Real Wealth #040 05/05/2006
Ø Gold producers are turning extremely bullish on the yellow metal.
Ø Some of the biggest produces are de-hedging their production.
Ø This is going to cause extremely violent up and down moves in the price of gold — with $50 to $100 swings up and down likely.
The world's largest gold producer, Barrick Gold, just took a historic step.
Barrick recently became the latest of the world's de-hedgers by chopping an astounding 4.7 million oz from its forward contracts book during its most recently closed quarter.
That's the single largest reduction of a hedge book by any company in history, according to the Mitsui Gold Hedging Report.
Over the past four years, Gold producers have becoming increasingly optimistic and confident in the continued rise of the price the yellow metal. This can be easily measured by the size of their hedge books, which has fallen from 100 million oz to 48 million oz, --a reduction of more than 50%!
In the long bear market in gold from 1981 to 2001, Gold Mining Companies acted rationally and sold their future gold production for a guaranteed minimum price.
This allowed gold producers to hedge the risk of even lower prices and allowed them to lock in a profit. While this practice allowed gold producers that expertly executed hedges the ability to collect a reliable premium for their time and risk...it also helped severely limit the companies' upside potential in the event of a surge in prices.
Hedging is a symptom of a bear market while De-Hedging is a symptom of a bull market.
Annual gold production worldwide is approximately 2,400 metric tons...and that figure is decreasing. On the other hand, annual demand for gold is rising — most recently measured at 3,700 tons per year.
Meanwhile, over half the gold sold forward by producers has been eliminated from the supply side of the equation during that last four years. When you stop and think about it, that's an amazing fact...
But it also raises the age-old question: Did the chicken or the egg come first?
Has the marked increase in de-hedging been the catalyst that ignited this gold market...and the reason gold prices have risen almost 100% in the last four years?
Or instead...are the major gold producers simply responding to the rise in price and giving their shareholders a greater chance of cashing in on steadily rising gold prices?
While one might be able to make a case for de-hedging playing a role in rising gold prices...the truth of the matter is the price of gold has risen for a whole host of reasons — and this is a fact I've written about many, many times.
No, the truth is this record de-hedging is validation that the price of gold is going to continue to rise sharply. As I've said before, we're still in the very early stages of what figures to be a long bull market for gold.
But there's a catch.
You see, as many of the world's largest gold producers take de-hedging to the extreme — and Barrick alone is planning to eliminate another two million ounces of the Placer Dome hedged position it purchased before the end of 2006 — there will be a potentially dangerous side effect that investors will need to be aware of.
As gold continues its upward climb — and there's no doubt that it will — you can expect most of the major gold producers to rid themselves of the overwhelming majority of their hedged positions.
And that creates a risk.
Because at that point, if gold moves up, say $100 and the major producers are nearly 100% de-hedged...there will be a tremendous incentive for the company to re-hedge a sizable position and "lock in" profits at a high number.
After all, these companies have an obligation to their shareholders — and many will become tempted to lock in profits as gold reaches "milestone" levels of $750, $800 or $900.
Essentially, the major producers will be caught between a rock and a hard place. On the one hand, they'll feel compelled to produce profits for their shareholders by re-hedging when the opportuntity presents itself.
But on the other hand, if a major producer sees its stock trailing the price of gold in terms of performance...they could be in big, big trouble. How do you think shareholders would react if a major producer hedged a large position on the way up...and then saw gold climb all the way to $1,500 an ounce?
It would be a bloodbath.
That's why the major producers are really in a tough spot.
But let's not forget — investors might also very easily get caught up in this...and here's how:
If the major gold producers view their hedge positions as trading positions, we could see very violent swings in the price of gold of $50...$100...or more.
These violent swings would, of course, be short-lived...but investors who panic as a result of them could lose their shirt.
It's important to remember that as gold continues to climb, we'll soon be entering into some waters that haven't been sailed in a long, long time. And we have the potential to explore new territory altogether.
So a few nasty waves are to be expected along the way.
The news about Barrick's historic de-hedging provides even greater evidence that the bull market in gold is just getting warmed up. But there is a very real potential for sharp, sudden movements in the price of gold if the majors begin acting irrationally in the months ahead.
Gold and Energy Advisor
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