Well, not quite. The miners need to do at least some hedging.
Imagine you're a big gold miner, like Barrick Gold or Goldcorp. All in, including costs like exploration and mining and wages and the cost of keeping
those huge trucks filled up with oil and tyres,
it currently costs these big miners about $950 to produce an ounce of the shiny yellow stuff.
Gold goes for thirteen hundred bucks an ounce right now, so the gold companies could in theory go completely unhedged - "naked", as they say - and run around with their gold-miner ding-dongs swinging in the breeze screaming "look at us we're making $350 an ounce aren't we awesome".
But then, what happens if gold drops to $1000 an ounce and you're not hedged? Your margins collapse to $50 an ounce, your shareholders are deeply unhappy, and you have to start cutting costs to preserve your profits.
If gold goes to $900 an ounce then you're really rooted; you have to start mothballing your most expensive mines, and eating into your working capital just to keep the lights on, because every ounce of gold you produce
costs you fifty bucks. At that point you might as well switch the lights off and go home.
So smart gold producers will hedge at least some of their output, so that if the price of gold slumps they've got a bit of cover (and a bit of extra time to start selling and mothballing assets before they run out of cash.
The problem, like I was saying, is that gold companies tend not to be very good at this hedging thing. The thing to remember when you read the next two paragraphs - when gold miners hedge, they have to sell gold; and when they unwind their hedges, they have to buy gold.
Back in the early 2000s I used to sit next to the gold desk; gold was down in the $300s, companies were scared it was going to zero, and we were writing gigantic five- and ten-year hedges left right and centre.
But a decade later, when gold was rocketing higher into quadruple digits, gold miners
were spending billions of dollars to unwind those awfully expensive hedges they sold when gold was a thousand bucks cheaper.
So gold companies need to do a bit of hedging, or they risk blowing up the company (which shareholders tend not to like). But they can't do
too much, because then if the gold price rallies the shareholders will hate them.
Any mining and commodity company executives who are reading this, here's your solution: buy put options. No funky exotic stuff; no zero-cost collars; no short options at all; just
buy put options. Your shareholders will bitch and moan because you're spending cash upfront to hedge, but they'll thank you in five years' time when gold has either tanked through the hedge level and your company is still alive, or screamed higher and you've taken them along for the ride. Plus you get the best possible accounting treatment - full hedge accounting, which you don't get when you do messed-up exotics, which makes for nice smooth accounts and no awkward mark-to-market volatility on the profit and loss accounts.
Also, volatility in almost every asset class is at historically low levels. That makes hedging with options cheaper than it's ever been.
I'm totally serious about this. I did this on the sell-side for ten years. I know what works and what doesn't. If you're a company executive, and you'd like me to help you design and execute a commodity or FX or interest rates hedging strategy, drop me a PM and we'll talk.
