GOLD

GOLD MINING INDUSTRY Demand & supply of gold Production of gold Market dynamics Large producers Firm cost structure and revenue composition Firm strategies going forward

DEMAND & SUPPLY OF GOLD The market dynamics of gold are dominated by short-term supply and demand fluctuations Sudden surge in demand or disruption in supply can lead backwardation, where the spot price is higher than the forward price The gold market is usually in contango, due to the smoothing of supply that is possible due to accessible stocks.

Demand & Supply of Gold

How Gold is Mined Exploration Exploration Drilling Blasthole Drilling Blasting Underground Mining Ore & Waste Haulage

How Gold is Mined Heap Leaching Mining Oxidization Leaching Stripping Electro-winning

How Gold is Mined Smelting Gold Bullion Refining Reclamation

HOW GOLD IS TRADED Over the Counter Between principals, not through exchanges Contracts terms are flexible Main centers: London, New York, and Zurich Mining companies and central banks tend to transact their business through London and New York Twice daily during London trading hours there is a “fix” which offers reference prices for that day’s trading.

THE SETTLEMENT PROCESS The basis of settlement is delivery of a standard London Good Delivery Bar, at the London vault nominated by the dealer who made the sale. Currency settlement for gold transactions will generally be in US dollars over a US dollar account held in New York.

Market Dynamics: Gold Prices

Gold Prices Comparisons Like all prices, the gold price reflects not only the inherent value of gold, but also the relative strength of the currency in which it is quoted.

LARGEST GOLD PRODUCERS BY MARKET CAPITALIZATION Companies: Anglo American PLC Newmont Mining Corp. Barrick Gold Corp. AngloGold Ashanti Ltd. Placer Dome Inc. Gold Fields Ltd. Market Capitalization: 35.87B 20.28B 13.73B 10.10B 7.76B 6.26B

FIRM COST STRUCTURE & REVENUE COMPOSITION Costs applicable to sales of gold and other base metals Depreciate, depletion & amortization Depreciation, depletion, & amortization Exploration, research & development General & administrative Mergers and resturing Writ-down of long lived assets Others Revenue Composition Sales of gold Sale of other base metals Gain on investment Gain on derivative instrument Gain on dividends, interest & foreign exchange income

ISSUES FACING GOLD COMPANIES There have been only a few large deposits found since 1998 and none of these have made it to production as of yet Rising costs with gold prices impose questions of the ability to finance and develop projects Copper-gold projects will become more common in gold company portfolios

FIRM STRATEGIES & KEY SUCCESS FACTORS Effective cost control to maximize margin by improving supply chain management and usage of technologies such as e-commerce Strategic balance between gold mine grades produced and life of assets Continuous commitment to research & development to uncover large gold deposits

RISK ASSESSMENT Three major market risks faced by firms in gold mining industries: Commodity Price Risk Foreign Exchange Rate Risk Interest Rate Risk

COMMODITY PRICE RISK Commodity Price Risk = Gold Price Risk (the change in the price of the gold) It affects gold mining companies’ Asset values Profitability of its operations Cash flows generated those operations

COMMODITY PRICE RISK The price of gold is affected by numerous factors: Demand for gold in both jewellery and industrial uses International/regional, political/economic trends The relative strength of U.S dollars of other currencies Financial market expectations Numbers of speculative activities Reserves Number of forward sales Production and cost levels for gold

FOREIGN EXCHANGE RISK Is the change in the relative values of currencies Since gold mining companies do not have the luxury of choosing where the ore bodies are, they usually have their mining operations, activities, investment outside of their countries Their revenue and costs are primarily incurred in foreign currencies Adverse movement will affect a company’s: Cash flows Profitability

INTEREST RATE RISK Interest rate exposures impact a company’s: Cash Balances Borrowings (to meet short falls in current cash flows) Long term debts Hedging activities (the impact international interest rate differentials) Returns on its assets Firm value Significant decrease in interest rates and/or increase in gold lease rates can have a great negative impact on the price of the new gold sales contract and on the difference between the forward gold price & current spot price

EFFECTIVE RISK MANAGEMENT All gold mining companies face a similar exposure The prospects depend on its risk management decisions and strategies Firm characteristics play a major role in risk management

MEASUREMENT OF RISKS Methods vary across industries and firms within the same industry No specific requirements needed for gold mining companies In theory, should use delta calculation Delta: the change in the value of a portfolio with respect to a change in the price of the underlying asset (gold) Delta % : portfolio delta / amount of gold produced over 3 years

MEASUREMENT OF RISKS BUT: Most gold mining companies do not use this delta calculation No mention of the volatility of spot gold prices Instead, they only briefly mention that a certain dollars per ounce change in the gold price would result in an increase or decrease in approximately how many dollars change in cash flow from operations and net income.

TECHNIQUES AND PRODUCTS Gold producers can use: Future Contacts Gold loan Gold Swaps Spot deferred contract Forward sales of gold Put options (Insurance purpose) To hedge themselves against the exposures

DERIVATIVE USAGE FOR GOLD PRICE RISK Most gold mining companies use: Forward contracts Spot deferred contract Put and call option Gold lease rate swaps Most prefer to use forward contracts as its hedging instruments due to the introduction of SFAS NO 133/138 This allows gold producers to not consider their sales contracts as derivative instruments as long as they are considered to be normal sales Gold mining firms can record the proceeds under this contract as revenue and can be held off balance sheet until maturity, the date of the delivery of the gold in the future

DERIVATIVE USAGE FOR FOREIGN CURRENCY RISK Gold mining companies use: Currency forwards Currency options Since gold is quoted and traded in US dollars, gold producers with operations and investment in a large number of countries outside U.S will be exposed to foreign exchange rate risks

DERIVATIVE USAGE FOR INTEREST RATE RISK Gold mining companies ONLY use: Medium to long term horizon interest rate swap Interest rate risk is not viewed as important as the gold price risk and currency risk due to the low leverage in the gold mining industry

FIRM CHARACTERISTICS FACTORS Firm Size Is measured by the firm’s gold reserves representing the maximum collateral value and the market value of assets It is proven that firm size is negatively correlated with the degree of hedging Smaller firms tend to have little negotiation power and have a higher chance of facing higher financing costs Liquidity Is important in determining how much funds a firm can provide in terms of emergencies With a large cash balance, firms will face fewer financial constraints and hardships So, they do less hedging as their risk management strategies

FIRM CHARACTERISTICS FACTORS Leverage Firms with higher leverage have a higher chance of facing financial constraints They do more hedging in their risk management strategies Since gold mining industry has low leverage levels, it will not have a major impact on the firms Average Cash Cost Is important element in determining gold mining companies’ profitability, efficiency and productivity There is a positive association between financial distress and average cash cost Since smaller firms tend to have a higher cash cost average than large firms, they have a greater tendency to encounter financial distress when the price of gold decreases

POTENTIAL HAZARDS Gold mining companies use different derivative instruments to hedge themselves against the risks that they face from potential future movement in market variables The main motives for hedging: To cover the total operating costs Remove price risk Enhance revenue Control their cash flows

POTENTIAL HAZARD BUT No assurance that outcome of hedging will be better than the outcome without hedging Leave firm’s profit to be dependent solely on the underlying productive activities May suffer opportunity loss

RISKS DUE TO HEDGING By hedging, firms face: Credit risk Market liquidity risk Mark to market risk Risks associated with factors such as: Default by counterparty Costs associated with unwinding the position Possible restrictions on credit lines In order to develop an effective risk management program, a firm should make a clear statement about the firm’s risk management philosophy

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