A major Russian gold producer earlier this month entered into the gold mining industry's biggest hedging transaction in six years. According to analysts at Thomson Reuters GFMS, gold producers will return to net hedging this year for the first time after 2011. Hedging future production certainly has its benefits. It guarantees future cash flows, especially during a volatile period like the one seen in 2013 when gold prices fell nearly 30%. However, it also limits the upside potential for mining companies.
Miners return to hedging
Hedging future production was common in 1990s. However, the practice became less common when gold entered into a decade-long bull run. In fact, mining companies spent billions of dollars to unwind hedged positions when gold prices surged in the era of easy monetary policy. In 2009, Barrick Gold (NYSE:ABX) raised over $5 billion to unwind its hedge book in order to capitalize on rising gold prices. Since then, the company has maintained a no-hedge position, which is not surprising given that gold prices surged after 2009 as the Federal Reserve launched multiple bond purchase programs.
AngloGold Ashanti (NYSE:AU) spent $6 billion to unwind its hedged positions. The company said last year year that it has no plans to return to hedging even though gold prices tumbled.
Despite major miners' aversion to hedging, gold producers will return to net hedging this year. According to Thomson Reuters GFMS, this will be the first time since 2011 that the gold mining industry will return to net hedging. This will be possible mainly due to a recent hedging transaction from Russian producer Polyus Gold.
The Russian gold producer recently announced that it entered into contracts to sell more than 300,000 ounces of gold over a two-year period. While the hedged position will give the company certainty over future cash flows, it also means giving up any future upside potential. Indeed, that is the major dilemma for gold miners. Hedging guarantees future cash flows, however, it means miners cannot capitalize if gold prices surge.
To hedge or not to hedge
Selling future production at a fixed price certainly has its benefits, especially in volatile times. In 2013, when gold prices plunged, hedging would have certainly benefited the industry. Late last year, John Lawson Thornton, Chairman of the Barrick Board, said that he would consider hedging strategy. Thornton noted that given the characteristics of a commodity like gold, it makes sense to hedge. Thornton's views, however, are not surprising, given that he has a banking background. The gold mining industry and investors, though, generally are not very keen on hedging.
Hedging is in fact seen as a a sign of weakness by investors, especially when it comes to majors such as Goldcorp (NYSE:GG) and Barrick Gold. Indeed, hedging may make sense for smaller producers that do not have the resources to cope with volatile gold prices. For major miners, though, it may not be a good idea, especially in the present environment.
As I have noted in several articles here, gold prices have found a strong floor at around $1,200 an ounce. Most major miners have all-in sustaining costs well below this level currently. More importantly, costs are expected to fall further as miners continue with their cost-cutting measures.
Therefore, miners have a lot more certainty in the present environment. Also, they would miss out any future surge in gold prices if they sold future production at fixed prices. This was the very reason why miners spent billions of dollars to unwind their hedged positions a few years. I do not expect them to return to the practice.
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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.