Mining Companies Appear to be Engaging in Hedging Activities once Again

Once upon a time in the West, We Dig It UP Mining, hedged or forward sold some of its expected gold production in order to mitigate price risk and to ensure that it captured reasonable profits on at least part of its production.

Then came the bull market in gold starting in 2001. We Dig It Up was nonplussed to say the least when it saw what its competitors' stock prices were doing while the price of gold was rising. Theirs' were exploding higher while its was languishing. As a matter of fact, New Kid on the Block Mining was bragging about its disdain for hedging while We Dig It Up Mining spend most of its stockholder meetings explaining why it was engaging in this obsolete strategy.

Eventually, threats from disgruntled shareholders and loss of market performance, were enough to convince the Board of We Dig It Up to abandon the practice of hedging altogether and join the crowd.

That is basically the way things have been since early in the last decade, until now!

What do I mean? Simple - Mining companies are now being faced with life and death decisions when it comes to the well being of their business. No one is quite sure how low the price of gold may or may not go but one thing they are certain of; gold down at current price levels means many miners are not going to be able to profitably (that word is key) dig the ore out of the ground for processing.

Put yourself in the seat of the CEO's and CFO's of the miners - Your life's blood is gold. If you can dig it out of the ground and make a profit, enough to pay your bills and reward shareholders, you can plod along, watching expenses, etc. while you wait for the price of gold to move higher. But when that will happen is unclear right now. So you now have a new risk that you have not faced in OVER a DECADE - namely the risk of price falling so low that you can no longer mine it profitably. Seriously, at what point during the last decade did anyone even dream of not being able to dig gold up profitably given the state of a nearly continuous rise in its price. So what do you do? I think the answer is self-explanatory - you have to lock in a selling price for gold that GUARANTEES your business a profit even if the price for the commodity you are mining were to fall even lower.

Welcome back to the world of risk management and HEDGING for the mining industry. That is what I believe transpired this past week. Many mining companies began to re-examine their swearing off of hedging or forward selling and moved to take steps that would guarantee their survival even if it meant leaving some potential profits on the table.

I have come to this conclusion based on my analysis of this week's Commitment of Traders report. I would like to point out here that Eric King and I discuss this in great detail on this week's KWN Markets and Metals Wrap so I strongly urge the reader to tune in to that audio interview when it is posted tomorrow (Saturday).

I did want to provide some graphics however to go with that audio interview.

Here is what I believe the trigger point was for mining companies to begin hedging once again. In looking at the following weekly chart of gold, note that area in the red rectangle that I have noted as STRONG SUPPORT. Keep in mind that although gold had been in a strong downtrend, it had not fallen below the $1340 - $1320 level since April of this year. As a matter of fact, that had marked the low price for gold this year. Strong buying, reports of record offtake  and long lines in Asia at coin shops had come every single time price moved to this region.

Now, when a market has been in a bullish trend for as long as gold has been, it is very difficult for many people to believe that the trend has changed. After all, that is what gold had been doing for over a decade; it had been retreating in price only to find strong support zones and then rebound and go on to make new highs.

This is why many of my friends in the gold camp continue to miss what has been happening in gold. They are not looking at the price chart objectively but continue to call for bottoms waiting for gold to slingshot back higher JUST LIKE IT HAS DONE FOR 10-11 years. Guess what? It did not do that.

I think this is the same problem that afflicted many of those who make decisions at the mining companies regarding risk management. That phrase, "risk management" has not really been needed in a continuously rising gold price environment. All of a sudden however, all of these mining company decision makers sat and watched gold CRASH through that floor of support in price and then proceed to drop over another $100 lower. Yes, it bounced today and yes, maybe the worst of the selling is over, for now, but as a mining company, can you really take the chance that the price of gold is not going to drop lower?

Good prudence calls for some risk mitigation and that means you lock in profits on SOME gold produced when the market gives you an opportunity to do so. This is one of the reasons I expect to see rallies in gold being heavily sold - hedging programs are going to be back in vogue.

Back to the Commitment of Traders report however from which I have deduced my theory. We have come to expect to see, each and every week, as the price of gold descends lower, the Commercial category, composed of the Producer/User/Processor/Merchants reducing the number of shorts as the price moves lower and increasing the number of longs. The opposite is true of course for the hedge fund category. They of course liquidate existing long positions (sell out) and institute new short positions (sell) as the price moves lower. That has been a very reliable pattern for most of the last decade in gold.

What this pattern fails to take into account however, is the fact that hedging fell out of favor among the mining companies a decade ago. Remember the grief that Barrick caught back then???? As a result, we have been accustomed to seeing the Commercial category as being primarily a proxy for the big Bullion Banks as we have not had to consider hedging of any large size by mining companies to deal with.

Nonetheless, it is in this category, the PRODUCER, that any gold mining company wishing to use the futures market to hedge is going to be placed for classification purposes. We might see some of that indirectly through the Swap Dealer category but let's let that go for right now and focus on the former category.

IN this week's COT report, we witnessed a departure from the norm that I just mentioned above; namely, we did not see the Producer/User/Merchant/Processor category have the normal substantial  shift in their overall net short position. Instead, what we witnessed was an increase of 8,754 new longs (futures and options combined) but we also saw an INCREASE in the BRAND NEW SHORT positions of some 7,151 contracts.

The pattern since the middle of May has been a steady decrease in the number of short positions in this category which is why this week's jump of over 7100 new short contracts caught my eye. In looking over the price action and considering the fact that the recording period for this Friday's release of the COT report included the week in which gold crashed through that critical downside support level of $1320, I am surmising that was the straw that broke the proverbial camel's back and has sent some of the mining companies back into the hedging business. In short, I feel very strongly that miners are now getting downside protection in gold to ensure that they can mine their product at a profitable level and SURVIVE!

Why this has caught my attention, and quite frankly I missed it back in early April, was that at that time, the $1525 level had come to have the same significance from a technical chart perspective as the $1320 level had this week and last week. If you look at the chart of outright commercial short positions, you can see that it has been steadily declining along with the price of gold for most of this year. There are brief periods however when the number of shorts has increased in this category. The first one occurred in early April when we had a huge downside break of chart support at $1525. I believe it was at this time, that some of the mining companies began to quietly institute some hedges. Not wishing to get the word out for fear of the stigma of hedging in the gold investment community, they did however begin showing some signs of worry and decided to get some minimal downside price protection.

We then had another spike in the short positions from late April into middle May. That was associated with the rally back up from below $1350 where price come close to reaching $1480. I have no doubt that was bullion bank fresh shorting but now in hindsight it might also have included some hedging by miners.

Of course we have just covered the reason I believe to be behind this week's spike higher in the number of commercial short positions.

I tend to write quite often that one day or one week for that matter, does not a trend make so I want to watch things proceed from this point and decipher price action further in conjunction with subsequent COT releases, but when I read stories in the financial news wires that mining companies are using a word that had been considered, taboo, for most of the decade, my eyes and ears perk up.

From what I can glean from this week's report, in combination with the price action and news stories, I think we can safely assume that hedging is back in vogue and will be until gold gives some evidence that it is ready to move sharply higher once again.

I wish to remind the readers that I live in the world of commodity futures and thus am not an equity expert nor do I hold myself out to be one. I would say however that it might be useful to long term holders of these mining shares to call their Investor Relations department and see if they will discuss whether or not the company might have instituted some hedges and put in place some risk management. At the very least, it would be enlightening. Quite frankly, any mining outfit that did lock in a selling price through the use of forward contracts or through hedging in the futures market, especially back in April of this year, is going to look like a genius to its shareholders right now, given the carnage to the gold price....