28 Aug 2013 Last updated at 02:30:13 GMT

WASHINGTON (Scrap Monster) : There’s always a lot of talk about gold and silver miners and their hedging policies.

Selling some future production at current prices raises money today. It can also help the gold or silver miner smooth out changes in the market. That should be to the benefit of the shareholders. Yet the main concern in hedging isn't how to manage this trade. It is the shareholders' view of hedging which counts.

Why? Starting in the late 1990s, gold miners suffered major losses when the gold price rallied. This is because they had excessively large "hedge" positions in place far out into the future. It is imperative that the act of hedging not get confused with the reality of mismanagement of hedging policies.

As gold prices began rising early last decade, investors came to hate the big hedge-book built up by the gold miners during the previous bear market. And simply put, miners need investment money to fuel their business. If the shareholders are not happy with the way they operate their business, then their share price goes down. And if the share price goes down, then the gold or silver miner's capitalization also goes down, which then affects their ability to borrow from the banks.

So with hedging both weighing on profits and annoying shareholders a decade ago, the famous "leverage" to gold prices offered to investors by precious metals miner stocks went missing, even before the financial crisis hit.

Using the commodities futures and options market adds transparency to the pricing model, plus a record of all prices traded when a hedge is placed. Much like BullionVault – where private investors trade only physical bullion at fully-paid prices – there is complete transparency on live market prices, execution and time of trades.

The commodities futures market, which enables the mining company to sell their production at a time in the future, requires margin money which is a deposit. This deposit may need to be increased in the case the contracts are losing money. Because if prices are rising, then the metal that you are waiting to come out of production is gaining in value. Essentially, this kind of hedge is a wash, but until you have the metal out of the ground you do not have the cash to cover the margin calls on your hedges, and this increases the need for more financing.

On the same exchanges, options contracts can also be traded. And there are different reasons for doing so. In a stable or declining market the mining company may determine to sell calls, which also means to write a call option, which earns income from the trader who buys it. (Writing a call option gives the buyer the right to buy the underlying commodity at a specified price.) In a rising market the same mining company may determine to buy put options. (Buying put options gives the buyer the right to sell the underlying commodity at a specified price.) In the case where the company sells calls they earn a premium, and when they buy puts they pay a premium for that right. One decision earns some money, the other is a cost like an insurance policy, where you pay a premium.

The gold or silver mining company can also trade through their banking relationships, using forward trades and options quoted to them by the bank. They may get preferential credit treatment if they already are getting their financing from this bank. The problem with this scenario is that they are limited to trading with this firm because of the relationship. The miner may of course have more than one banking relationship, enabling them to trade elsewhere. This will in turn create a need for more operational controls of the trades being placed.

Such OTC trades are not in the public domain. They are known as "over the counter" and are conducted privately in what bankers call the "physical market", because the deal is for physical delivery of metal, rather than cash settlement as is usual with New York gold futures and options. So there is less transparency, and the result is that operationally transactions need to be confirmed by looking at other markets, on top of confirming each individual trade with the banking entity. The bullion banker, if it is a well-established relationship, may assist and provide services that make going this route the better choice.

Other derivatives are tools based on the standard market products. Option collars, straddles and spreads are some to name a few. To complicate things a market can also go into Backwardation, even while the price is dropping as we have recently seen in the gold market. This would mean that hedging forward or in the future will add costs to the bottom line. This is not so in a regular Contango market where the seller normally receives a higher price to cover financing and carrying costs.

There are other variables as well for a mining company to consider, such as fuel costs and equipment costs, current and into the future. Then they must also consider hedging those commodities that they use as well, such as oil. This is why it is imperative that any mining company have a strong market-experienced team handling their price protection needs.

In the end result, what I have been sharing here is that every company has their own set of costs and prices needed to be successful. Each one of these mining companies must be looked at independently. But hedging should not be a four-letter word. In fact hedging should be an everyday tool for any company that makes a living producing commodities. They must work at optimizing their profits while limiting their price risk.

Otherwise they no longer are a business concern but a speculator. This is because no one knows, at least not on this planet, where the price of a commodity will go for certain.

Courtesy : Bullion Vault

Author: Paul Ploumis