Derivatives revolutionize gold markets, says author

Timothy Green, author of The World of Gold, has kept a close eye on gold markets for much of the past three decades. That was a relatively easy task years ago, he says, when it was a straightforward physical market dominated by two producers — South Africa and the Soviet Union.

However, South Africa’s share of world production has slipped to about 25% from 80%, while production from the former Soviet Union is in decline. Meanwhile, a new group of large producers, mostly North American-based, has come to prominence, operating large mines with the latest processing methods and investing in new opportunities around the world. Looking ahead into the future, Green projects that Indonesia, West Africa (Ghana) and China are poised to become important gold producers.

“Enormous changes have taken place on the production side,” Green told The Northern Miner. “But in parallel with that, gold markets have changed because of the derivatives revolution. They (derivatives) have irrevocably changed the nature of the bullion business.”

Green’s visit to Toronto was part of a tour to launch New Frontiers in Gold: The Derivatives Revolution, a new book by gold-market analyst Jessica Cross. Drawing on her experience at Consolidated Gold Fields and RTZ, Cross “de-mystifies” the basket of derivatives — whether futures, forwards, options or spot deferreds — and explains how the mining industry is adapting to them. Cross defines derivatives (in the gold sector) as “any predominantly paper product, usually highly leveraged, whose value, but also its usefulness to its owner and the very purpose of its existence, is directly or indirectly dependent on the price of gold.”

Green, the book’s publisher, says derivatives are often poorly understood by the industry, despite the fact that they are an important tool of the risk management business and have become an integral part of the gold market. “The driving force in the last gold boom (1973-1983) was rising oil prices and the purchasing power it gave to Middle Eastern countries,” Green explains. “But in the 1990s, the driving force that got gold prices moving was the funds. Gold had a good run in 1993, but has languished lately because the attention of fund managers has now turned to other metals.”

Green believes, however, that physical demand is maintaining gold at the US$380-per-oz. level. “Physical support from jewelry and industry is better than people realize. Fabrication demand is well ahead of production,” he says. Green contends that the gold price is “on stepping stones upwards,” and predicts that it will push through US$400 per oz. sometime in 1995. “But there is not the drive of the funds to push it higher, because they are doing something else,” he says.

The Derivatives Revolution also evaluates the impact of gold loans and mine hedging programs on the gold market, together with the growing importance of central bank option programs and the effect of speculation by commodity trading advisers.

Cross wades into the “great hedging debate,” and argues that mining companies should hedge. Mining companies should “be creative,” she says, and make the effort to understand the products at their disposal in order to make the most of the flexibility offered by derivatives. Indeed, Cross believes hedging is just as important as cutting operating costs, because “the ideal investment is in a stock whose management has the skills to manage all areas of risk — including price.”

Assessing the new dimension offered by derivatives, she writes: “Their highly leveraged nature is both the beauty and the beast within the derivative. Like the little girl in the nursery rhyme, when derivatives are good they are very, very good, but when they are bad they are horrid. It all depends on how they are used.”

She also points out that this “creative financial inventiveness” has spread to other commodities, including base metals (particularly copper, nickel and aluminum) which are now getting their share of derivative buffeting. Cross concedes that the rate of growth in derivatives and their degree of leverage has caused a great deal of concern about their possible effect on financial markets in general. This concern, she says, is only being exacerbated by a spate of onerous defaults and company failures, many of which were blamed on derivatives. “It is arguable whether the products themselves are to blame, or whether the fault lies with the manner in which they have been applied,” she writes.

Nevertheless, Cross forecasts more regulatory and obligatory disclosure in the years ahead. Derivatives, she says, are in the process of undergoing a grueling test of endurance as market-makers and regulators view critically not the products, but their implementation. “We must expect changes,” she concludes.

New Frontiers in Gold: The Derivatives Revolution is available for US$45 through The Gold Institute, 1112 16th St., N.W., Suite 240, Washington, D.C. 20036. (Phone: 202-835-0185)