Dodging the derivatives bullet - Part 2

In Part 1, we discussed some of the pitfalls of derivatives and hedging. This time, we’ll dig a little deeper into an example of a real-life derivatives disaster by having a posthumous gander at gold miner Sons of Gwalia.

To get the ball rolling, let’s talk about gardening. More specifically, Japanese gardens. These are the only place where one may expect to find a perfect hedge. As the experience of our wheat farmer from last issue proves, even those financial hedges made with the best of intentions can turn out to be costly. Our farmer made an ‘honest mistake’, which is something we all do, large companies included. So, was Sons of Gwalia’s downfall the result of an ‘honest mistake’?

Well, partly. As far back as we can readily find the company’s annual reports, there’s evidence of lots of hedging of future production or, in financial jargon, Sons always had a large hedge book. That means it sold most, if not all, of its anticipated gold production several years into the future. The most important part of that previous sentence is ‘anticipated’, a point we’ll return to shortly.

Gold, a metal for which there’s worldwide demand, is priced in US dollars. Thus Sons, to ensure its Australian dollar revenues, had to also hedge the Aussie dollar against the Greenback. As a result, Sons operated with a large hedge book of forward gold sales in US dollars and another large hedge book of forward Australian dollar purchases to match. In a perfect world, as with our wheat farmer, Sons of Gwalia had ‘locked in’ its future revenues. All it had to do was produce the gold at around its budgeted cost. And that’s where the trouble began.

Producing gold at around its budgeted cost is something Sons had done for many years—and from some of the most difficult, marginal gold operations in the land. It was a feat that certainly commanded respect. Sons ran its operations with the kind of financial tightfistedness that, in the pubs around Kalgoorlie, earned it nicknames such as ‘stingy Soggies’ and ‘the southern cross misers’ (a reference to their operations at Southern Cross, WA).

Then, suddenly, things went wrong. We’ll never know the whole truth but hazard to suggest Sons started to believe the market hype surrounding its tantalum operations and that the future really was a tasty oyster to be devoured with glee. In short, Sons was probably overcome with corporate egotism. The new managing director saw taking over the Tarmoola gold operations north of Kalgoorlie as a way to excite the market further. But doing so also proved, as these things often do, to be a grave mistake. Sons was now the proud owner of an even more marginal operation with some acute problems.

The problems at Tarmoola took up management’s time and led to increasing costs across the entire gold division. Very soon the company was battling to produce its committed ounces at a profitable price. Here’s where the words ‘anticipated production’ come to the fore.

Given a certain amount of machinery, employees and an expected grade of ore, a miner anticipates the amount of gold it will dig up each year. But when the employees and machinery, despite all their hard (and expensive) efforts, turn up less than expected, financial misery can ensue. Perhaps Sons didn’t dig out as much ore as hoped for, or perhaps the grade wasn’t as high as first thought. Either way, the pile of gold at the end of the year was less than expected.

But, being a miner in a rather large hole, the company made a fatal mistake—it kept on digging. As best as we can work out, an originally ‘honest hedge’ book became more of a speculative tool—we assume in an attempt to rectify its dire situation—and the hole just kept getting deeper. But once Sons’ directors realised that its gold reserves couldn’t possibly be large enough to deliver on all of its financial hedges, they were forced, by law, to appoint administrators. The rest is history.

The warning signs regarding Sons’ difficulties were all there, plain as day—although the company’s derivative disclosures in the accounts told us little, if anything, of what was going on. More revealing were the departing founders, fleeing chief financial officer, disappearing CEO and ugly cash flow statements. No investor can gain the requisite understanding of a company’s derivative exposure from its accounts. Instead it’s best to rely on the oblique warning signs emitted from those on the inside.

Death by derivatives

Other companies to undergo ‘Death by Derivatives’ include Pasminco and CIM Resources—and that’s just the miners. Many companies have a seemingly perverse desire not just to hedge but to go the next step and get deeply involved in things they really don’t understand: making predictions about the future prices of commodities and currencies. In the end, part of the reason that companies employ derivatives in the first place—so they can borrow swathes of money from bankers—ends up compounding the problem.

Perhaps the most interesting lesson from Sons’ situation is the predicament of mining low-grade deposits. If Sons didn’t hedge and the gold price fell significantly or the Aussie dollar rose markedly, it would have been operating at a loss and could have gone bust. If Sons did hedge but production fell short, a rising gold price could kill it—which is precisely what happened.

As there’s no such thing as a perfect hedge, resource investors should generally avoid companies with marginally-profitable deposits. If a company has a market position strong enough, low enough costs and a balance sheet tough enough, the need for hedging is dramatically reduced, if not eliminated. And those are exactly the sort of companies in which we prefer to invest.

Derivatives aren’t necessarily evil instruments. But what they won’t do is take a bad situation and make it good. Like debt, derivatives can massively accentuate the good times and the bad. All investors can do is run when things start to smell a little fishy.