearish i.e. when there is a high perceived probabil-ity that gold prices will decline. The perceived probability of losses is higherin the latter case. A risk manager isnt directly interested in the pinpointforecast of the future gold price furthermore, which is invariably wronganyways. He/she is interested in a range of potential price outcomes with thesubjective probabilities of such outcomes.

Currently, the gold price scenarios are more bullish than bearish. Ac-cordingly, gold producers are scaling back their hedging activities. Yet thesharp decline in the gold price the week of July 26 serves as warning thatnothing is certain, and even the low probability scenario of a price decline canturn up.


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The foregoing does not apply to hedging that is motivated by issues re-lated to new mine development. It is often a requirement of the lender thatsome percentage of future output of the new mine be hedged in order thatthe risk of future financial difficulties is reduced. But here, too, the drivingfactor is risk, and how to reduce it!

The mechanics of hedging

When a gold producer contracts to sell gold forward it is for a specificdate at a specific price. For example, a producer may contract to deliver 100ounces of gold one year from today. The buyer, or counter-party, is typically abullion bank, and it is legally bound to pay the contracted price upon deliveryof the 100 ounces. The price is set today, of course.

The forward price is calculated from the current spot price ofgold, the current lease rate for gold, and the current US DollarLIBOR rate (the London interbank offer rate). Because the bullion bankborrows gold from a central bank at that banks lease rate, sells the gold di-rectly into the market at the spot price, and invests the proceeds at theLIBOR, its net return is spot + LIBOR lease. This net return is paid tothe producer.

Since LIBOR is invariably higher than the lease rate the forward price istypically at a premium to the spot price. The premium is called a contango.When the contango is large (when LIBOR is high and lease rates are low)there is a financial inducement to the producer to sell gold forward. Indeed,the risk manager typically compares the forward price of gold with the vari-ous gold price scenarios and the respective probabilities to help formulate ahedging strategy.

It follows when a producer sells gold forward there is a spot mar-ket sale of gold, and this affects the price of gold. In effect, selling gold for-ward accelerates the impact of future supply. From a central bank perspec-tive gold loans provide a way to earn a small return (the lease rate) on theirgold assets. If central banks (or in rare cases, private holders of gold) werenot willing to lend gold, producers could only sell gold forward to anotherbuyer directly, with the bullion bank acting as a broker (much like sellinggold in the spot market). The forward market would collapse to a small frac-tion of its current size.

A forward sale is not the only means of hedging gold price risk. The goldmarket now encompasses all the sophisticated derivative instruments used in


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currency and credit markets. A producer can also buy a put option ongold, for example. If open for one year, the producer has the right to sell acertain quantity of gold at a specific (floor) price one year out. The producerwould exercise the option in the event the actual gold price fell below thefloor price (the correct name is the strike price). In the event the gold pricedid not fall below the strike price, the producer would sell gold in the marketdirectly, loosing only the premium paid for the put option.

The seller, or writer, of the option typically, again, a bullion bank hasa more complicated task of managing its own exposure to gold price fluctua-tions however. With a forward contract the bullion bank expects to receive(the 100 ounces of) gold, which it will return to the central bank from which itwas lent. It is square, gold bullion coming in matches gold bullion going out.With a put option the bullion bank doesnt know for certain whether it willreceive gold from the producer however. At regular intervals the bullion banktherefore makes a statistical estimate of the likelihood of receiving gold, andsells/buys gold forward as the likelihood increases/decreases. This deltahedging by the bullion bank is quite complicated; suffice it to say that a putoption generally leads to less spot market selling of gold than a forward con-tract.

A third method of hedging gold price risk employs both put op-tions and call options. A producer can buy a put option as above, and atthe same time sell a call option. The call option sold to the bullion bank givesthe bank the right to receive gold from the producer at another, higher strikeprice. The bullion bank pays the producer a premium for this right. If for ex-ample the producer buys a one-year put option at $280 and sells a one-yearcall option at $350, then the price the producer will receive one year hence forits gold will fall somewhere between $280 and $350. If the actual price of goldfell below $280 the producer has the protection of the put option with a$280 floor price, and if the gold price rose through $350 the bullion bank willexercise its right to call up the gold from the producer at $350. (This sort ofhedging instrument is sometimes referred to as a min-max call option. Inthe foreign exchange market it is sometimes called a range forward.)

Min-max call options are popular among some producers becausethe premium received for the call option helps pay for the cost of theput option. With luck, the producer can structure an acceptable price rangewith no out-of-pocket expense. (Smaller producers often find this a net ben-efit, as cash is generally tight.)


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THE COSTS (AND RISKS) OF HEDGING

Opportunity Cost

As they say, there is no free lunch! The benefit to a producer of transfer-ring gold price risk to a bullion bank has costs attached to it. The trick is tokeep these costs to an acceptable level. (We will see below how Barrick doesit; what follows here are the textbook costs of hedging.)

The first, and obvious cost is that a producer will not profit as much as itmight from a significant rise in the price of gold. This cost is an opportunitycost an opportunity missed, as it were. (My economics dictionary definesit as a gain foregone.) With a forward contract the opportunity cost is thedifference between the forward price, and the actual price in the spot marketon due date. If 100 ounces were sold forward at $325, for example, and the ac-tual gold price on due date was $335 then the opportunity cost is $10 perounce, or $1000. (Of course, the opportunity cost has to be compared againstthe cash gain of a potential decline to, say, $300.)

In theory, the opportunity cost of a forward sale is open ended. Inthe event gold shoots up to $1000 the opportunity cost of a $325 forward saleis $67500 for 100 ounces. Yet, an event that causes gold to shoot upwards to$1000 is by its very nature a low probability event, and therefore not gener-ally expected. A good risk manager is aware that low probability events dohappen however. (LTCM, for example, was bankupted by a confluence of sev-eral extremely low probability events.) The risk manager will therefore en-sure that there are provisions in the contracts and in the companys gold pro-duction schedule to deal with such chance events.

A put option is designed to limit these opportunity costs directly.By ensuring a floor price for gold, but not limiting the upside, the produceronly ever pays the premium for the option. In the event the premium is $500for a $295 put option on 100 ounces (or $5 per ounce), then a price rise to$350 nets the producer a $345 price. In the event gold falls to $275 the pro-ducer exercises at $295 for a net price of $290. The $500 premium is a cashcost, paid up front, and never recovered. It is often referred to as an insur-ance cost.

The cost of a min-max call option is generally just an opportunity cost,provided the premium collected for the calls equals the premium paid for theputs. In the above example, where the range is $280-350, the opportunitycost starts above $350 and is again open-ended.


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A Lower Stock Price

While an opportunity cost is not a cash cost, it will be registered some-where. In the event gold prices rise beyond the forward price, theory holdsthat the stock price will be lower than otherwise because the producersearnings/revenue stream will be lower than otherwise. (Of course, when thegold price sinks below the forward price the stock price will be higher thanotherwise because of the extra revenue received.)

To the degree that a gold stock is also a call option on gold bullion to beproduced, and since such a call option becomes more valuable when the prob-ability of higher gold prices rises, a cap on the gold price to be received by theproducer will also hurt the stock price. (Theory seems to support the notionthat gold stocks are options on gold bullion, meaning that upward volatilityin the gold price is positive for the value of gold stocks.)

It follows that investors who have a very bullish view of the goldprice will prefer to invest in gold stocks that have few/no gold hedgesoutstanding. But when the price outlook is very bullish risk managers arealso very likely to hedge less gold output! A certain synchronicity develops, inother words. Yet the risk manager, by the very nature of the role, is unlikelyto unwind hedges as fast as the investor might wish. Ergo, the cost of hedg-ing to the producer when the gold price outlook is very bullish is a shift of in-vestor sentiment to other, less-hedged producers.

The Economic Cost

The third cost of hedging is more difficult to establish. There should bean economic cost to hedging, in so far as risk takers need to becompensated for accepting a risk the producer does not want to bear.The academic literature is not conclusive on the actual cost however. Sufficeit to say that in the currency markets forward rates are not particularly bi-ased, meaning that over long periods of time there is no advantage to nothedging the amount received in the spot market when not hedging averagesout to be about the same as the amount received in the forward market whenhedging.

I am inclined to say that because central banks have lent their gold attoo low lease rates however, that there has been a definite advantage to hedg-ing gold the contango has been higher than it should have been in a per-fectly competitive market these last 15 or so years. Accordingly, I believehedgers have on average received more for their gold than non-hedgers have.But 15 years may be too short a time period of analysis.


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Suffice it to say, that more academic work needs to be done on this aspectof the costs.

The Risks in Hedging

This section deals with the risk of inadvertently constructing hedgeswhere something goes wrong. (Hedging tools are sophisticated, and the legalcontracts are often complicated.) The reader has heard of a number of caseswhere hedges nearly bankrupted several producers. Without referring tospecific cases (I dont have full knowledge of these cases in any event), let meoutline areas where hedging mistakes can be made and/or where frictionscan develop between the producer and the bullion bank to the detriment ofthe producer.

The first risk is that a producer may have inadvertently oversoldits output forward. It is understood that a producer must deliver the con-tracted amount of gold on due date. If the producer cannot, there is a prob-lem! (I witnessed first hand a large Canadian manufacturing bankruptcy inthe early 1980s because the company could not deliver the billions of US Dol-lars sold forward against Cdn Dollars, and the Cdn Dollar declined precipi-tously in the meantime. The company had made US Dollar revenue forecaststhat did not materialize because of the 1980-82 recession.)

If a producer cannot deliver the agreed amount of gold on due date theproducer must buy gold in the market and deliver that to the bullion bank. Inthe event the price of gold is below the contract price (below the forward pricenegotiated some time ago) the problem is academic. The producer buys thegold in the market and delivers it on the contract at a profit. In the event thegold price is above the contract price, however, there will be a cash loss which can potentially be huge. If gold is sold forward at $300, for example,and gold shoots up to $400 the cash loss will be substantial. Such cash lossescould bankrupt the producer.

Along similar lines, there is something called a margin call . Margincalls are a requirement in the futures industry, where small and large specula-tors take positions in a market with only a fraction of the total value of the con-tract. The broker marks to market a speculators position daily and subtractsany hypothetical loss directly from the account balance. In the event the remain-der falls below a minimum level, the broker makes a margin call to the specula-tor. The speculator must then deposit more money in the account or the contractis liquidated and all losses are charged to the speculator.

Margin calls could come into play in gold hedging when a producer hassold gold forward, and the price of gold skyrockets. When the forward con-


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tract is marked to market the hypothetical loss could exceed the credit limitof the producer, for example. Despite the producers full ability to deliver goldagainst the contract on due date, the bullion bank may depending upon thespecifics written in the contract ask for more margin. In the event the pro-ducer cannot raise the required amount of cash again, depending upon thespecifics written in the contract the bullion bank may liquidate the contractat very significant loss to the producer. (This is a terrible situation for theproducer, of course! The producer might very well have been able to deliverthe required amount of gold on contract date, and incur an opportunity lossonly maybe not even an opportunity loss, in fact, were the gold price to fallas sharply as it rose. But instead the producer suffers a punishing cash loss!)

The Costs to the Industry

This is a most contentious issue, and one that needs some illumi-nation because it threatens to fracture the generally good relationsamong gold producers generally.

It is true that when a producer initiates a forward hedge contract the ac-celerated selling of gold will lower the spot price of gold somewhat. Gold thatwill be produced in the future is sold immediately, meaning that often bothcurrent and future output is sold in the spot market at the same time. Sinceproducers have gone from zero hedging in the early 1980s to 3073 tonneshedged at the end of 2001 (source: Gold Field Mineral Services - GFMS) therewill have been an impact of these extra 3073 tonnes on the market. Table 1provides an estimate of the average yearly price impact of hedging these 3073tonnes.

It follows that those producers who chose not to hedge will havereceived somewhat lower prices for their output than otherwise. Thesenon-hedgers could have also hedged their future output of course, but thatwould have lowered the price of gold yet further. One is apt therefore to con-clude that the cost of hedging has been borne by the non-hedgers.

But there is more to this issue! It is undoubtedly true if all producers re-frained from hedging and the central banks that otherwise lent their golddid not turn around and sell it then the gold price would have been higherin past years. But the same can be said about gold production; if goldproduction had been lower in recent years the gold price would havebeen higher as well! Does it therefore follow that producers should collec-tively curtail production when gold prices are soft? That would be dangerousin the extreme! While OPEC might be able to fix production schedules tomaintain higher oil prices, the full weight of anti-trust legislation would fallon gold producers who attempted to do that for the gold price.


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GOLD PRICE SUPPLYHedging Actual change adjusted % of impact on impact

Year Net $/oz. (%) (tonnes) Supply price - % US$/oz1983 4 423.61 12.91 1326 0.30 -0.12 -0.511984 38 360.78 -14.83 1846 2.10 -0.84 -3.061985 62 317.26 -12.06 1868 3.46 -1.38 -4.451986 45 367.85 15.95 2023 2.25 -0.90 -3.341987 149 446.22 21.30 1973 8.18 -3.27 -15.101988 353 436.87 -2.09 2438 16.95 -6.78 -31.771989 178 380.79 -12.84 2899 6.54 -2.62 -10.231990 234 383.59 0.73 2719 9.42 -3.77 -15.011991 66 362.26 -5.56 2868 2.36 -0.94 -3.451992 135 343.95 -5.05 3181 4.43 -1.77 -6.211993 142 359.82 4.61 2932 5.09 -2.04 -7.481994 105 384.15 6.76 3016 3.61 -1.44 -5.621995 475 384.05 -0.03 3345 16.55 -6.62 -27.231996 142 387.87 0.99 3285 4.52 -1.81 -7.141997 504 331.29 -14.59 3887 14.90 -5.96 -20.991998 97 294.07 -11.23 3592 2.78 -1.11 -3.301999 506 278.56 -5.27 3763 15.54 -6.21 -18.462000 -15 279.11 0.20 3731 -0.40 0.16 0.452001 -147 271.07 -2.88 3488 -4.04 1.62 4.32

Total 3073 average -9.40

Assume producers de-hedge the full amount over the next 8 years

2002 -300 325.00 19.90 3400 -8.11 3.24 10.212003 -300 335.00 3.08 3400 -8.11 3.24 10.522004 -350 345.00 2.99 3400 -9.33 3.73 12.422005 -400 355.00 2.90 3400 -10.53 4.21 14.342006 -400 365.00 2.82 3400 -10.53 4.21 14.752007 -400 375.00 2.74 3400 -10.53 4.21 15.152008 -400 385.00 2.67 3400 -10.53 4.21 15.562009 -400 395.00 2.60 3400 -10.53 4.21 15.962010 -123 405.00 2.53 3400 -3.49 1.40 5.58

Total -3073 average 12.72

source: GFMS, Murenbeeld estimates

HEDGING

TABLE 1


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Hedging is a means of guaranteeing higher expected future pro-duction than otherwise. The criticism of hedging therefore comes down tocriticism of an action intended to secure higher future production. But shoulda producer not attempt to secure higher output? Should a producer not useall the tools available to it to secure what it perceives to be in its sharehold-ers best interests? Indeed, should a new ore body be mothballed, despite aproducers willingness to risk time and development capital, because it mightrequire the guarantee of a forward contract? To put it more squarely, whoseinterests should a producer serve: its own shareholders or the shareholders ofthose producers potentially hurt by its actions?

The fact that individual gold producers actions may depress the price ofgold is also a fact of life in other markets. Indeed, even central banks com-plain that the collective action of participants in the currency markets (spotand forward) often drives the price of the currency beyond reasonable levels and accordingly hurts the economy. And the currency market is huge incomparison to the gold market!

It is in the nature of any market that if both producers and consumerscollectively feel that the price of the commodity is more likely to decline thanrise, their collective action will make it happen. Accordingly, if everyonethinks the gold price will go down, it will indeed decline. Should those pro-ducers who have determined that such a decline represents too much risknevertheless stand firm and forgo actions to reduce this risk?

Lest we forget, the knife cuts both ways! Producers who have hedged inthe past are, in light of more bullish price expectations, now paring backtheir hedges. And this is contributing to a rise in the gold price whichwill now benefit the non-hedgers disproportionately. Table 1 also pro-vides an estimate of the price impact of a hypothetical decline in gold hedgingover the next 8 years. What hurts non-hedgers on the way down should feelvery good on the way up! That in the interim some non-hedgers may havehad to pack it in, well, that is the markets way of cleaning house. Quite liter-ally, their lost output has been gained by the hedgers.

So, what can we conclude? First, the gold market is small; indi-vidual actions by large producers do have an impact on the gold price. Largegold producers are not, in the strictest sense, price-takers. While the ac-tion of any one of a million little gold producers will not affect the gold price,the gold market is in a period of consolidation - meaning the impact of anyone producers actions in the market will be magnified in the future. Yet, pro-vided that there will be a number of large producers in the industry, it doesnot follow that each producer should serve the markets interest before its


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own shareholders interests. Rather, large producers should support themarkets interest through programs which boost the demand for gold, as hasbeen proposed by Barrick and others. Indeed, the large hedgers are, to myknowledge, among the most active in promoting gold demand.

As long as there is a forward market for gold and a perceivedneed to transfer price risk, hedging will continue. It will rise as themarkets view turns bearish and it will fall as the markets view turnsbullish! All producers should therefore make their peace with hedgingand let the gold equity investor decide which management style bestsuits the investors own risk preference a management style that al-lows for hedging, or a style that does not.

AN ANALYSIS OF BARRICKS GOLD HEDGING PROGRAM

The Barrick Program

In Note 16 of the 2001 annual report it states, The Company maintainsa commodity-price-risk-management strategy that uses derivative instru-ments to mitigate significant, unanticipated earnings and cash flow fluctua-tions that may arise from volatility in commodity prices The Companyuses spot deferred sales contracts and options contracts to manage theserisks. One can safely conclude from this that the companys intent is to man-age price risk, much as we indicated under The Theory of Hedging.

Table 2 provides a summary of data made available in Barricks annualand quarterly reports. We have made some simplifying assumptions in thetable for the purposes of exposition. Barrick will not agree with these (unreal-istic) assumptions for obvious reasons. The first is that Barrick will generateno new additions to its reserves. At an assumed 5.7 million ounces of produc-tion per year going forward (with which Barrick will also take issue), Barrickwill have an effective life of about 13 years before its reserves run out. Evenunder these stringent assumptions, however, Barrick appears morethan capable of delivering against all its hedge contracts as they falldue!

Indeed, the total number of ounces hedged is only 27% of (assumed) 2002reserves. The hedge contracts are spaced out, furthermore, so that no morethan 62% of assumed production is due in any one year. Bear in mind thatin reality Barrick will find more reserves it has every year of its existence.This means that the hedged ounces, if not replaced with new hedge ounces,will decline sharply as a percent of reserves. Output is also very likely to behigher than 5.7 million ounces going forward.


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TABLE 2BARRICK Gold Hedge Positions - June 30, 2002

2002 2003 2004 2005 2006 2007+ TotalSpot Deferred

thousand ounces 1400 2800 2650 1600 1600 7850 17900average price ($/oz) 365 340 340 335 340 346 344

Call Options - variable pricethousand ounces 500 420 400 170 820 2310strike price ($/oz) 342 320 328 349 362 343

Min-Max Call Options - variable pricethousand ounces 200 150 350

cap price($/oz) 297 310 303floor price ($/oz) 266 280 272

Call Options - fixed pricethousand ounces 60 115 230 405strike price ($/oz) 310 343 354 344

Total Hedges - Deferred, Call, Min-Max 1600 3510 3185 2000 1770 8900 20965

Assumed Production*assume current production forward 2980 5700 5700 5700 5700 51800 77580

Proven and Probable Reserves**year-end, assuming no yearly additions 77580 68900 63200 57500 51800 0

* Expected production for 2002 is for July-December

** Reserves are at mid-year 2002, assuming there were 80.3 million ounces of reserves at 2001-end and no additions during the first half of 2002

Hedges - Percent of Production 54% 62% 56% 35% 31% 17%Hedges - Percent of Reserves 27%

All Barrick hedges are of a spot deferred type, which means thatthey do not represent a direct claim on production in any one year.There is accordingly no reason for Barrick to get itself into the situation ofhaving to deliver gold that it has not produced. Ergo, the worst disaster inhedging that of having inadvertently hedged more gold than can be deliv-ered is not relevant in the case of Barrick. (Only in the last few years of itsassumed 13-year life, when reserves are nearly depleted and Barrick has notyet delivered against any of its contracts, will there be a potential opportu-nity cost.)

I did not discuss spot deferred contracts in the theory section because itis more appropriate to do so here. (Spot-deferred contracts are often pro-ducer-specific, owing to the nature of the credit and trust involved.) The typi-cal spot-deferred contract is a forward contract that may be rolled over into anew forward contract on due date. If we assume that a producer has negoti-ated a one-year spot deferred at a price of $340, it may deliver against thiscontract one year from now, or it may roll over the contract into another


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one-year forward contract. The new forward price will be $340 plus the pre-vailing one-year contango, regardless of what the spot and forward prices areat the time. (Only the contango is uncertain!)

In the standard spot deferred contract the roll-over isnt neces-sarily automatic however. The counter party (bullion bank) may requiremargin or other comfort measure before agreeing to a roll over. In theabove example, were the actual price of gold on due date to be $375, the spotdeferred would be underwater by $35. Even the roll over would only havea contract price of about $350 ($340 plus a one-year contango of, say, 3%),which would still be less than $375! It follows that a bullion bank might be-come nervous in such a situation. Suppose gold rose by another $50 in the fol-lowing year? Without absolute confidence in the producers ability to producethe agreed amount of gold and without deep producer credit lines the bullionbank might panic and pull the plug on roll over date, if not before.

The Barrick spot deferred contracts have the unique feature ofbeing of 10 or of 15 years duration. This means that Barrick can roll thecontracts for 10 or 15 years before termination, without question. TheBarrick contracts have shorter pricing dates however. Much like a 10-yearmortgage might be re-priced every 1, 3, or 5 years, depending upon whetherthe borrower chose a 1-year, 3-year, or 5-year term, Barricks spot deferredcontracts are re-priced at regular intervals before their maturity/terminationdate. (Table 2 also shows when the repricing dates occur.) And much like a10-year mortgage, the lending institution cannot close out Barricks spot de-ferred contracts before maturity/termination date only Barrick can closethem out early.

There are some caveats to the last statement, to be sure. Barrickscounter parties can request termination at the next price setting dateif there has been a material and lasting impact on Barricks ability todeliver gold (if something disastrous were to happen to Barricks productionfacilities, say), or if the counter parties are unable to acquire bullion in theopen market or any organized exchange or to fund any such acquisition (ifthe bullion bank cant borrow any more gold anywhere). Barrick must alsohave a minimum net worth of $2 billion, and a long-term debt to consolidatednet worth ratio of no more than 1.5-2.0:1. Currently these are $3.2 billion and.25:1 respectively. These caveats are clearly spelled out in the Master Trad-ing Agreement which covers all Barricks contracts. Were Barrick to fallafoul of its obligations in the Master Trading Agreement the hedgedounces will be the least of shareholders worries.


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Last, Barricks counter parties cannot make a margin call justbecause the value of the spot deferred contracts, when marked to market, arein significant loss. There are no margin clauses in the Master Trading Agree-ment. (Again, as with a mortgage, the lender does not ask for margin whenthe value of the property falls below the outstanding mortgage.) Barricksonly obligation is to deliver gold on a date of its choosing; depending upon thespot price of gold on that date, all Barrick will incur is an opportunity loss!

Lets look at an example. In Table 2 there are 2.8 million spot deferredounces of gold coming due in 2003 at an average price of $340. Regardless ofthe actual price of gold in 2003, Barrick may choose to deliver against thesecontracts or have them re-priced for the next 1-5 year period. In the eventthe gold price was less than $340 Barrick might choose to deliver againstthese contracts. In this case Barrick would report another gain on its hedgingactivities.

In the event the gold price was, say, $500 however, Barrick might chooseto roll over all 2.8 million ounces. The counter party cannot force Barrick todeliver against the contracts. But Barrick might also choose to deliver someof the 2.8 million ounces, in which case it would average the $340 received onthe contract with the price received in the spot market for the rest of its pro-duction. The average price received will then be lower than otherwise, andthere will be an opportunity loss!

While spot deferred contracts are Barricks preferred hedge contracts, italso has option contracts at variable prices, and options at fixed prices. TheMaster Trading Agreement states however, An exercised option shall betreated as a forward contract. This means that Barricks call options, whenthe counter party exercises them, become forward contracts at the strikeprice. If Barrick so chooses, these can be deferred in a manner similar to theother spot deferred contracts.

For all intents and purposes, Barrick need not deliver any gold atbelow-spot market prices before final termination date of the contract and these termination dates are all at least 10 years into the future. (In-deed, it will be more than 10 years into the future on the 15-year contractsbecause Barrick must be given 14 years notice when a 15-year counterparty decides that the agreement will not be extended. I have assumed forthe purposes of this discussion however that Barricks mine life is only 13years.) Ergo, even the 62% hedge/production ratio for 2003 is relatively mean-ingless given Barricks ability to roll the 2.8 million spot deferred ounces, andthe .71 million optioned ounces, into the future as it sees fit.


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The Benefits of Barricks Hedging Program

I will dispense with the benefits quickly. They are self-evident. The Pro-gram has insulated Barrick more than adequately against the risk of a sharpgold price decline. Some 27% of reserves has been hedged at prices well above$300 per ounce. The Program to date has generated significantly higher rev-enues than could have been obtained through the spot market only. Over thelast 58 quarters, 14.5 years, these higher revenues have contributed an extra$2 billion. This money has been spent on exploration, development, produc-tion and acquisition in other words, on increasing Barrick production with-out shareholder dilution. The $2 billion has also helped increase Barricks le-verage to gold, because the extra expenditure on exploration has led to sig-nificant increases in gold reserves. (This fact seems to be neglected entirelyby Barricks detractors; the Program has allowed the company to grow in avery difficult environment!)

In the event gold prices were to decline again from current levels (at thetime of writing, gold was trading around $315) Barrick should continue to dowell. With the exception of 200,000 ounces with a floor of $266, due in thesecond half of this year (but which can be deferred, of course), and 150,000ounces with a floor of $280 due next year, all contracts have a floor price wellabove $300. (In fact, the weighted average price per ounce of hedged gold overthe next 13 years is $343 see Table 2. And the actual price Barrick will re-ceive could be significantly higher, depending upon the contango at the re-pricing dates.)

The Cost of the Barrick Program

The cost of the Barrick Program is either an opportunity cost orthe cost associated with Barrick not being able to deliver what it hascontracted to deliver. (The latter leads Professor Fekete to speculate thatBarrick will be ruined financially - see above.)

With respect to opportunity cost, there is no doubt that if/when Barrickdelivers gold on outstanding contracts at below-spot market prices it willsuffer an opportunity loss. Such was argued in the theory section as well.Barrick mitigates opportunity losses, however, through the flexibilityof the spot deferred contracts. As noted above, Barrick can choose not totake an opportunity loss by simply rolling the contracts forward on re-pricingdate to the next re-pricing date. In other words, Barrick need not take anyloss at all on any of its contracts until termination date 10-15 yearsfrom now.


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Will Barrick have to take an opportunity loss at termination date? Thatdepends upon a number of factors; the simple answer however is that therewill be no opportunity loss if the spot price of gold on termination date is be-low the contract price. And that could happen! Remember that on each re-pricing date a new contango is added to the original contract price. In theorythere is a point in time when the additional contango catches up with thespot price, provided the spot price doesnt forever rise by more than theamount of the contango. In theory, therefore, Barrick need never take an op-portunity loss. The point in time when the contango catches up to the spotprice might well be beyond Barricks assumed 13-year life, however.

It follows there is risk of opportunity losses during the last four years ofBarricks assumed 13 years of remaining life. This would happen if [1] someof the 20.965 million ounces currently hedged were rolled forward continu-ously until there were only an equal amount of reserve ounces left to bemined, and [2] the spot price of gold was above the final contract price on ter-mination date. In theory, these opportunity costs could be substantial.Yet they are still not cash costs! And we must assume that the aver-age investor, noting Barrick has not replaced any of its reserves, willhave long abandoned the company to its deserved fate.

In reality, Barrick will add reserves going forward, and it will be able toroll its contracts forward as well. In short, if one assumes that Barrick is anongoing concern, demonstrably so if the past is a guide, then much of the riskof opportunity cost will be mitigated.

Barrick does face a potential problem however in the event thecontango turns negative. A negative contango (backwardation) could leadto significant opportunity losses for Barrick. Backwardation represents thebiggest threat to the Barrick Program because the new contract price de-clines on each re-pricing date when there is backwardation. If the spot mar-ket for gold continues to rise or simply trends sideways - then rolling overmeans rolling over into larger and larger potential opportunity costs!

So, how likely is a negative contango? The fact is, the gold market isalmost never in backwardation (LIBOR is almost always higher than the goldlease rate). The two charts herewith show that the three-month contango hasnot been negative since 1993, for example, while the one-month contango wasnegative exactly once on March 9, 2001. Barrick contracts have re-pricingdates of 1-5 years, and the contango for these dates have not been negative inmy experience. It is therefore safe to assume that the contango will bepositive on re-pricing dates. I wont shrink from saying however thatbackwardation represents a risk to the Barrick Program, which can only bealleviated through delivery and booking the opportunity loss immediately.


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-2

-1

0

1

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5

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7

6/3/94 6/9/95 6/14/96 6/20/97 6/26/98 7/2/99 7/7/00 7/13/01 7/19/02

GOLD CONTANGO

Friday dataLast Date: August 9, 2002

-2

-1

0

1

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6/3/94 6/9/95 6/14/96 6/20/97 6/26/98 7/2/99 7/7/00 7/13/01 7/19/02

GOLD CONTANGO

Friday dataLast Date: August 9, 2002

3 month contango

1 month contango

backwardation


21

With respect to the second cost of the Barrick Program, Barricks po-tential inability to deliver against its contracts, let me note immediately thatBarrick need only deliver see Table 1 62% or less of any one years pro-duction. Unless Barrick production problems exceed some 3 million ouncesper annum, Barrick will be able to deliver on all contracts. Further to thispoint, Barrick operates in geographic regions that are no more politically un-stable than those where other major gold producers operate. Suffice it to saythat if the investor is worried about Barricks ability to produce less than halfof the 5.7 million ounces a year I have assumed, that investor is probably toorisk-averse to be investing in the stock market altogether!

The Master Trading Agreement does deal directly with this issue, how-ever. Barricks counter parties can force delivery on re-pricing dates if it hasbeen established that there has been some material and lasting impact onBarricks ability to deliver gold. But again, if that impact is greater than halfthe assumed yearly production then Barrick has larger problems than itshedge contracts.

Barricks average counter parties are of AA credit standing, meaningthat if central banks refuse to lend gold to these parties there simply will beno gold lending market. In this event the counter party can force delivery onre-pricing date. But here again, the fact that Barrick has structured the re-pricing dates such that only about half of expected production falls due in anyone year mitigates this potential problem.

In short, there are no life threatening scenarios that we can de-velop for the Barrick Heding Program without first assuming thatBarrick will suffer some apocalyptic event at its various mine sites.

CONCLUSION

Global public companies must have a business strategy that takes ad-vantage of every opportunity to improve returns and reduce risk, states the2001 annual report. Looking backward, one can certainly see that Barrickhas done exactly that. It has generated some $2 billion with the Program inthe last 58 quarters, which has allowed the company to grow under the mostdifficult market conditions.

Criticism of the Program, and of Barrick management, is there-fore largely off base. Producers who received lower gold prices for their out-put because Barrick (and others) were hedging the price risk of their futureoutput do have a point, to be sure. The price of gold would have been higherhad there been no hedging. But given that Barrick management believes that


22

their hedging Program is in the best interest of the company and its share-holders, it seems to me that there could indeed be a class action suit againstBarrick by its shareholders if management went against its own best judg-ment in this regard.

Yet despite an enviable record, Barrick has come under yet morecriticism in recent days, criticism bordering on the libelous. One wouldthink, now that the outlook for gold has improved, non-hedgers would bethankful that the hedgers are delivering against old contracts and therebykeeping gold bullion off the market and helping its price to rise! Indeed, I amwont to conclude that criticism of Barrick has taken on religious overtones.Those who argue against hedging just dont believe that gold price riskshould be hedged, regardless. I doubt whether reason and debate will haveany impact on the most vociferous of Barricks critics.

I have set forth the argument for hedging gold price risk. I have not saidthat it will always be profitable, after the fact. Hedging may incur opportu-nity losses, a lower equity price in rising bullion markets, and significant fi-nancial risks if structured badly. The inability to deliver gold when required,for example, can be life threatening. As in all management matters however,bad decisions, poor contracts, misunderstandings of obligations, etc., can dountold damage to shareholder interests.

Hedging is a tool, to be used by those who understand it and feelthey can profit from it. In the case of Barrick the tool has enhanced rev-enue, smoothed out the impact of price fluctuations on revenues, and elimi-nated the impact of the worst possible gold price scenarios. Not all gold man-agers want to avail themselves of this tool, and not necessarily all sharehold-ers want management to do so. That is why there is a market, so that alltypes of shareholders the risk takers and the risk averse can find the par-ticular stock that best suits their needs.

For Barrick, being somewhat risk averse compared to other gold produc-ers these last 15 or so years, has been extremely profitable. No one can knowwhether it will continue to be as profitable over the next 15 years. Yet thedata presented in Table 2 suggest that it is very likely to be quite profitablefor the next eight or so years. More to the point, I have uncovered none of thebombs, or other dangerous and ill-conceived aspects of the Program thatBarrick detractors are so quick to claim. I rest my case.

sep 112002

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