On August 30th 2004, Sons of Gwalia went into voluntary administration, announcing that it would not be able to produce enough gold to meet its hedge book commitments. (Parkinson, 2004) As of June 30th, 2003, Sons of Gwalia reported gold reserves of 3. 27 million ounces of which those numbers are now suspected.
(Hedges Fell Sons of Gwalia, 2004, p. 10) “Ferrier Hodgson, the administrator, said Gwalia’s gold reserves, which the group had put at 3. 27m ounces last year, had been reduced by hundreds of thousands of ounces”. (Marsh, 2004) Gold mining is risky.The commodity is scarce, hard to find and challenging to produce.
There was a flaw in the Sons of Gwalia’s hedging policy and its prediction on the reserves of its gold mines. Sons of Gwalia extended its hedging policies beyond hedging into speculation as a means of a profit generating tool. (Geoghegan, 2004). Sons of Gwalia’s flawed prediction on its gold reserves paved the way for its insolvency. There is no guarantee against unforeseen production shortfalls or cost overruns due to labour problems, faulty mine plans or issues related to sovereign risk.
Hedging limits the upside price swings that the mining industry once depended upon to offset risk factors such as these. Unfortunately Sons of Gwalia’s Tarmoola gold mine in Leonora was plagued with operation problems thus unable to meet its predicted production level of its reserves. (Geoghegan, 2004) Its hedging tool was based on the presumption that Sons of Gwalia would be able to produce and have the required amount of gold in its reserves to meet its “hedge” commitments.
However, the flaw in its hedging meant that the hedges that were locked in were at a lower price than the spot price. Therefore Sons of Gwalia’s gold resources became uneconomical to follow through as summed up by John Leevers, CEO of Sons of Gwalia. (Marsh, 2004) This deteriorated Gwalia’s hedge position to which Gwalia finally declared insolvency.
Conclusion Positioning a risky, capital-intensive project such as gold mining as a spread business, similar to a bank model would be ludicrous.Ask a financially savvy person on what the term hedging would mean and most likely the answer will be this: a strategy intended to reduce investment risk. Sons of Gwalia used hedging as a means of a profit generating tool which backfired on them. In the resource sector, hedging should never be used as a profit generating tool.
Hedging should always be used as a means of evaluating and reducing future risks. Sons of Gwalia is the second company in Australia to have incurred insolvency through bad hedging committals.