Barrick’s Secondary Offering to Buy Them Out of Bad Hedging

Barrick Gold Corp. (ABX) is the largest pure gold mining company in the world, so you would think no one is more in tune with the price of the precious metal than they are. Well, they have gotten caught with some bad hedges that were intended to provide the company with downside protection. Meanwhile, the price of gold has climbed to above $1000 as the dollar loses strength. This has obviously hurt profitability as the firm is not getting the full benefit from the rise in gold, and Barrick management has said that it will have to take a $5.6 billion charge on earnings from buying off these contracts. Now, the company is conducting a secondary offering in order to raise capital in order to clear those hedges.

“It’s going to take a $5.6 billion charge to earnings as a result of a change in accounting treatment for these contracts, and essentially Barrick says there’s been increasing concerns among investors about these hedges that it has on gold. And given the increasingly positive outlook for gold the company, again, is reversing so a $3 billion offering. $2.9 billion of it going to eliminate some of its gold hedges, a positive call on gold by Barrick Gold today…they’re playing the commodity trader.” — CNBC’s Fast Money 9/8/2009

Since the traders’ discussion on last night’s Fast Money, Barrick has taken the opportunity to increase the offering to $3.5 billion citing strong demand. Clearly, investors in Barrick have been displeased with the company's hedging of 9.5 million ounces of gold well below current market value, and now that ABX plans to buy out those hedges investors are flowing back in. The pressure from shareholders should not be a huge surprise; after all, if you are long ABX then you must be bullish on gold. It appears that management has caved to the wishes of their shareholders, possibly an expensive proposition.

Of course, there are two ways to interpret this secondary offering. We know that Barrick is bullish on gold, and there are plenty of gold bugs to scoop up the 94.8 million shares. They are of the opinion that gold itself is a hedge against inflation and perhaps could benefit from a flight to safety if the market has a downturn. Also, with the unprecedented fiscal stimulus firing up the printing presses, they think time will be on their side.

On the other hand, gold has had quite a run since the beginning of the year when deflation was the buzz-word. Gold has topped the highly psychological $1000 barrier a few times in recent years, but it has not stayed there long. Furthermore, with gold approaching all time highs the company would have saved a substantial amount of money by waiting for a pull back to make this move.

We will be interested to see how this works out for ABX, but one thing we know in hindsight is that they hedged themselves at a far too low price. This put them between a rock and a hard spot and finally management bent to the demands of shareholders. This was not from a position of strength, and now the company has paid a very hefty price and is exposed to any pull back in gold prices. Of course, if the price of gold does not falter in the near term and continues its climb then they made a painful but wise decision.

At Ockham, we have a Fairly Valued rating on ABX at the current price in the mid-$30’s. One thing we know for sure, ABX has levered themselves to the price of gold, possibly more to the downside than the up because of the cost of paying off their hedges.

Original post

Comments

[nobby73]

I suspect they already did the offsetting trades, which is why they would have to recognize the $5.6 bn (as there is no net hedge the trades will be on balance sheet.) but as gold seems on the way up, as are gold mining stocks, the secondary offering is the right course of action, even if painful. Shareholders want to take the commodity price risk, otherwise they would take their money elsewhere.

It is easy to sit in judgement on their decision to hedge in the first place, but what is done is done (unless you are a state owned Chinese enterprise), so take the hit and move on.

You say they are levered up to the price of gold, but if hedged, they are levered up to the price of the dollar and if we do see a steep jump in gold or inflation, or both, they could be in serious trouble as their profit margins get assailed from all sides.

The previous poster quotes the CEO of AngloGold Ashanti and it is well worth remembering how Ashanti lost their independence....

2009 Sep 09 05:13 PM

[Bill L.]

The author correctly points out just because they are in the gold business does not mean they are not subject to the herd mentality. Look at the airlines; they put hedges on at the top of the oil market. This might actually be a sign of extreme bullish sentiment.

Personally, I am not a gold buyer here. In fact their may be more value in going long the dollar (buy low sell high) Sentiment, in metals is at very high levels, especially in silver, while running into significant overhead resistance. Meanwhile sentiment in the dollar is at the extreme low levels requisite for a reversal, while running into a zone of support.

Also, I would add that gold versus the dollar has been reaching resistance highs, but gold vs a basket of currencies as actually quite clearly been trending down... As a bull you should want to see a broad rally against all currencies. I guess as long as it's increasing you P&L... still caution is warranted.

2009 Sep 10 11:58 AM

[Stone Fox Capital]

one bad decision after another. Can't believe they raised money to eliminate hedges.

2009 Sep 10 02:19 PM

[Laurence Hunt]

Remember history. Barrick won by hedging in the 80s and 90s when the gold price was in decline. They just reacted very slowly to the emergence of gold's secular bull in 2001.

My guess, we're getting near Barrick's last chance to get out of the hedges near or under $1000. Gold is over-bought near term, so a correction here is a probable (though not necessary) event. However, gold is very over-sold long-term, and can't spend much more time hanging out at this level before it runs to $1300.

I don't think Barrick is the best market timer by any means. They should have dehedged when gold was climbing steadily above the $250 level back in 2002! Again, they could theoretically have dehedged this time last year at a much lower cost (though there was no investment capital available then).

So here we are again, and this time Barrick has finally bitten the bullet.

In brief, I don't think the Barrick decision means much about timing. They're just doing what they have to do, and what they should have done say 8 years ago.

My guess, by next spring, Barrick's timing this week will end up looking like one of their sharper moves....

2009 Sep 10 04:10 PM

[Moochacha]

Dumb question but if Barrick is buying is there someone selling, and could this drive up the price?

2009 Sep 10 05:39 PM