Tuesday, November 25, 2008

The Tailwind in the Gold Market

The global gold hedge book has seen dramatic changes as a result of gold producers systematically reducing hedges to take advantage of higher prices. Over the last year, gold producers have reduced hedges by over 40%, resulting in the lowest amount of gold hedges since 1987. GFMS and Societe Generale recently released their quarterly report on the hedge book, the following table summarizes the hedge book over the last year.

Composition of the Delta-Adjusted Global Hedge Book

Moz

Q2 07

Q3 07

Q4 07

Q1 08

Q2 08

Q3 08

YoY Change

Q3 07 vs. Q3 08

Forwards & Gold Loans

23.58

20.20

18.26

14.92

13.44

11.92

-40.9%

Options

10.02

8.99

8.60

7.96

5.51

5.00

-44.4%

Total

33.60

29.19

26.86

22.88

18.95

16.92

-42.0%

Source: GFMS

Until recently, the preferred method of hedging was the use of forward contracts since they have a delta of 1 and provide a 1 to 1 hedge on production. However, as the price of gold increased, producers and shareholders were no longer satisfied with limited profits. Naturally, they wanted to take advantage of any upside in price, while also protecting against the downside. To accomplish this goal producers are now hedging downside risks with put options.

The reduction in forward contract hedging and the trend toward purchasing put options has radically changed the composition and sensitivity of the hedge book. As recently as the first quarter 2008 the hedge book was structured in such a way that in a rising price environment market makers would have to sell more gold to hedge their positions. When gold prices fell, market makers would have to buy more gold. As market makers adjusted their position they kept volatility low by selling into rallies and buying dips.

The following tables are based on data from GFMS and compiled by Societe Generale in the report "Global Hedge Book Analysis." These tables illustrate the changes in delta-adjusted volume during periods of different gold prices and volatility.

Sensitivity of Q1 08 Options Book as of March 31, 2008

Move in Volatility (%)



Move in Gold Price (US$/oz)




-200

-100

0

100

200

4

7.59

7.78

7.96

8.07

8.12

3

7.59

7.79

7.96

8.07

8.13

2

7.59

7.79

7.97

8.08

8.13

1

7.60

7.79

7.98

8.09

8.14

0

7.60

7.79

7.98

8.09

8.15

-1

7.60

7.79

7.99

8.10

8.15

-2

7.60

7.80

8.00

8.11

8.16

-3

7.60

7.80

8.01

8.12

8.16

-4

7.60

7.80

8.01

8.12

8.16

Source:GFMS

The simplest explanation of the table is that the larger the numbers the more gold needs to be hedged. This hedging is undertaken by the banks and brokers (market makers) that are writing options to the gold mining companies.

For example, if a mining company purchases a put option the writer of that option will in effect be long gold. In gold hedge book terms this is called being long delta volume. Suppose the delta of the option written is +0.5 and the nominal value of the trade is 100,000 ounces, then the writer of the option (market maker) is exposed to being long 50,000 ounces of gold. Typically the market maker does not want to make a directional bet so they must offset the risk. The market maker will borrow 50,000 ounces of gold from a central bank and then sell that gold in the spot market, effectively eliminating directional risk. In this way, the hedging activities of the mining companies are reflected in the spot price of gold. This is why the sensitivity of the options hedge book is so important to gold prices.

For most of the current decade the delta-adjusted volume has increased as gold prices increased and decreased when the price of gold fell. This was primarily because the hedging activities were concentrated in forward contracts with a delta of 1 and resulted in a 1 to 1 offsetting trade. The following table illustrates the change that occurred in Q2 2008.

Sensitivity of Q2 2008 Options Book as of June 30, 2008

Move in Volatility (%)



Move in Gold Price (US$/oz)




-200

-100

0

100

200

4

5.80

5.61

5.50

5.45

5.43

3

5.80

5.61

5.50

5.45

5.42

2

5.80

5.60

5.49

5.44

5.42

1

5.80

5.60

5.49

5.44

5.42

0

5.80

5.59

5.48

5.43

5.41

-1

5.80

5.59

5.47

5.43

5.41

-2

5.81

5.58

5.47

5.42

5.41

-3

5.81

5.57

5.46

5.42

5.41

-4

5.81

5.56

5.45

5.42

5.41

Source:GFMS

There are two striking observations about this table. First, the absolute amount of delta-adjusted volume has decreased, which makes sense in an environment of de-hedging activity. Second, and most importantly, the sensitivity has reversed. Now, as gold prices rise market makers will have to buy gold to offset directional exposure, while in a falling price environment market makers will have to sell gold.

The net outcome is that volatility has increased as market makers have essentially become momentum players buying and selling with the prevailing trend. Looking at the log change in prices of the SPDR Gold Trust (GLD) provides a standardized comparison of volatility.



It is clear that in the last 3 months the changes in the price of GLD have become more volatile and the volatility followed both up and down markets.


Sensitivity of Q3 2008 Options Book as of September 30, 2008

Move in Volatility (%)

Move in Gold Price (US$/oz)

-400

-100

0

100

400

4

5.62

5.08

5.01

4.97

4.96

3

5.64

5.08

5.01

4.97

4.96

2

5.65

5.08

5.00

4.97

4.96

1

5.66

5.08

5.00

4.97

4.96

0

5.67

5.08

5.00

4.97

4.96

-1

5.68

5.07

5.00

4.97

4.96

-2

5.70

5.07

5.00

4.97

4.96

-3

5.71

5.07

4.99

4.96

4.97

-4

5.73

5.07

4.99

4.96

4.97

Source:GFMS

The most salient observations about this table is that once again the amount of hedging has decreased and the sensitivity of the book has decreased remarkably. In June 2008, a $100 decrease in the price of gold would result in the amount of gold sold as a result of offsetting hedges to increase by 0.11 million ounces. Now, a $100 decrease in the price of gold results in 0nly 0.08 million ounce increase in the amount of offsetting gold hedges. The prevalence of put options has had a large effect on the the price of gold.

The result of all these changes is that if the price of gold begins to trend up it no longer has the twin headwinds of the mining company hedgers and the market maker hedging activities. In fact, gold has an implicit tailwind built into the structure of the market.

Disclosure: I am long DGP and call options on GLD.

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