Gold to TUMBLE back to US$35 per ounce, page-14

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    re: succor for the hurting goldbugs via/ kitco forum:
    LONDON (ShareCast) - There may be trouble brewing in the gold market. But for a change, this trouble will be good for gold bugs as an unusual confluence of events pushes gold, currently trading around $310 an ounce, to $400 and above. And it will prove very bad for any big-name banks caught on the wrong side of this price move.

    The phenomenon revolves around a highly unusual form of gold derivatives, a market in which Citibank, Goldman Sachs and JP Morgan are the major players. The particular form of derivative is a type of hedging pioneered by Barrick, one of the world's largest gold producers and a leader in innovative hedges.

    Ordinarily, a hedge protects a producer or investor from the downside, but, other things being equal, it does so by limiting their upside. Barrick, however, has managed to construct a hedge that allows it considerable upside if gold rises. And one big bank could be caught very short.

    Barrick has been a very good hedger, making use of all sorts of instruments and investment strategies. In fact, at the end of 2001, its hedge book had assets of $5.5bn, which was more than the gold-mining part of the company.

    It appears that part of this success comes from what is known as a spot deferred forward sale contract, which it started using in 1990.

    Barrick makes a forward contract with a bank to deliver (unmined) gold at a certain price at a certain date. But - and this is what makes these contracts different and, indeed, dangerous for counter-parties - Barrick also had the right to defer the delivery of the gold for periods ranging from five to 10 years. Recently Barrick has entered into contracts that allow it to defer delivery for 15 years.

    While deferring or rolling over a contract is not unusual in the financial world, it can usually be done for only a short period and both parties have to agree. But Barrick appears to have pulled off a coup by writing extended-length contracts that allow it to take the decision unilaterally.

    This can be very lucrative for Barrick. Say gold is trading at $300 an ounce and Barrick agrees to sell Bank X 1m oz of gold at $320 an ounce in 12 months. If gold then trades at $310 an ounce one year later, Barrick will sell the gold to the bank and receive a better price than it would get elsewhere. But if gold has shot up to $350, Barrick can choose to defer the sale to the bank, and sell its gold in the market. This gives it the best of both worlds - little risk and the highest price available.

    If you are Bank X holding the obligation to buy the 1m oz at $320 per ounce, then you need to hedge this position in the market. Standard gold futures contracts have no deferral clauses, so you sell forward the gold that you don't have, which means you are now relying on Barrick to deliver the gold so you can fulfil your end of the bargain.

    If Barrick decides to defer the sale, though, there could be trouble - which is what we hear could happen.

    Apparently, one sizeable bank active in this market has a gold derivatives book of $41bn, a significant part of which is attributable to its dealings with Barrick. Barrick's contract apparently has the option to defer any sale. If the gold price starts to accelerate, Barrick could choose to defer and the bank will have to find some other way to get the gold it needs to fulfil its own obligations.

    How will it do that? It will have to buy the gold - potentially hundreds of millions of dollars worth - in the market. A forced buyer of that size would send gold rocketing to $400 or even $450 an ounce, prices not seen since the early 1980s.

    You may have a question: How could a bank do something so risky? Eight words give a clue to that: Enron, Savings & Loans, Long-Term Capital Management.

    Ian Williams is head of fixed-income and commodity research at Durlacher.

 
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