In this case study, we explore the strategies employed by American Barrick Resource Corporation, a prosperous gold mining company. The discussion revolves around the diverse hedging programs implemented by the company and the differences observed among these programs. Interestingly, American Barrick was established by Peter Munk, a Canadian entrepreneur who lacked prior involvement in the gold mining industry.
During the years of 1983 and 1992, American Barrick witnessed remarkable growth. Its equity capitalization soared from $46 million to approximately $5 billion, while its annual production skyrocketed from 34,000 ounces to 1.325 million ounces. Moreover, its proven and probable resources surged from 322,000 ounces to almost 26 million ounces. Despite a decline in gold prices, American Barrick remained both fast and profitable. The company achieved profitability through various means, including acquiring gold mines at reasonable prices and discovering reserves in Goldstrike that facilitated economies of scale.
This case examines American Barrick’s approach to managing unexpected production from the Meikle Mine, the evolution of its hedging programs, the financial instruments involved, and the impact of these programs on the company’s outstanding performance. Gold-mining companies, as producers of commodity products, incurred minimal marketing and distribution expenses. The market readily accepted their product at market price after extraction and refining.
The profits of gold producers were determined by the quantity of their production and the difference between the prices at which they sold their output and their costs. Gold producers operated in four main phases: exploration, acquisition, digging, and ore processing. In the exploration phase, gold producers gained a competitive advantage based on the physical features of the ores they found. This advantage could be achieved by finding mines with gold closer to the surface, mines with richer ores, or mines with ores that were easier to recover. If their exploration techniques allowed them to estimate gold quantities before excavation, they had an even greater advantage.
In the acquisition phase, gold mines required significant investments in infrastructure for digging and processing ore. These fixed or sunk costs were necessary due to the geology and economics of gold mining. A gold producer gained a competitive advantage based on the number of ores it owned. Owning more ores increased the likelihood of obtaining one of these natural advantages mentioned earlier.
The mine process is a common practice in the industry, where a large amount of ore must be mined and processed to extract small quantities of gold. American Barrick’s Goldstrike Mine serves as an example, with approximately .127 ounces of gold found per ton of ore. This means that around 16,000 pounds of rock need to undergo mining and processing to obtain one ounce of gold, which can be sold for $300-400. The mining procedure includes crushing, heating, sorting based on density, chemical treatment, and refining to remove impurities.
Using advanced technology in gold mining tools can give a competitive edge. For instance, having a tool that can extract gold more efficiently would be advantageous compared to conventional tools. Furthermore, marketing and distribution costs are not incurred by gold-mining companies since their product is considered a commodity. Once the gold is extracted and refined, there is always a market where it can be sold at prevailing prices. The profitability of a gold mine relies on production quantity and the margin between selling price and expenses.
To gain a competitive advantage, gold producers should focus on the cost of gold production, which is influenced by the quality of the gold deposit and operational efficiency. It’s important to consider input costs and ore features when selling gold to maximize profits, as the selling price is beyond their control. Throughout its history, Barrick has employed various strategies such as gold financings, forward sales, options strategies, and spot deferred contracts under its risk management program known as American Barrick’s hedging program. These measures allowed Barrick to reduce exposure to price fluctuations while remaining flexible to benefit from increasing gold prices. Hedging against gold price risk is crucial for gold producers due to high production costs and frequent price fluctuations. Looking ahead, one-third of mines are projected to be unprofitable at current prices.
Interest, currency, and commodity derivatives were used as alternatives to effectively manage the risk of inflation. However, the practice of discounting inflation was introduced in 1984 through the selling of gold forward, and the discovery of approximately 18 million unexpected ounces of gold reserves at Goldstrike further accelerated hedging activities. This event set a standard for risk management at American Barrick, ensuring protection against price declines for all production up to 3 years and 20-25% protection for the subsequent decade.
The financial team was looking for ways to make money during the fluctuations in rice prices in early 1991. They sold about 1 year’s worth of production in one hour. According to American Barrick’s first annual report, their corporate strategy was to acquire or develop various gold-producing interests only in North America. Another aspect of American Barrick’s strategy was to maintain conservative financial policies, such as issuing minimal debt and mitigating the firm’s gold price risk.
Munk’s objective was not to remove risk entirely (because of the potential benefits), but instead to control it, thus positioning American Barrick as a cost-effective commodity producer that prioritized avoiding future losses over maximizing profits. The board of American Barrick established a risk management guideline with Goldstrike: the company would have complete protection against price declines for production up to three years in the future, and 20-25% protection for the next ten years.
Specific details of the methods and implementation were delegated to the financial team, who submitted regular reports to the firm’s board of directors. We now focus on analyzing the strategies of American Barrick to gain a deeper insight into the advantages of each strategy and the effectiveness of the risk management program at the corporation:
- Gold financings:
- In 1983, American Barrick financed the purchase of the Renabie Gold Mine in Ontario, Canada, by issuing common shares. However, an extra $18 million was still needed for capital expenditures to develop the mine.
In 1984, to finance its expansion, American Barrick raised $17 million through the Barrick-Cullaton Gold Trust. Under this trust, investors received 3 percent of the gold mine’s output when the price of gold was $399/ounce or lower, and 10 percent when the price was $1,000/ounce. Investors benefited from both the higher volume and price of gold. American Barrick’s subsequent acquisitions were funded through bullion loans and gold indexed Eurobond offerings.
The Mercur Mine received funding through a loan from Toronto Dominion Bank. In return, they received 77,000 tons of gold, and American Barrick would make installment payments to repay the loan. An advantageous aspect of this arrangement was that the loan was backed by the mine itself, which had a value of over $50 million. Additionally, American Barrick secured funds for the Goldstrike Mine through a bullion loan totaling 1,050,000 ounces, which was the largest gold loan in the world at that time. Moreover, the corporation raised funds by offering $50 million worth of 2% gold indexed notes to Eurobond investors in 1987.
Investors purchased notes at a price of $1,308 and received annual interest payments of $26.16. In a forward sale of gold, a party agrees to deliver a set amount of gold on a specific date for a pre-determined price. No money is exchanged until the contract ends. In many markets, the seller of the forward contract receives a premium (contango) that is higher than the current gold price. Contango is determined by the difference between the interest rate for lending dollars and the interest rate for lending gold.
In 1984 and 1985, gold prices experienced a significant decline, prompting American Barrick to engage in their first explicit forward sales of gold. This was necessary as the declining prices brought the company’s profitability to levels equal to their estimated break-even point, posing a threat to their financial stability. In order to protect themselves, American Barrick sold approximately 20,000 ounces of gold in 1984. However, this strategy was not entirely advantageous, as it meant forfeiting the opportunity to sell at higher market prices, which were more appealing to potential investors or buyers.
Starting in 1987, American Barrick began exploring option-based insurance strategies as a means to mitigate the risk of price declines while still retaining some of the benefits associated with rising prices. They employed a collar strategy, which involved purchasing put options while simultaneously selling call options on gold. By using the premiums obtained from the sale of calls to purchase puts, the collar strategy did not require an initial cash outlay. This aspect made the strategy more acceptable to the firm’s board of directors.
Spot-deferred contracts (SDCs) became a key strategy for the firm in 1990, replacing new options positions. SDCs are a type of forward sale of gold that differ from true forward sales in that they have multiple delivery dates, with the final one occurring 5-10 years after the contract is initiated. Initially, American Barrick’s SDC trading agreements required delivery within 4-4 years, but due to its substantial reserve base and strong financial position, the company was able to negotiate subsequent agreements allowing for a 10-year delivery timeline.
American Barrick utilized spot-deferred contracts to capitalize on rising gold prices and establish a minimum selling price for its gold. Firms were closely monitored for their management of price exposure, with differentiation based on these strategies. Certain major producers opted not to engage in risk management activities, arguing that hedging diminishes shareholder value, thereby enabling shareholders to fully leverage increases in gold prices.
American Barrick recognized the importance of managing gold price risk as a fundamental aspect of their business, forming one of their four primary objectives. Different gold mining companies in North America exhibited a range of risk management policies and practices. Over its ten-year history, American Barrick’s hedging program adapted and employed various tools, including gold financing, forward sales, options strategies, and spot deferred contracts. By implementing these measures, American Barrick mitigated some gold price risk while retaining flexibility to capitalize on increasing prices. This diligent focus on money and company value distinguished American Barrick from similar firms in the industry, propelling them to the forefront of the gold mining sector. Their approach involved exploring different methods, evaluating their efficacy, and adopting alternatives that promised greater value. Notably, they prioritized investor interests in their funding approaches, earning my genuine admiration for the corporation.
The success of American Barrick was not due to luck, but rather to its commitment to risk management and thorough research on derivative transactions. American Barrick’s major positions were established with Goldstrike during a period of high gold prices. This suggests that their hedging practices would have continued to generate extra revenue if the price of gold had consistently risen throughout the company’s history.
