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GOLD

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GOLD MINING INDUSTRY

Demand & supply of gold Production of goldMarket dynamicsLarge producersFirm cost structure and revenue

compositionFirm strategies going forward

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DEMAND & SUPPLY OF GOLD

The market dynamics of gold are dominated by short-term supply and demand fluctuations

Sudden surge in demand or disruption in supply can lead backwardation, where the spot price is higher than the forward price

The gold market is usually in contango, due to the smoothing of supply that is possible due to accessible stocks.

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Demand & Supplyof Gold

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How Gold is Mined

Exploration Exploration Drilling Blasthole Drilling

Blasting Underground Mining Ore & Waste Haulage

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How Gold is Mined

Heap Leaching Mining Oxidization

Leaching Stripping Electro-winning

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How Gold is Mined

Smelting Gold Bullion Refining

Reclamation

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HOW GOLD IS TRADEDOver the Counter

Between principals, not through exchanges

Contracts terms are flexible Main centers: London, New York,

and Zurich Mining companies and central banks

tend to transact their business through London and New York

Twice daily during London trading hours there is a “fix” which offers reference prices for that day’s trading.

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THE SETTLEMENT PROCESS

The basis of settlement is delivery of a standard London Good Delivery Bar, at the London vault nominated by the dealer who made the sale. Currency settlement for gold transactions will generally be in US dollars over a US dollar account held in New York.

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Market Dynamics: Gold Prices

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Gold Prices Comparisons Like all prices, the gold price reflects not only the inherent value

of gold, but also the relative strength of the currency in which it is quoted.

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LARGEST GOLD PRODUCERS BY MARKET CAPITALIZATION

Companies: Anglo American PLC Newmont Mining

Corp. Barrick Gold Corp. AngloGold Ashanti

Ltd. Placer Dome Inc. Gold Fields Ltd.

Market Capitalization: 35.87B 20.28B 13.73B 10.10B 7.76B 6.26B

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FIRM COST STRUCTURE & REVENUE COMPOSITION

Cost Structure: Costs applicable to

sales of gold and other base metals

Depreciate, depletion & amortization

Depreciation, depletion, & amortization

Exploration, research & development

General & administrative

Mergers and resturing Writ-down of long lived

assets Others

Revenue Composition Sales of gold Sale of other base

metals Gain on

investment Gain on derivative

instrument Gain on dividends,

interest & foreign exchange income

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ISSUES FACING GOLD COMPANIES

There have been only a few large deposits found since 1998 and none of these have made it to production as of yet

Rising costs with gold prices impose questions of the ability to finance and develop projects

Copper-gold projects will become more common in gold company portfolios

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FIRM STRATEGIES & KEY SUCCESS FACTORS

Effective cost control to maximize margin by improving supply chain management and usage of technologies such as e-commerce

Strategic balance between gold mine grades produced and life of assets

Continuous commitment to research & development to uncover large gold deposits

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RISK ASSESSMENT

Three major market risks faced by firms in gold mining industries:

Commodity Price Risk

Foreign Exchange Rate Risk

Interest Rate Risk

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COMMODITY PRICE RISK

Commodity Price Risk = Gold Price Risk (the change in the price of the gold)

It affects gold mining companies’ Asset values Profitability of its operations Cash flows generated those

operations

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COMMODITY PRICE RISK

The price of gold is affected by numerous factors: Demand for gold in both jewellery and industrial

uses International/regional, political/economic trends The relative strength of U.S dollars of other

currencies Financial market expectations Numbers of speculative activities Reserves Number of forward sales Production and cost levels for gold

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FOREIGN EXCHANGE RISK

Is the change in the relative values of currencies

Since gold mining companies do not have the luxury of choosing where the ore bodies are, they usually have their mining operations, activities, investment outside of their countries

Their revenue and costs are primarily incurred in foreign currencies

Adverse movement will affect a company’s: Cash flows Profitability

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INTEREST RATE RISKInterest rate exposures impact a company’s:

Cash Balances Borrowings (to meet short falls in current cash

flows) Long term debts Hedging activities (the impact international interest

rate differentials) Returns on its assets Firm value

Significant decrease in interest rates and/or increase in gold lease rates can have a great negative impact on the price of the new gold sales contract and on the difference between the forward gold price & current spot price

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EFFECTIVE RISK MANAGEMENT

All gold mining companies face a similar exposure

The prospects depend on its risk management decisions and strategies

Firm characteristics play a major role in risk management

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MEASUREMENT OF RISKS

Methods vary across industries and firms within the same industry

No specific requirements needed for gold mining companies

In theory, should use delta calculationDelta: the change in the value of a

portfolio with respect to a change in the price of the underlying asset (gold)

Delta % : portfolio delta / amount of gold produced over 3 years

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MEASUREMENT OF RISKS

BUT: Most gold mining companies do not use

this delta calculation No mention of the volatility of spot gold

prices Instead, they only briefly mention that a

certain dollars per ounce change in the gold price would result in an increase or decrease in approximately how many dollars change in cash flow from operations and net income.

TECHNIQUES AND PRODUCTS

Gold producers can use: Future Contacts Gold loan Gold Swaps Spot deferred contract Forward sales of gold Put options (Insurance purpose)

ǂ To hedge themselves against the exposures

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DERIVATIVE USAGE FOR GOLD PRICE RISKMost gold mining companies use:

Forward contracts Spot deferred contract Put and call option Gold lease rate swaps

Most prefer to use forward contracts as its hedging instruments due to the introduction of SFAS NO 133/138

This allows gold producers to not consider their sales contracts as derivative instruments as long as they are considered to be normal sales

Gold mining firms can record the proceeds under this contract as revenue and can be held off balance sheet until maturity, the date of the delivery of the gold in the future

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DERIVATIVE USAGE FOR FOREIGN CURRENCY RISK

Gold mining companies use: Currency forwards Currency options

Since gold is quoted and traded in US dollars, gold producers with operations and investment in a large number of countries outside U.S will be exposed to foreign exchange rate risks

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DERIVATIVE USAGE FOR INTEREST RATE RISK

Gold mining companies ONLY use: Medium to long term horizon

interest rate swapInterest rate risk is not viewed as

important as the gold price risk and currency risk due to the low leverage in the gold mining industry

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FIRM CHARACTERISTICS FACTORS

Firm Size Is measured by the firm’s gold reserves representing the

maximum collateral value and the market value of assets It is proven that firm size is negatively correlated with the

degree of hedging Smaller firms tend to have little negotiation power and have a

higher chance of facing higher financing costs Liquidity

Is important in determining how much funds a firm can provide in terms of emergencies

With a large cash balance, firms will face fewer financial constraints and hardships

So, they do less hedging as their risk management strategies

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FIRM CHARACTERISTICS FACTORS

Leverage Firms with higher leverage have a higher chance of

facing financial constraints They do more hedging in their risk management

strategies Since gold mining industry has low leverage levels,

it will not have a major impact on the firms Average Cash Cost

Is important element in determining gold mining companies’ profitability, efficiency and productivity

There is a positive association between financial distress and average cash cost

Since smaller firms tend to have a higher cash cost average than large firms, they have a greater tendency to encounter financial distress when the price of gold decreases

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POTENTIAL HAZARDS

Gold mining companies use different derivative instruments to hedge themselves against the risks that they face from potential future movement in market variables

The main motives for hedging: To cover the total operating costs Remove price risk Enhance revenue Control their cash flows

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POTENTIAL HAZARD

BUT No assurance that outcome of

hedging will be better than the outcome without hedging

Leave firm’s profit to be dependent solely on the underlying productive activities

May suffer opportunity loss

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RISKS DUE TO HEDGINGBy hedging, firms face:

Credit risk Market liquidity risk Mark to market risk

Risks associated with factors such as: Default by counterparty Costs associated with unwinding the position Possible restrictions on credit lines

In order to develop an effective risk management program, a firm should make a clear statement about the firm’s risk management philosophy

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The EndThe End