Many articles deal with the outcome of hedging on banks, interest rates, and financial markets. Yet, there is another very interesting impact of hedging: Production costs and investments in the gold and raw material industry are very much influenced by hedging of gold and other commodities.

Hedging instruments allow for strategies designed to protect a producer and its customers against market price fluctuations. By locking in prices, a company gains control over variable costs and revenues inherent in its business. In addition, hedging instruments can also provide capital for future investments in machinery, equipment and property. In its early beginnings future contracts provided stability and capital for farmers. Step by step future instruments became important financial instruments in banks, metal mining industry and finally also in the gold industry.

For gold and other metals the long-term implication of hedging are different from the farming business. As farming investment focus is short term year over year, the gold and metal industry has to invest for the long term and also tends to hedge for the long term.

This long-term hedging also provides capital for investments and expansion of production. Thus increasing capacity and production in the short term. Even when prices experience a downturn, investment in new capacity can be still high through funds from forward sales, thus driving down the price of its products even more. So, we are faced with a paradoxical situation of growing supply at declining prices. This defies all laws of economics.

Nevertheless, the laws of economics still apply in the long term. As prices of gold and other metals are down, less and less projects become viable in the industry. In the gold industry, only a few companies have profitable projects to invest in long-term at current depressed prices. This drives many companies out of business. So, although a lot of gold is sold forward, which suggests high supply, the actual future production will be very low in the long run.

As many low cost projects will be locked in at very low prices, the best companies and projects in the industry will be stuck with their investments at low profits for a long time even when the gold price starts to increase. This is the price they have to pay for the cheap capital of forward sales. As the best companies have invested too early at low prices, it will be increasingly difficult to expand capacity and find good projects when prices will increase in the future. In addition, rising prices will substantially reduce forward sales as companies cannot afford to lock in low prices and get the blame from shareholders. This in turn will reduce investments and therefore reduce production, which further increases the price of gold. This will lead to an upward spiral in prices and we will have another economical paradox: supply will decline even when prices go up. This will spiral prices up even more as the low-cost producers are also low margin producers and are unable to invest in future production.

For precious metals mining investors there is another implication of this trend: Do not invest in industry leaders as these leaders are stuck with low prices and cannot invest further when prices really increase. It is more wise to invest in industry laggards struggling to find capital for their projects now when prices are low. These struggling companies could become the industry leaders when prices increase as they did not have locked in low prices and their projects - even at higher costs - are much more profitable compared to the industry leaders.

In the current gold price environment the buy (industry leaders) and hold - strategy could end up with a nasty surprise when gold prices will go up finally. The industry leaders will be not more profitable than today, thus their share price is not very likely to go up when gold prices will skyrocket. Only the industry laggards and the small junior companies will finally succeed.

What will happen to the gold industry in the near future happens already now for the oil industry. Many big and good companies are locked in their forward sales contracts in oil and oil products. The big companies relied on forecasters predicting low oil and oil product prices for a very long time. Thus they are not able to invest in new capacity now as they are locked in low prices and they simply lack capital for expanding capacity in the future. This is especially true for integrated oil companies, which cannot raise consumer prices for gasoline and distillate fuel. Despite high oil prices, many big integrated oil companies have barely increased profit due to their hedging and due to low refining and marketing margins (Texaco last earnings disappointment).

This environment is an enormous factor for propelling prices to highs never seen in the past as supply even declines when prices go up, thus further propelling up prices. US oil production is still at the same level as last year when oil prices were at a record low. This year production will very likely decline once again. Even more astonishing is the low level for new drilling rigs, which has barely recovered from last year despite record oil prices. This is a consequence of hedging and in this environment we will see record prices for oil and oil products. Only small companies which are free of hedging can invest and expand production. Yet their impact on the overall market will be low. The very high oil price will also likely trigger inflation and a strong increase for precious metals.

As hedging may be very beneficiary for some agricultural commodities, it actually has an inverse impact on precious metal mining and other long term planning industries: it triggers more supply in a declining price environment and adds fuel to the fire of rising prices through lower supply. Rather than smoothing out peaks in commodity prices, hedging has a leverage on prices for precious metals and oil. The hedging had clearly turned the economics of mining upside down. Supply, demand, reserves and production costs are not any more the most important factors for the price of the product. It is simply market mechanism of hedging, which determines the price of gold and precious metals. This mechanism has disappointed many investors in the last few years as the gold price was still held down by a steady new supply of mined gold despite low prices.

Currently this huge leverage works on the downside, yet in the not too distant future this leverage will turn to the upside. For oil and platinum group metals this upside leverage has already begun . Gold and silver will follow soon.

This environment makes it very essential to find the right investment strategy for the commodity sector. For gold and precious metals it is important to invest only after prices went up. This is already the case for platinum, palladium and oil. Secondly, it is important to invest in small companies sitting on an attractive inventory of mining and cash reserves. And thirdly, it is very important to be patient, as only the laggards will make money in the coming high price environment for gold and commodities.

Starting with palladium and oil is a good strategy. North American Palladium (PDL in Toronto) and Courage Energy (CEO in Toronto) are excellent plays for the next future. After the first run up in palladium and oil, it may well prove profitable to pick up silver mining companies, and then small gold mining firms.

I look forward to receiving your comments

Dr. Heinrich Leopold
31 January 2000

hleopold@ibm.net