The risk management philosophies of the founder of American Barrick Resource Corporation, Peter Munk, are indicative of the financial management policies of this company. Monk advocates the financial stability of ABX as having come from a combination of financial conservatism and rising low-cost production. Their ‘unique gold hedging program’ is intended to protect the company from the impact of troughs in the gold price and allows cash flows to be planned confidently.
This, in turn, offerers investors predictable and rising earnings away from the political risks of gold mining in South Africa while cashing in on the benefits of producing as much gold as possible as quickly as possible and thus rebutting effects of changes in the gold spot market. Goal of a gold mine’s price risk management program The goal of price risk management for a gold mine should be the same as any firm whose income is subject to fluctuations in market price, interest rates and, but not only, foreign exchange rates.
Market cycles need to be smoothed out to contain losses and fluctuating cash-flows so both short and long-term decisions can be made. While the conservative approach to price risk management taken by ABX has limited potential profits to those prices locked-in long before mining begins, they also guarantee cash-flow and profitability of new projects as the ‘worse-case-scenario’ is omitted from the equation. Smith and Stulz (1985) argue that by reducing the likelihood of costly financial distress, risk management can increase the expected value of the firm.
This increase in value comes from the reduction in deadweight cost, and an increase in debt capacity, which in turn can benefit the firm through valuable tax shields or reductions in agency costs of free cash flow. Shapiro and Titman (1986) extend the cost of financial distress to include the deterioration of valuable relationships with buyers and suppliers. They notice that buyers’ loyalty for a firm can be severely affected during its financial crisis.
In particular, probability of financial distress faced by gold mining firms normally increases as the price of gold falls below their cost to produce gold and make fixed financial payments. Risk management helps such firms keep gold price constant. Indeed, American Barrick with their very successful hedge has never been in any financial recession since it was established, regardless of changes in gold price. However, a surprised counterargument is mentioned by Tufano (1996) that he found very little evidence from his model to show that there is a positive relationship between a good hedge and low probability of financial distress.
Many academic articles including Stulz (1990), Lessard (1990) and Froot et al (1993) argue that without risk management, firms will be forced to pursue non-optimal investment policies. They figure out a strong link between cash flow and investment due to market imperfections (including information asymmetries). When the cash flow is low or negative, it is very costly for firms to obtain external financing. Risk management program that prevents the information asymmetries can assure a lower financing for firms’ investments.
They also predict that the use of risk management becomes more intensive for small firms and those facing high external financing costs than larger ones. American Barrick has always used intensive external financing, therefore, all of its gold price hedges have been incorporated with this purpose. For instance in 1983, to develop the Renabie Gold Mine, it raised an additional $ 18 million for capital expenditures through the so called traded royalty trust. Once again for the next two large acquisitions in 1995, American Barrick used bullion loans and gold-indexed Eurobond to raise capital.
In valuation of the hedging program, Peter Munk stated that: “… gold hedging program gives American Barrick extraordinary financial stability…. allows us to plan our cash flows with confidence and in combination with our rising production…. “Risk management can increase shareholder value by reducing tax paid. Smith and Stulz (1985) argue that in the presence of a convex tax schedule, firms would reduce expected taxes by using risk management to fix the level of taxable earnings. Greater convexity of the tax schedule should lead to more risk management.
In fact, half of the firms studied by Graham and Smith (1999) are able to reduce the present value of their taxed by reducing the volatility of their taxable income. The estimated marginal tax rate for American Barrick is consistently close the statutory rate1, which means that they have maximised their tax saving. The risk management program has been growing in both size and complexity. The evolution involved in movements from gold financings to forwards, to options and to spots deferred contracts.
Almost all financial instruments have been used to hedge the gold price. American Barrick first started with conservative financing method by keeping low leverage and large amount of cash for investment. Then after 1984, the firm significantly accelerated the hedging program to cover 100% production with forward contracts. However, after the changes of gold prices during the Gulf War 1991, the firm quickly realised that forward contracts could only protect it from downwards gold price but could not bring advantage from upwards trends.
It then created more complicated instruments such as options, warrants and collars. Overtime, American Barrick began to develop customised contracts using financial instruments available for major dealers. It engaged with over-the-counter contracts and intensively used spot deferred contracts for the risk management program. The purposes of the hedging program were to create financial stability and take advantages of investment opportunities. As gold prices were fixed by the program, the firm could be more confident to plan its production and hence cash flows and profits.
Taxable income was also fixed to the most profitable level. As being analysed in Q3, the risk management reduces financial stress, brings more opportunities for investments. The very high growth and huge acquisitions of Barrick show that the hedging program is consistent with the investment goals. In addition, the Barrick’s out-performed stock3 over the decade show that the hedging program did very well to generate higher margins and returns.