In Ted Butler's Archive

Lessons Learned?

By Theodore Butler

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

Just this morning, my wife informed me that she just had a telephone conversation with an old friend who passed along regards for me, as well as the comment that she noticed gold had moved up quite a bit and how she hoped I wasn’t feeling too bad because silver hadn’t. When I told my wife that silver had gone up even more than gold, she was genuinely surprised, as I’m sure her friend would have been.

With 2005 now history, we can speak with precision about what occurred over the past year. The most obvious is to record and note actual price performance. For the year, silver appreciated 30% in price. This gain was 50% greater than the almost 20% increase in the price of gold. To the casual observer this might have been somewhat surprising, given the amount of publicity given to gold. But silver investors have learned to take it in stride, content with profits and value and not headlines, as silver has outperformed gold in each of the past three years

In fact, silver has cumulatively outperformed the other popular precious metals (gold, platinum and palladium) over the past three years by a wide margin, with the three-year return on silver close to almost double the equivalent gain in gold, 50% greater than platinum and almost 7 times the gain in palladium. Considering the value and fundamentals of silver, I would think that the out performance of silver compared to other precious metals (and all other natural resources) should become a regular feature in the years to come. By the time you do see silver in the headlines, the out performance should be astounding.

But, I am not using the occasion of the closing of the books on 2005 to showcase silver’s price performance. I have another thought in mind. The end of the calendar year is also the occasion for marking-to-market on a wide variety of derivatives transactions. While it will be several weeks until the publicly traded mining companies report official year-end hedge book results, it is the closing prices of December 30 that will determine those results, plus any positions that were added or liquidated during the third quarter.

I’m going to go out on a limb here and talk about two companies in particular, even though there could have been trading changes during the quarter that cause my figures to be wide of the mark. I don’t think there have been major changes and the situation is serious enough that I don’t want to wait until the companies report to get my message out. If there have been major changes that render my numbers way off, I will acknowledge my error, if and when that becomes obvious. In the meantime, I just don’t want to wait.

The first company I want to write about is Barrick Gold, which is scheduled to become the largest gold mining company in the world by virtue of its merger with Placer Dome. On December 30, that merger was not consummated, so the figures I will discuss apply to Barrick without Placer, although also being a hedger, the addition of Placer to Barrick will only increase the numbers I quote.

Barrick Gold is the largest gold hedger in the world, holding a short hedge position of almost 13 million ounces. In the last quarter alone, because the price of gold increased by roughly $43, Barrick should record a mark-to-market loss of $560 million on its gold short hedge. The loss for the year and half-year comes to a cool billion dollars. This should increase the total outstanding loss on Barrick hedge book to just shy of $3 billion. With Placer added in, the loss has to be greater than $4 billion.

The almost $3 billion open gold loss on Barrick’s books is greater than their cumulative total profits for the entire existence of the company. To my knowledge, it is the largest derivatives loss in history. I ask you to think about that for a moment. The world was atwitter with the recent $200 million copper loss by China, as well as the $500 million oil loss and bankruptcy by China Aviation Fuel (Singapore) last year. Barrick is set to report a $560 million gold hedge loss for the quarter, $1 billion for six months and almost $3 billion in total, and the financial world looks the other way.

According to Yahoo, of the 20 analysts covering Barrick, 18 rate it as a hold, buy or strong buy and 2 as a sell (there were no strong sale ratings). This, for a company that is holding the largest open trading loss in history. Why is that?

I think it is because Barrick has succeeded in doing the only thing it can do – trying to downplay the short gold position and to hide it deeply in its financial statements. It has even taken to splitting the gold short position into two pieces in its financial notes. I think this is to make it look like the loss is smaller than it actually is, although even cut in half, it still ranks as the largest single trading loss in history.

The problem with Barrick’s gold short position is that it is too large to be covered, or bought back, without major consequences, either to the company or the gold market. With a total dollar amount approaching $7 billion needed to buy back the short position, it would seem too costly for the company to buy back. A close out would also force the company to acknowledge the trade was stupid and ill advised in the first place, something the company’s reputed arrogance would argue against. And at 13 million ounces, the short position is much larger than the combined gold held in all the gold ETFs. A sudden gold buy of 13 million ounces would surely send the gold market flying, greatly compounding Barrick’s loss.

What makes the Barrick record derivatives trading loss even more shocking and remarkable is that the company was given ample time and repeated warnings about its outsized gold short position. I know this to be true because I personally warned them. Actually, I did a lot more than warn the company personally; I also warned them publicly. And I did it when gold was below $275 an ounce. In addition, I also contacted and warned their auditors, the New York Stock Exchange (where Barrick trades as ABX), the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).

My main reason for attacking Barrick’s short position then was because I felt it was manipulative to gold (and silver) prices. I still do. I know Barrick denies it has manipulated the gold market, but when they put the position on and caused millions of ounces of gold to be dumped on the market, the price of gold dropped by almost $200 an ounce, and when they stopped, the price rose $200. It’s as simple as that.

Here are some articles that I offer as documentation of my claim. You decide if Barrick and the regulatory authorities were adequately forewarned.

With the company, its auditors, the NYSE, and the SEC, I argued that the giant gold short position could jeopardize shareholders and employees. With the CFTC, I argued that Barrick was manipulating the gold market and was circumventing commodity law by being short years worth of production, way above the 12 month limit granted to hedgers. I was not successful in convincing the company or the regulators to rectify the situation.

The irony is that had any one of these organizations done anything to end the stupid and manipulative short position, Barrick would be better off by $3 billion. As an aside, I have often joked that had Barrick taken my advice, I could have earned a sizable commission for the billions I would have saved them.

The lesson here is that just because those in positions of great power and responsibility say or do something, doesn’t make that something right. Barrick and the regulators were clearly wrong not to address the issue then, when gold was way below $300. It was, and is, wrong for a company to short years of production. Too many bad things can happen. It’s just common sense.

Just like it is wrong for silver to have a COMEX short position larger than all known world inventories and to be larger than world mine production. It’s also common sense that something bad will eventually happen to the shorts there, no matter what the regulators say.

With Barrick’s rotten experience of shorting years of production so obvious, you would think no company would ever do that again. You would be wrong. Apex Silver (SIL) just did it. And they did it at precisely the wrong time. Specifically, Apex sold two years’ production of both zinc and lead during the third quarter, as well as 6 months’ production of silver. At the close on December 30th, zinc prices had climbed almost 40% since September 30th, with outsized gains in lead and silver as well, putting Apex’s shorts immediately under water. They’ve got to be many tens of millions of dollars in the hole already. We’ll see when they report 4th quarter results.

And get this; Apex is not scheduled to actually produce any metal for a couple of years. So there is no way the company could deliver material against their short sales now, even if they wanted to. What is it that makes mining executives take such big trading risks? I have seen no evidence that shareholders want mining management to take such big risks. Shareholders want management to increase production and reserves and show a profit, not to try to outsmart the market.

The purpose of this essay is not to pick on Barrick or Apex, but rather to offer something constructive. First, if you are going to invest in mining companies, you must be aware of your company’s hedging position. You don’t have to invest in a company that insists on hedging; there are plenty of companies that don’t hedge. Mining companies that hedge have not had better performance than non-hedgers, to my knowledge. Besides, most invest in resource companies precisely because they think the resource will go up in price. Shorting the resource takes away the very reason for resource investing.

Second, if you are part of management of a mining company, think long and hard before shorting the resources you produce. Your shareholders generally don’t want you to, and much can go wrong. I can’t think of any management-hedging heroes. And please remember, selling more than one year’s actual production is not hedging; it’s gambling.

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