Aug 062015

Reuters recently covered the latest Societe Generale/GFMS gold hedge book analysis report, which noted that “while miners overall remain wary of hedging … those who do favour the strategy are leaning more strongly towards options”. The total size of the hedge book has increased from its low of 91 tonnes in Q4 2013 to 193 tonnes at Q1 2015, but it is still massively below its peak of 3230 tonnes in 1999 (see chart below).


After the gold price peaked in 2011, there was industry and media chatter about miners returning to hedging, with Paul Walker of GFMS reported in April 2012 as calling for miners to consider hedging again. As I noted at the time, any “rush by miners to lock in hedges would result in a negative feedback loop, to their own detriment” as not only would the hedging depress the price, but it would encourage speculators to also short sell gold in anticipation of miners returning to hedging.

The topic of hedging appeared in the media during 2013 and 2014 as the gold price weakened further, but it is clear from the chart above that so far gold miners have not looked to repeat the late 1990s where they were hedging into a falling price, obviously sharing the view of Barrick’s CEO Jamie Sokalsky in March 2014 that “he was not interested in hedging because investors want to capture gold’s upside”.

With hindsight one could say that miners should have hedged in 2011 and 2012 but it can be tempting for mine managers to try and speculate as part of their hedging programs, the results of which can be fatal. A recent academic study looked at this practise of “selective hedging” where managers “speculate within the context of their hedging programs by varying the size and the timing of their derivatives transactions based on managers’ market views”.

The paper focused on 92 North American gold miners from 1989 to 1999, which is when the bulk of hedging was talking place. One flaw with my chart above is that it is just the total amount of hedging, which can give an incorrect view of the extent of hedging. The academics therefore look at the miners’ hedge ratio, which “represents the fraction of gold production over the next three years that has been hedged”, shown in the chart below (arrows mine).


What I find interesting in this chart is that the hedge ratio was relatively flat up to the mid 1990s but then increased as the gold price broke down from its narrow trading range. The fall in the gold price would have put some miners into financial difficulties, maybe tempting them into trying to increase the performance of their hedges, so it is not surprising that the academics found that “that smaller firms and firms that are closer to financial distress are the firms that are more likely to engage in selective hedging”.

A timely study considering Metal Focus was reported yesterday as concluding that “on an [all-in sustaining cost] basis, the proportion of loss-making mines at $1,100 swells to 24%”. Metals Focus say that this does not mean that mines will be shut down, as “closing a mine in itself is often a very costly undertaking” and thus “mining companies will often be prepared to operate at a loss in the short term in the hope that commodity prices recover”.

For mines running at a loss it may make sense to look at hedging even at current low prices because it provides protection against further gold price falls – extending how long they can continue to operate and thus increasing the chance they will still be around when the price recovers. While this may make sense for each miner individually, it doesn’t make sense for the industry as a whole if everyone does it. Let’s just hope miners have learnt the lessons of the 1990s.

Aug 052015

Amid a sea of mainstream media gloomy gold gloating, this unemotional article from Financial Times’ Alphaville blogger Matthew Klein asking the question how much of your portfolio should be in gold is worth a read.

The first part discusses the idea that each person’s optimal portfolio depends upon their unique personal circumstances and risks. For example, if you have a stable job like a tenured professor, you could afford to have a more risky portfolio than a casual labourer. Matthew then asks, so “do you have liabilities [ie risks] that gold can usefully hedge”?

He notes that gold is a form of cash, just like paper cash, as it doesn’t earn a return. However, “what makes gold attractive is that, unlike fiat cash, gold has a strong negative correlation with the level of real interest rates” making “it a good hedge for those times when your fiat cash earns less than what it used to in real interest”.

Matthew argues that gold volatility would suggest a “relatively small weight as a proportion of short-term liquid assets in a neutral portfolio (less than 5 per cent), although the specific weight should also be affected by the propensity of your home currency to experience severe bouts of negative real interest rates”.

The World Gold Council has done numerous studies on the optimal amount of gold in a portfolio and they also come to the conclusion that investors should only hold modest amounts of gold (no more than 10%). This is at odds with the Harry Browne Permanent Portfolio strategy, which contains 25% gold and, at least for an Australian implementation of this strategy, produces consistent and low volatility returns (see chart below, or check out the back tested annual returns here).


Given gold’s negative returns in recent years, it is worth highlighting Matthew Klein’s observation that “good hedges don’t necessarily have positive expected returns over time, but they can still be worth having because they can smooth out your gains and losses on the rest of your holdings”.

As an example, look at the following comparison of three portfolios starting with an initial balance of $10,000 in 1972 through to 2014, which I did using this online tool.


You can see here that the inclusion of 5% gold in a traditional 60/40 stocks/bonds portfolio increases returns and reduces the risk and worst year. The Permanent Portfolio produces a much lower overall portfolio balance, but note the massive risk reduction, particularly in terms of worst year. For those with high risk aversion who can’t afford a bad year (for example, those in retirement who don’t have an investment timeframe over which to recover the loss), that performance hit may be worth it to avoid the pain of years where there are massive losses.

The online tool is quite detailed with a number of options, so I’d suggested playing with it on different asset allocations and timeframes. My only concern is that it only does annual portfolio rebalances and my gut is this would probably skew it against gold compared to monthly rebalances.

For those who have really been bashing gold investment recently, I think this blog post from 2013 speaks to the idea of “unique personal circumstances and risks” where John Cochrane says that some think “about gold as an out of the money put option on calamitous social disruption, including destruction of the entire financial and monetary system.” In the end, criticising gold is about discounting the need for this optionality. OK, great, but as John says “you still have to think why this option is [not] more valuable to you than it is to [goldbugs]”.

Aug 032015

Michael Pettis argues that a market dominated by speculators tends to be more volatile as it is sensitive to changes (in consensus) in the way news is interpreted. If gold is entirely a speculative market, as I argued in Friday’s post, then we should see high volatility. While gold is more volatile than many other assets and currencies, it is not as excessive as we would expect based on Pettis’ theory. Why is this? I think it is because it is difficult for gold speculators to converge on a consensus view.

Divergence of Convergences

While I agree that the game theory-ish Keynesian beauty contest means speculators will converge on a view of a market, gold is composed of a number of groups with fundamentally divergent frameworks through which they view gold. A US Hedge Fund has a completely different view of gold compared to an Indian farmer, for example. Furthermore, many of these groups do not have a game theory approach – if you mentioned to an Indian farmer whether he is considering what all gold investors think about how all gold investors view gold, he would say “what the?” If participants are not aware of beauty contest dynamics then convergence doesn’t occur.

Note that within each group there is a convergence or agreement about how to view gold and when to buy it, there are just divergences between each group. Hence we have lower volatility as each group’s differing view counterbalance. The above implies that a savvy investor needs to implement a modified beauty contest: identify groups unaware of such game centric thinking and estimate their view of gold then identify game aware groups and then work out their view of the unaware groups plus their view of what game aware groups think other game aware groups think. Confused? No wonder no one can agree on gold.

Divergence Globally

In the latest World Gold Council (WGC) Gold Investor report they say break down the “drivers of gold into key factors: currencies, inflation/deflation, interest rates, consumer spending and income growth, systemic and tail risks, and supply-side factors.” Plenty of areas for divergent views. In addition, the WGC then point out that gold is a global market, so each of those factors differ between countries. I would argue that even if every gold market participant was playing a Keynesian beauty contest there is no way that with such a wide variety of factors to consider, and difficulty for the participants to communicate/signal their view, could any convergence occur.

Divergence Over Time

Adding to the complexity of the gold market is the fact that its structure is changing. As an example, it used to be that Western retail investors would run away when gold dropped significantly, but on the big drops in 2013 and 2015 we saw big surges in buying. Another example – consider the following two charts from the WGC Gold Investor report.


As the make up of participants in the gold market changes, then their influence on gold changes as well. WGC also makes good points on how conventional (ie Western professional investor) views about the influence of the US dollar and real interest rates on gold may be wrong.

Zero Correlation

I think the result of the above may explain why gold has no correlation to many asset classes. In the chart below from the WGC the correlations in red are not (statistically) significantly different from zero.


Those assets with zero correlation to gold are basically equities and debt; the positive ones being commodities, and the big negative the dollar. It shows that there is no consensus about how gold should relate to equities and debt.

Current Market Situation

While I have been arguing that gold is basically a highly divergent market, at the moment I think there is a dangerous convergence on the idea that gold will continue to fall, certainly in the Western markets (as discussed here) but this would also affect sentiment in other markets. It seems to be primarily driven by narratives around US interest rate rises as signalled by the Fed. On that I’ll leave you with this from Pettis’ article, modified to suit the current gold market:

“In this market, you [sell] because you believe that everyone has agreed on the collective interpretation of government signaling. Anything that undermines the confidence you have in the collective interpretation must undermine your decision to [sell], and in fact because everyone is watching everyone else, at some point, this can become a collective decision to [buy].”