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10 november 2014

A negative outlook for gold prices and capital-intensive projects make the largest Russian gold miners increasingly resort to hedge contracts. This mechanism provides a guaranteed income fr om the sale of their products to counterparty banks, almost regardless of fluctuations in the market price for gold. By the spread of this practice, which can be safely regarded as crisis management, one can judge the situation in the gold market - the higher the proportion of hedges, the more unenviable are the prospects of gold in the opinion of market players, taking into account that they are willing to neglect a possible upside associated with this asset. When prices were high, gold producers did not enter into hedge contracts, resorting to them only for project financing. However, the 30-percent drop in prices in 2013 changed the attitude to hedging, as it provided stable revenues for companies in the downturn.

Gold miners seek hedge contracts only in an emergency, including due to that industry players repeatedly ran into negative effects of this measure in the past. Long-term hedging, which was beneficial during record price slumps, results in losses in periods of price recovery. In 2004 to 2007, Polimetall (later turned into Polymetal), once Russia's largest producer of silver, used to sell large amounts of this precious metal at fixed prices to Standard Bank London (subsequently succeeded by ABN AMRO), which organized a syndicated loan for this company. Polimetall’s lost profits fr om the operation, which did not allow the silver producer to use favorable market conditions to their full extent, were estimated at over $ 80 million in 2007 alone. Having fulfilled its obligations, Polimetall declared that in the future the company's policy would be to avoid any agreements that may lim it a potential positive impact of rising prices for precious metals.

Polymetal keeps the word and today remains the only one of the four largest Russian gold miners avoiding hedges. The first to return to hedging was Petropavlovsk having a high debt burden and high-cost projects. Petropavlovsk was prudent to enter into the first contract in February 2013, after a long break, putting in about 47% of annual production (399,000 ounces) at an average price of $ 1,663 per ounce. It was in February of 2013 that gold peaked and started to decline on the background of a possible QE3 phasing-out by the United States, slower growth in China and the sale by Cyprus of some of its gold reserves. In May 2013, Petropavlovsk secured another contract reflecting the gold price valid in that period, which was $ 1,408 per ounce. This three-month contract was valid until June 2014. The risk taken by Petropavlovsk was justified. By the end of 2013, the company’s average selling price, taking into account the hedging effect, reached $ 1,519 per ounce - almost 10% higher than the average market price during the period.

"To hedge gold prices was not our brilliant idea, it was a necessity,” Andrei Tarasov, First Vice CEO of Petropavlovsk, explained in the beginning of 2014. “We hedged our prices based on the requirements of auditors and banks, and not because we foresaw the fall in gold prices in 2013.” He said that the company resorted to hedging, if the forecast for gold prices in the budget did not allow servicing the current debt or current activity. Petropavlovsk set the price at $ 1 200 per ounce for 2014 and therefore this year it was reasonable to have hedge contracts at a price not lower than this level. Gold spot prices rose to $ 1,350 in the first quarter of this year, and it was inexpedient to have a conservative hedge for the company, but prices went corrected by the second half of the year, and Petropavlovsk managed to get a positive effect to the tune of $ 59 per ounce from its hedge contracts for the first 9 months of 2014. The company sold gold at an average price of $ 1,329 per ounce in January-September of 2014.

Performance of Russia’s largest gold miners in the first 9 months of 2014 and production dynamics year on year


* Gold equivalent

If for Petropavlovsk with loans on hands hedging was explained by its pre-default condition, Russia's largest gold miner, Polyus Gold went for hedging for two reasons. Firstly, the company wanted to insure the cash flow of its least profitable gold field, which was Kuranakh (providing about 8% of total production at the cost exceeding $ 1,250 per ounce), and that of its placers. Polyus’s other operations have lower production costs and they will not be subject to hedging, the company said.

However, in early July this year, Polyus Gold suddenly released a large-scale strategic price protection programme, under which Polyus hedged almost 40% of its projected production until 2018. In this case, on the backdrop of volatility in gold prices the logic of Polyus was to provide a steady cash flow to implement its main investment project, the Natalka Gold Field, one of the largest idling gold deposits in the world having a reserve of 40.8 million ounces. Polyus will need $ 320 million to finance capex at Natalka, while the overall level of capital expenditures totaled $ 1.3 billion. The commissioning of the first stage of the Natalka Mining Division, initially scheduled for the end of 2013, was postponed to the summer of 2015 due to poor market prices.

Polyus is pursuing a strategy consisting of two parts. The first part includes forward contracts at fixed prices, which appear to be a traditional and conventional instrument, though not typical for a large-scale producer like Polyus. The company intends to sell 310,000 ounces of gold at a price of $ 1,321 per ounce starting from July 1, 2014 to June 30, 2016.

The second part of the program is a series of options, called zero cost Asian gold collars or revenue stabilizers, under which Polyus Gold may sell up to 2.52 million ounces of gold (surpassing the level of production in 2013 1.5 times). This component of the program consists of two tranches, which differ in their volume and implementation terms. The first tranche is valid from April 1, 2014 to March 30, 2018, while the second - from July 1, 2014 to June 29, 2018. Within the first tranche, Polyus will sell 300,000 ounces of gold annually during the first three years of the programme, whereas in the fourth and the last year the company will sell as much as 900,000 ounces. The second tranche will see 120,000 ounces sold annually in the course of three years and 360,000 ounces during the last year.

These transactions differ from the regular hedging by the cap and floor limits set for the price range. Each of the tranches has its own collar - for example, in the first one it is $ 1,634 and $ 950 per ounce, respectively. Let us describe how it works taking the mentioned tranche as an example in which there is a possibility to sell maximum amounts of gold.

If gold prices decrease below $ 950 per ounce, the tranche will be canceled and the gold miner will sell gold at its market value. If gold prices will stay within the $ 950 - $ 1, 382 range, the contract price for Polyus will be the highest - $ 1,382 per ounce. If gold will be traded in the range of $ 1382 - $ 1634 per ounce, Polyus Gold will again sell its goods at market prices. But if the price exceeds $ 1,634 the miner will sell gold at $ 1,518 per ounce.

In the course of three of the four years of the programme, Polyus will benefit from a moderately optimistic scenario, selling gold to banks at the maximum price, but in case gold prices will exceed $ 1,525 per ounce, the company will have to let its counterparties skim the cream off in exchange for hedging. In fact, the company has deliberately rejected the possibility of a sharp rise in gold prices and took care to maximize its revenues in a market situation considered most likely.

In the first 9 months of 2014, the hedging programme brought Polyus $ 11 million of additional income: the company sold 144,000 ounces of gold at a price of $ 1, 371, while the weighted average price for gold in this period reached $ 1,293 per ounce.

Last October, Nordgold announced that it was mulling a possibility of hedging as well, though previously the miner did not see the need. Despite the fact that gold has a very bad history with hedging, Nordgold’s CEO Nikolai Zelenski says that "short-term insurance of risks associated with downward movement in gold prices may justify itself if the company has a substantial investment program." "For example, if you have to implement some program of capital investments and the price seems reasonable, then why not fix it for three quarters ahead? Such opportunities are there and we think of them, but so far there is nothing specific about it," he said.

We should note that the "short-term" hedging for three quarters, in the version of Nikolai Zelenski, does not differ much from the last year's hedge taken by Petropavlovsk.

The fact that Nordgold changed its attitude may be explained by that counterparty banks remain optimistic about gold prices - and thus can offer miners favorable conditions to date, - as well as by large-scale investment commitments. Currently, Nordgold is implementing two development projects: one is Gross in Yakutia (requiring $ 300 million in capex and awaiting the decision to be launched after the company will obtain a construction permit depending on market conditions) and the other is Bouly in Burkina Faso (wh ere capex is reaching $ 140 million).

Igor Leikin for Rough&Polished