Barrick Gold Corporation Due Date: August 15 th, 2015 Case Name: Case Code: Barrick Resources Corp.: Managing Gold Price Risk 293128-PDF-ENG Publication Date: April 1993
CASE SUMMARY: American Barrick (now referred to as Barrick in the modern day) was a major mining company throughout the 80 s and 90 s. Their only product for sale was the commodity known as gold. Although their costs of extracting and marketing the gold were relatively fixed, the sales price (and therefore annual revenue) was entirely dependent upon external forces. Without strategic and proactive intervention, Barrick s profits would have been extremely volatile. The primary question was whether Barrick sacrifice some of its potential profits in exchange for earnings stability. BARRICK AND THE GOLD-MINING SECTOR: STRENGTHS: Barrick was based out of Toronto and only invested in mines within North America. This freed them and their investors of concerns regarding the political instabilities inherent with African mines. Barrick always committed itself to a hedging program to stabilize revenues. This allowed them to enjoy steady profits when other mining companies suffered as gold prices dropped. With a market cap of $4B-5B, Barrick enjoyed economy of scales. Barrick was founded and led by Peter Munk, an entrepreneur with a demonstrated track record of success. The business grew 100x within a 10- year period under his leadership. It was Munk who was responsible for the firm s philosophy of moderating gold prices and avoiding leverage (because of a prior business failure). Barrick acquired its mines at relatively low prices because they were purchased when gold prices were depressed. Mines spun out a lot of cash, allowing Barrick to acquire mines at a rapid pace with minimal financing. This reduced interest expense. Barrick was more cost-effective than its competitors. Exhibit 3 shows that Barrick spent $274 to move 1 ounce of gold whereas competitors spent $288 - $415/oz. WEAKNESSES: Barrick was a mining company that only focused on one commodity. Since it wasn t diversified in other metals, this created the potential for far more volatility.
Barrick incurred additional costs from the hedging instruments it used to stabilize revenues. When gold prices went up, Barrick s profits were somewhat reduced because it was essentially paying for unused insurance. OPPURTUNITIES: Gold is always in demand, whether it be for jewelry, dentistry, arthritis treatment, electronics, space engineering. In addition, gold is used by numerous governments to back their currency. For much of these, there is no substitute because gold is malleable and robust. Since mines can spin off product for many years, mining companies can stagger and diversify mine acquisitions and developments. This is akin to a pharmaceutical company releasing new drugs on a regular basis that enjoy 20 years of patent protection. Investors like to buy gold in times of uncertainty, inflation, and fear. THREATS: Gold is valuable, but still a commodity. Market participants can only compete on price. Gold prices are sensitive to economic strength, prevailing interest rates, and changes in government policy, things that gold miners have zero control over. Operational expenses are fixed, regardless of gold prices. In an academic vacuum, one would expect mining companies to cease operations when gold prices get too low. This improves impractical because the mine may flood and kill the initial capital investment. Any mining operation is going to be capital intensive. For example, the Meikle Mine cost $180M of initial investment. Since gold mines yield product over a long period of time, this exposes a company s profits to a decade of price variations. It can be difficult to predict how much gold a mine will produce. A good example of this the Meikle Mine having 1.7M extra ounces of gold showing up unexpectedly. If we assume the 1992 market price listed in Exhibit 15, that would mean Barrick did not foresee $566M in sales revenues! Gold can be difficult to extract for a variety of reasons, such as high temperatures. It takes 16,000 pounds of processed rock to produce 1 oz of gold.
Mining operations invite all kinds of regulatory, social, and environmentalist pushback. Safety issues arise, either stemming from workers being the victim or the cause. ASSUMPTIONS AND MISSING INFORMATION: PRICES: In the 10 years preceding this decision point, gold prices fluctuated wildly between $328 and $522 per ounce. See Exhibits 5 and 9. COSTS: The combined capital, operating, and termination cost for delivering the gold was $307.50/oz plus a 4% sales commission. That means Barrick would have to sell gold for $320.31/oz to break even. See Exhibit 14. POTENTIAL PROBLEM: In 1989, Barrick s engineers estimated that the Meikle Mine had 5M ounces of gold under the water bed, but were unsure whether the temperatures were too hot to extract the gold. 3 years later, they concluded that The gold was useable There was more gold than previously anticipated It could be extracted much quicker than previously anticipated The bottomline impact was that Barrick was going to enjoy 1.7M ounces of gold it wasn t originally counting on. The sales revenue from this newfound gold was open to interpretation. On one hand, the bulls felt that the need for gold would outpace the new supply of gold. They also predicted that Bill Clinton s policies would lead to inflation and this would lead to gold prices rising. On the other hand, the bears felt that the fears of a global war had subsided and there wouldn t be enough fear to drive the price of gold up dramatically. The HBS case study asks the reader whether Barrick should take steps to immunize profitability from gold price volatility. STRATEGIC RESPONSES: There are a number of maneuvers Barrick could have engaged in. Take note that these strategies are not mutually exclusive. Barrick could have, and did, combine some of these strategies. Diversification Ceasing Operations Royalty Trusts Bullion Loans Forward Sales Options SDCs (Spot Deferred Contracts)
EVALUATION OF VARIOUS STRATEGIES: Diversification: Barrick could have reduced revenue volatility by diversifying amongst different metals. It elected not to go in that direction, as management had planted its feet on being a gold-only company. Ceasing Operations: Fortunately for Barrick, the price of gold never got so low that it became grossly unprofitable to stay in business. If gold fell enough, it would still not be a reasonable response to suspend operations. This is because mines would flood. Royalty Trusts: Barrick innovated a gold royalty trust. Investors were promised a 3% to 10% cut of the mine s production, where the percentage increased as the FMV of the gold increased. This aligned the company s interests with the investor s interests because both parties benefited when gold went up in price and/or when the mine s output (measured in ounces) exceeded expectations. The key takeaway is that Barrick was essentially pre-selling a 3% - 10% fraction of the gold at a fixed price. Barrick used these kinds of financial instruments to raise a combined $67M for expanding the Renabie Gold Mine and the Camflo Mine. Forward Sales: As we learned in class, a forward contract occurs when a buyer and seller agree on a future delivery and a predetermined sales price. Gold prices had bottomed out in 1985 and. Barrick ended up suffering from their short positions because gold prices rose through 1986. However, the company would have gotten close to being unprofitable if the price had continued to fall and Barrick had been fully exposed without hedges. Taking on the responsibilities of delivering gold at a fixed price would be called a short hedge. Options: As we discussed in class, options can set upper or lower limits on sales prices. To hedge against price decreases, they could have taken long positions (bought) put contracts. This would allow them to sell gold at the strike price even if gold fell below the put s strike price. To counterbalance the expenses of buying put contracts, they took short positions (sold) call options. The upside to this is that they collect a guaranteed amount on the option premium. The downside to this is that if the price of gold shoots up dramatically before expiration, the call owner can execute the call and buy the gold from Barrick at the lower strike price. Therefore, this strategy sets a floor and ceiling for Barrick s sales prices. SDCs: The problem with forwards and options is their timeline. A 1-year option does little good if a new gold mine has an expected lifespan of 10 years. A spot-deferred contract solves this problem.
When Barrick sells an SDC, it s making a promise to deliver a fixed amount of gold at a fixed price. However, the delivery times are variable and at the discretion of the seller, to some extent at least. Barrick would commit to selling over 100,000 ounces to bullion dealers, but would have flexibility over a 10-year period as to when to deliver portions of that 100,000 ounces. The general strategy was to deliver the gold when gold price was lowest. In the year of this decision, Barrick s use of SDC s had gone up to 4.3M ounces. CONCLUSION: Ultimately, Barrick s management responsibility is to serve and cater to their shareholders, not their customers or employees. For better or for worse, part of creating shareholder value is offering an income stream that is both profitable and predictable. For these reasons, I believe it would be prudent for Barrick to continue hedging their newfound gold supplies in the same way they had done in the past. It only takes two or three quarters of losses, or even missed expectations, to undo the goodwill and investor confidence that has built up over a decade. If we look at Exhibit 4, we can see that their stock outperformed their industry peers by an astounding margin. A huge reason behind this is because most other gold miners did NOT hedge against falling gold prices. To further validate this theory, competitors (e.g. Battle Mountain Gold in 1990) began to hedge in a manner similar to Barrick. Exhibit 6 shows that as time went on, more firms were participating in hedging activities and a large proportion of their gold supplies were being hedged. This is also reflected in Exhibit 8. When the price of gold is rising, Barrick s profits may appear muted compared to their competitors. However, they will be vindicated every time the gold price drops, as they already were in the year 1992. I will end this with a relevant Warren Buffett quote: Only when the tide goes out do you discover who's been swimming naked