Barrick Gold Nails the Hedge

February 27, 2009 | By: Hard Assets Investor

By Julian Murdoch

It's gold week around here at HardAssetsInvestor.com, so let's take a look at a company that pulls the shiny stuff out of the ground. It happens to be one of the biggest players in this space, and it happens to have reported earnings this last Friday: Barrick Gold Corp (NYSE: ABX). (See earnings call transcript.)

Why look at a gold company if you are a commodity investor? It all depends on how you like to play. There are advantages and disadvantages to pick-and-shovel plays - we discussed some of them in Gold Vs. Miners back in October.

One of the interesting ratios we looked at was the price of gold compared with the value of the Amex Gold Miners Index (GDM). While this is an invented ratio, it's worth tracking over time. Back in October, the ratio of the price of gold to the value of the Amex Gold Miners Index was above 1.5 - a high number, historically, implying that gold miners were cheaper than they'd been in years. In October, gold prices were in the $750 range, and the Amex Gold Miners Index was sitting around 500.

The picture has changed a bit now.

The ratio is currently playing much closer to 1-to-1. Even though gold has climbed to $1,000/ounce, gold companies' stock prices have risen too - sending the GDM climbing to similar levels.

Barrick Gold Corp

With that in mind, let's look at Barrick.

Like many stocks (in many sectors of the economy), Barrick has had tremendous swings of late.

After big drop-offs in June, August and September, the stock bounced back a healthy 78.4% from the low of $18.14 it hit on October 27, 2008. But even with the jump, Wednesday's closing price of $32.36 is still almost 40% lower than its 52-week high of $53.55. And that downward spiral you see at the end of the chart? That's just Barrick dropping along with the rest of the market at the start of this week.

Last Friday, Barrick announced earnings that beat analyst estimates by 1 to 2 cents a share (depending on who you look at - Reuters or Bloomberg). That "beat" is dwarfed by one-time charges, which pulled the fourth-quarter results into the loss column.

The reason behind the beat is more complex than just pricey gold. Remember, Barrick Gold Corp. is not a pure gold play - no matter what its name says. It does do the majority of its business in gold, but it also plays in the industrial metal markets with its copper production.

Perhaps more importantly, Barrick employs a disparate hedging strategy. It eschews gold hedges, but does hedge copper as well as other nongold assets, such as oil and currency (Australian dollar).

Since Barrick does not hedge its gold, one would expect to see its stock performance closely mirror that of spot gold - at least to some degree. And usually, it has.

But look at what has happened recently. Beyond the stock price taking a larger hit than gold, we can see points of divergence - specifically in the recent past. At the tail end of the chart above, spot gold rose, but Barrick's stock fell. It's a similar pattern, in abstraction, to what's happened throughout down cycles in the last year. Whenever stocks take a serious plunge, Barrick goes with them, while gold itself stays relatively strong in comparison. Classic safe-haven behavior, but still, obvious high correlations to gold.

Compare that to copper:

Clearly the market understands the copper hedge. Barrick reported that it averaged $3.06 a pound for copper during the fourth quarter - compared with an average copper spot price of $1.79. Plus, Barrick managed to produce more copper than was expected. Both bright spots on the balance sheet.

Where's The Profit?

So we have this company that produces both gold and copper - metals that have very different roles in the economy. Gold - the flashy high-priced one with little industrial utility; and copper, the boring one that is in demand on the industrial side of things. Both are affected by the state of the global economy, but in different ways.

The obvious question is one of sensitivity: How exposed is Barrick to each metal? How exposed is the company to the ups and downs of the commodities it produces? It would seem to be an easy question to ask and answer, but if you are interested in this simple data, you have to wade through pages and pages of management discussion to find it. In this case, it was on page 67 of 116 of Barrick's year-end report.

Here's the beauty of locking in the right contract price. At least for 2008, copper - a market in decline - was simply more profitable than gold. Interestingly though, copper's sales as a percentage of total sales was lower in 2008 than it was previously. In 2007, copper accounted for 21% of total sales. Meanwhile, gold has accounted for a larger percentage of total sales (by dollar amount) - gold was 79% of total sales in 2007 compared with 2008's 84%. That's the rising price of unhedged gold in action.

The breakdown of expenses between the two metals has remained largely stable - with copper accounting for roughly 11% of total expenses for both 2007 and 2008.

All that's the long-winded way of saying that Barrick, at least for 2008, benefited from hedging copper prices while maintaining control of expenses in a big way. At the same time, Barrick's unhedged gold operations were able to reap the rewards of higher prices. This is also borne out with another simple statistic from their report:

In other words, they simply got it right. It's worth pointing out, however, that these are operational figures, and when you spend your evening with their numbers, they can often seem buried underneath the weight of exploration, M&A activity, capital projects and the like. So while Barrick had record cash flows from its core operations, it still reported negative financial earnings.

Conclusion

The thing to remember when looking at commodity companies - especially mining companies - is that there really aren't any pure-play companies. The big mining companies have multiple products that they are producing and it pays to look closely at how much of each they are pulling out of the ground and where their profits are coming from. It may turn out that the company you are looking at for gold exposure isn't as exposed as you would like. For more of a pure-play option, you'd have to look at true junior miners - a topic for another day, and a risky proposition in any economic climate.

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