The following case study reports on a highly successful gold mining company, American Barrick Resource Corporation. We discuss herein the many of the techniques being used in their hedging programs and the variation between such programs. The company itself was founded by a gentleman named Peter Munk, who was a successful Canadian entrepreneur and had come to American Barrick with no prior experience in the gold-mining business.
That being said, the company grew from an equity capitalization of $46 million to about $5 billion, its annual production grew from 34,000 ounces to 1.
325 million ounces, and its proven and probable resources grew from 322,000 ounce to nearly 26 million ounces, all between the years of 1983 and 1992. American Barrick was both fast and profitable, with its profitability coming from many sources, despite a decline in gold prices. The company acquired its gold mines for relatively low prices, and later found reserves in Goldstrike that enabled its scale of economies.
During this case, we determine how American Barrick should handle the unexpected production from the Meikle Mine, the development of its hedging programs over time, the financial instruments of those programs, and how these hedging programs contributed to American Barrick’s superior performance.
The Industry As producers of commodity products, gold-mining firms had virtually no marketing or distribution costs. There was always a ready market for their product, at market price, once extracted from the earth and refined.
Therefore, the profits were a function of the quantity of its production and the difference between the prices at which it sold its output and its costs. Gold producers operated having four main phases: Exploration: Competitive advantages can be viewed as mines with gold closer to the surface, mines with ores richer in gold, and mines with ore in physical forms more amenable to recovery have natural cost advantages over others. A gold producer gains competitive advantage based on the physical features of the ores, and, therefore, can have an advantage if their exploration techniques allow them to determine gold quantities (rough estimation) before the actual excavation takes place. Acquisition: Gold mines also needed large fixed or sunk costs. The geology and economics of gold mining required firms to invest large sums of money to create infrastructure needed to be able to dig and process the ore. A gold producer gains a competitive advantage based on the number of ores that it owns, as having more ores increases the likelihood of obtaining one of these spoken-of ‘natural advantages’.
Develop Mine Process: It is industry standard that large amounts of ore must be mined and then processed in order to extract very small amounts of gold. To point, the ore in American Barrick’s Goldstrike Mine contained an estimated . 127 ounces of gold for each ton of ore, meaning that to produce a single ounce of gold that might sell for $300-400, American Barrick would need to mine and process about 16,000 pounds of rock. Once mined, the ore would be treated by processes including crushing the ore, heating the ore, sorting by density, chemically treating it, and finally refining to remove impurities.
A competitive edge might be found in the technological benefits of gold mining tools being used. For instance having a tool that can mine gold at a faster rate would be an advantage over more commonly used tools. Sell gold: As producers of commodity products, gold-mining firms had virtually no marketing or distribution costs. There was always a ready market for their product, at market prices, once taken from the earth and refined. A gold mine’s profits were a function of the quantity of its production and the difference between the prices at which it sold its output and its costs.
Long-term, gold producers can have a competitive edge over others based on its cost of gold production, driven by the physical features of its gold deposit and the efficiency of the firm’s operations. All of this is mentioned to say that the advantage in selling gold comes when the input costs and features of the ores purchased creates you the most profit for your dollar spent, as it is not the gold producer that determines the price that gold is selling. Barrick’s risk management program American Barrick’s hedging program evolved over the company’s 10-year history nd used a variety of tools to manage gold price risk. With gold financings, forward sales, options strategies, and spot deferred contracts, American Barrick shed some of its gold price risk while maintaining flexibility to profit from rising gold prices. Now, a gold producer would think to hedge gold price risk for a few key reasons. The cost to create the gold product is high, as developing the final product takes a long time. Also, the price of gold does fluctuate often. One in three mines was unprofitable at current prices, looking forward.
Interest, currency, and commodity derivatives were alternatives to manage inflation risk more efficiently but discount inflation An experience in 1984 with selling gold forward or the discovery of nearly 18 million unexpected ounces of gold reserves at Goldstrike, sped up the pace at which hedging activity took place. With Goldstrike, American Barrick’s bard set a guideline for risk management: The firm would be finally protected against price declines for all production out 3 years, and 20-25% protected for the following decade.
The financial tea sought out best ways to gain money from this during the rice fluctuations in early 1991, selling about 1 year of production in one hour. Since its first annual report, American Barrick stated, “The corporate strategy I to acquire or develop a diversity of gold-producing interests exclusively in North America”. A second tenet of the American Barrick strategy was to maintain conservative financial policies by issuing little debt and by moderating the firm’s gold price risk.
The goal that Munk had, though, was not to eliminate risk (due to the potential upside) but, again, to moderate, so that its appeal would be its positioning as a well-run, low-cost commodity producer that was willing to sacrifice a little bit of potential profits if it meant avoiding loses later on. With Goldstrike, American Barrick’s board set a guideline for risk management: The firm would be fully protected against prices declines for all production out 3 years, and 20-25% protected for the following decade.
Specific details of the methods and implementation were left to the financial team, who provided regular reports to the firm’s board of directors. Now, we key in to examining the strategies of American Barrick in order to better understand the benefits of each strategy and the robustness of the risk management program at the corporation: * Gold financings: * In 1983, it funded its purchase of the Renabie Gold Mine in Ontario, Canada, by issuing common shares. Since there was still a need for an additional $18 million for capital expenditures to develop the mine.
Later, in 1984, to fund the expansion, it raised $17 million through the Barrick-Cullaton Gold Trust. This trust paid investors 3 percent of the gold mine’s output when the price of gold was at or below a price of $399/ounce and 10 percent of production when gold was at $1,000/ounce. Investor benefits from increased volume of gold and the increased price of gold. * American Barrick’s next two large acquisitions used bullion loans & gold indexed Eurobond offerings.
Used to fund the Mercur Mine, this involved a loan with Toronto Dominion Bank, where they received 77,000 tons of gold and American Barrick would repay the loan in installments. A great thing about this is that the loan was collateralized by the mine itself (valued over $50 million). The corporation’s 1,050,000 ounce bullion loan used to finance Goldstrike Mine was the largest gold loan in the world at the time. * American Barrick also raised funds through gold-indexed underwritten offerings. In 1987, the firm offered $50 million in 2% gold indexed notes to Eurobond investors.
Investors paid $1,308 per note and received annual interest payments of $26. 16. * Forward sales * In a forward sale of gold, a party commits to deliver a specified quantity of gold, t a specific date, for a price set at the beginning of a contract. No money changes hand until the termination of the contract. In most markets, the seller of the forward receives a premium (contango) above the current gold price. Contango is equal to the difference between the interest rate for lending dollars and the interest rate for lending gold.
A sharp drop in gold prices in 1984 and 1985 led to the first explicit forward sales of gold at American Barrick. As prices fell to levels equal to the firm’s estimated break-even, the company’s profitability was jeopardized. In reaction, American Barrick sold about 20,000 ounces in 1984 to protect itself. Selling forwards was not so beneficial, because the firm lost the opportunity to sell at higher market prices-a low gold price was attractive to the investor/buyer. * Options & Warrants Beginning in 1987, American Barrick started to experiment with option-based insurance strategies that could both mitigate risk of price declines and allow the firm to still retain some of the benefits of rising prices. They executed what is known as a collar strategy, allowing them to simultaneously buy put options and sell call options on gold. By using the premiums receive from the sale of calls to purchase puts, a collar strategy required no initial cash outlay, which made it more acceptable to the firm’s board of directors.
* Spot deferred contracts In 1990 the firm stopped adding new options positions and began to use spot-deferred contracts (SDCs) extensively. SDC was a type f forward sale of gold. The difference from the true forward sale is that there are multiple delivery dates, with the final one being 5 -10 years after the initiation of the contract. American Barrick’s initial SDC trading agreements called for ultimate delivery within 4-4 years, though as a result of its large reserve base and strong financial position, it was able to negotiate subsequent agreements giving the firm 10 years within which to make delivery.
American Barrick saw spot-deferred contracts as a way to profit from increases in price of gold and also set a minimum price on its sales of gold. The big picture The degree to which firms managed their output price exposure was well tracked, and firms differentiated themselves on the basis of these policies. Some large producers engaged in no risk management activities, stating that hedging actually takes away from the shareholder’s value on an individual basis “so that its shareholders might capture the full benefit of increases in the price of gold”.
American Barrick believed that managing gold price risk was an integral part of business and one of the firm’s four stated business objectives. The level and type of risk management activities varied among gold-mining firms, and in North America there was a wide range of risk management policies and practices. For American Barrick’s hedging program evolved over the corporation’s ten-year history and used a wide range of tools to manage gold price risk. With gold financing, forward sales, options strategies, and spot deferred contracts; American Barrick hed some of its gold price risk while sustaining flexibility to profit from rising gold prices. It seems to me that American Barrick paid very close attention to its money and company value, more so than other firms of similar interest, and that is what set them apart and put their destiny on the pinnacle of the gold mining industry. They did what was necessary in becoming the leader by trying a method, examining it, and moving forward with an alternative if it projected more value. Investors remained at the forefront of their funding methods, and that is one thing that I truly respect of the corporation.
The success of American Barrack was not derived from luck, but rather from a dedication to its focus on risk mitigation and researching its options for its derivative transactions. American Barrick’s largest positions were established in conjunction with Goldstrike when gold prices were highest. This provides reason to believe that its hedging practices would have continued to make the corporation additional revenue if the price of gold continually rose throughout the progression of the corporation’s history.
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