Forward Gold Sales Suggest Fears Prices May Fall

August 4, LONDON (MarketWatch) -- Gold producers are increasingly locking in forward sales of the metal or tying it up as collateral for loans to expand their production, indicating some miners are concerned gold prices could weaken before they complete their projects.

Miners have forward sold material and set up 'options'--orders to buy or sell at specific price levels--for more of their gold production during the first three months of the year than the amount of hedged positions they closed in the same period, U.K.-based metals consultancy GFMS said Wednesday in a report.

The first-quarter rise in hedging activity this year marked the second quarterly increase in the last 12 months, GFMS said. During these periods, miners locking in a price for their production added net supply to global hedges by forward selling or committing more gold than they'd bought back in order to exit such trading positions.

Hedging activity boosted the global supply of hedged gold by six metric tons in the first quarter, GFMS said, up 4% from the previous quarter to 152 tons at the end of March.

That's a small portion of annual global gold production, however. In 2010, global gold production rose to a record high of 2,689 tons, up from 2,590 tons the previous year, according to another GFMS survey.

With gold prices already at record highs this summer, market participants will keenly watch for the second quarter hedging figures to see whether this activity will actually weaken the market.

"If gold miners, seeing the price reaching this far, are tempted to lock in prices, it would exaggerate a move downward in the gold price," said Carl Firman of metal consultancy Virtual Metals.

The most significant hedger of gold in the first quarter was Swedish producer Boliden AB (BOL.SK). It added 10 tons of forward sales in the period, equivalent to more than half of the additional global hedges in the first quarter, primarily to secure the long-term viability of the expansion of its Garpenberg complex in Sweden.

Another significant forward seller during the quarter was Mexico's Minera Frisco (MFRISCO.MX), which extended its hedging positions by 17 tons to cover additional production costs from its latest development projects. Golden Star Resources Ltd. /quotes/zigman/17293/quotes/nls/gss GSS -4.85% , Industrias Penoles (PE&OLES.MX) and Great Basin Gold Ltd. /quotes/zigman/19212/quotes/nls/gbg GBG +3.30% also added hedging programs during the period.

While most of the first-quarter hedging has been attributed to forward selling within deals to secure financing for expansion projects, gold's recent rush to new highs may exacerbate this process in coming quarters as miners and financing bodies are increasingly eager to build a buffer against a potential drop in gold prices, said analysts.

"Project hedging is inherently to do with fear of price decline, but more specifically about securing financing or revenue against a future project," said Matthew Piggott, a metals analyst at GFMS. "When hedging is occurring, people are very conscious of price trajectory and the impact on shareholders."

Since the financial crisis, lenders to the often-volatile mining industry have imposed stricter requirements. Miners are frequently required to lock in prices for future production in order to convince banks to secure the funding to develop new projects or fund expansion. Miners hedge their gold-market exposure by locking in a price to be paid in the future, when its metal is produced. The aim is to protect a portion of a miner's cash flow in the event that gold prices suddenly fall, allowing the company to meet its daily operating expenses and limiting losses.

But until recently, as gold prices have risen steadily in recent years, miners bought back the gold that they had tied up in forward sales agreements. This enabled those companies to gain exposure to the rise in prices. Large gold producers AngloGold Ashanti Ltd. /quotes/zigman/223116/quotes/nls/au AU +1.25% and Barrick Gold Corp. /quotes/zigman/12772/quotes/nls/abx ABX -0.41% , for example, spent much of 2009 and 2010 closing out gold hedges.