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DERIVATIVES MAY BE THE REAL BOMB
By Thom Calandra
www.cbs.marketwatch.com
May 6, 2002
SAN FRANCISCO (CBS.MW) -- Berkshire Hathaway's Buffett is
an insurance executive, so he's entitled to talk about risk from
nuclear bombs.
Why shouldn't he? Palestinian supporter Sultan Abul-Aynayn
not so long ago was quoted as saying, "If one hair on the head
of Yasser Arafat is harmed, the U.S. had better protect its
interests around the world. We are not like Osama bin Laden,
but we have our own style of response."
That's "a chilling warning," says James Dines, editor of
pro-gold The Dines Letter in California. "Should the safety of
all Americans depend on Ariel Sharon's decision whether or
not to kill Arafat?" Sharon was in Washington on Monday,
headed to the White House.
But Warren Buffett, the world's second richest person, also
talks about derivatives. He and his right-hand man rate
derivatives somewhere below sewage. As the head of a
large, multi-billion-dollar enterprise, Buffett and his partner,
Charles Munger, are qualified to talk about the use of
options, futures, lending, leverage and other practices
known commonly as "derivatives."
Buffett figures derivatives will mess up lots of companies.
Berkshire Hathaway's reinsurance unit, General Re, is
registering some losses as it closes the loop on derivatives
contracts. Munger was quoted this weekend, at the annual
Buffett-fest, as saying, "To say derivative accounting in
America is in the sewer is an insult to sewage."
That would make Dell Computer (DELL), in a $1 billion-plus
derivatives boo-boo, an insult to sewage.
That would make scores of companies that take
off-balance-sheet hits to earnings because of their
once-fancy artificial hedges, joint ventures and extreme
leverage -- an insult to sewage.
Those derivative tangles include, in a strange twist of
fate, a few hedged gold companies. The gold sector is
among the North American stock market's biggest gainers
this year.
John C. Doody, editor of the numbers-crunching Gold Stock
Analyst newsletter, figures Barrick Gold in its latest reported
quarter saw the mark-to-market value of its so-called hedge
book drop to a negative $121 million as of March 31 from a
positive $380 million on June 30, 2001.
Barrick, one of the world's largest bullion miners, uses
written "call" option contracts and other derivative devices
and gold lending practices to enhance the price it gets for
its ounces of gold. The so-called hedging in the
"spot-deferred market" works well when gold is flat or down
in price, not so well when gold prices are rising, as they are
now.
Doody at Gold Stock Analyst puts the negative swing of the
company's hedge book at $507 million. "This swing far
offsets the net profits earned of $46 mil in the first quarter of
2002 plus the $66 million in the third quarter of 2001 plus the
$82 million in the fourth quarter of 2001. The net is a loss of
$313 million."
In a conference call last week, Barrick's executives assured
questioning Wall Street analysts, who asked numerous
questions about the company's gold-hedging, they were
monitoring the situation. Yet some observers are not
convinced.
"The sensitivity of the derivative portfolio now stands at
about $21 an ounce," says Douglas Pollitt at Pollitt & Co.
in Toronto. "Each $1 an ounce upward move in the gold
price sees the mark-to-market (of Barrick's derivative
contracts) drop by about $21 million. At $350 an ounce,
the mark-to-market would be over $1 billion in the red."
Gold prices this year have risen to $312 an ounce from
$270 at the start of January.
Pollitt calculates the notional value of Barrick's
spot-deferred contracts at 18 million ounces. "Add to this
another 5 million in written call options, (which the company
now calls 'variable priced sales contracts'), and, one way
or another, the company is short about 23 million ounces
of gold. This is a fantastic number and begs the question:
Could Barrick cover even if they wanted to?"
CBS MarketWatch placed a call to Barrick's Toronto
headquarters on Monday regarding the company's
exposure to the hedged market and was awaiting a
response.
The writer of a call option is giving the purchaser of that
contract the right to buy something, in this case gold, at
a strike price written in the contract. In exchange, the writer
of the option receives a little money, a premium. The
strategy for selling a call option is usually to enhance the
value of a security or a commodity when the investment is
declining in price, something that had been happening to
gold for years, until January.
Barrick, to its credit, said in its report to investors that
it will reduce exposure to hedging this year. The Toronto
company, world's second largest gold producer after
Newmont Mining, says it earned $46 million for the March
quarter, down from $87 million in the year-ago three-month
period.
Barrick, according to its quarterly report, sold half its gold
in the spot-deferred market for $365 an ounce. The fact that
it sold the other half in the spot market was a first for the
company. Barrick stated it expects half its gold for the
remainder of the year to be sold in the spot market, where
an ounce of gold is attached to no derivatives and gets
exactly what the spot market is dictating for bullion.
Barrick also estimates that for every $25 increase in the
gold price, the company's annual earnings and cash flow
rise by approximately $70 million. "In total, 22 percent of
reserves, or 18 million ounces, are sold forward using
spot-deferred contracts at an average minimum price of
$344 per ounce, deliverable at the company's option
over the next 15 years," the company stated to investors.
"This position is down from 18.2 million ounces in the last
quarter of 2001 at an average price of $365 an ounce."
Of course, if gold prices were to shoot far higher, in rapid
fashion, Barrick, as a writer of call options, could find itself
required to deliver gold to buyers at prices that are below
the spot price of gold. Other distortions of the gold market
are possible in a gold rally.
Pollitt, the Toronto analyst, says theory and reality are like
night and day. "Converting dollars into gold is quite different
than converting gold into dollars," he said Monday morning.
"When the dreaded yellow metal was in the doldrums and
nobody cared, well, Barrick might have had a way out. But
now? Now you've got good company on the bid, now
you've got all those dollars chasing what little gold is left.
And any whiff that Barrick had stepped into the ring looking
for 23 million ounces would set the market ablaze."
Large gold producer Anglogold in South Africa this year
said it would continue to reduce its reliance on the
forward-sale, or hedging, of its gold production.
Non-hedged gold miners, led by Gold Fields of South
Africa, have seen their stocks outpace the gains of hedgers
Barrick and Anglogold by wide margins this year. Gold
Fields, its shares poised to shift to the New York Stock
Exchange on Thursday, is up almost 175 percent this
year vs. a 30 percent stock price gain for Barrick and
60 percent for Anglogold.
The use of derivatives in many different forms has
supporters, lukewarm and otherwise. Federal Reserve
Chairman Alan Greenspan in February testimony said
derivatives have "contributed to the development of a
far more flexible and efficient financial system."
Greenspan was not referring to any particular industry,
like waste management. Those sewers are best left to
derivative accountants, Buffett and Munger would say.
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