News & Thoughts

Dodging the Death by Dilution bullet

Sep 26, 2018

Mining is a risky business. How risky depends on many things. Sometimes I think for mining equity investors it’s a bit like betting on a game of Russian Roulette being played by the CEO. Investors of course must also remember that ‘death’ for the player is often much less painful than it is for them.

Sure, when the gun goes bang there is blood on the walls, but the CEO will be paid to walk, the company will raise a heap more equity at bargain basement prices (and often re-strike all the options for remaining management and the board) and the new CEO will spin the chamber and start pulling the trigger all over again.

‘Death by dilution’ is why those betting on the game often suffer more, even though they never hold the gun.

I have found that the Russian Roulette analogy also helps when running scenario analysis and trying to help miners decide if they should hedge price risk and how much they might hedge.

Lucky for most miners, and their investors, the theoretical gun at their head is generally not a six-shooter, but I try and imagine playing the game with a gun with 20 chambers.

At one level it’s simple. The more bullets in the chamber, the greater the risk. But it’s not that simple because the punters and players of real-life Russian Roulette know the odds. They know the number of bullets so the risk is certain, the odds can be calculated. Miners in real life are not assessing risk, they can never know the actual odds of success or failure, they are playing a game of uncertainty. Each time they spin they are guessing at the number of bullets in the chamber and that number changes through the cycle. Sometimes very quickly.

Assessing some of those uncertainties is easier than others.

Where your mine is located and your expected price of production feature highly in the uncertainty profile. Costs in the lower quartiles might protect you from much of the expected future price volatility, but they are not guaranteed protection against political risk. Many would bet on a higher cost mine in a safer jurisdiction every time. They see a lower stakes game with fewer ‘political risk’ bullets in the chamber.

Whether a company is funding activities with equity, or with a solid dollop of debt, also changes the uncertainty profile considerably. Debt can greatly enhance equity returns when metal prices are rising or stable but it increases the risk of ruin. That is, it raises the metal price at which no free cash is created. Debt puts more bullets in the chamber.

Hedging also changes your uncertainty profile. It reduces your exposure to falling metal prices, increasing the certainty of cash creation assuming you deliver on your plan and reduces the risk of ruin. Many players acknowledge that debt and hedging are ideal, if not necessary, bedfellows if you want to stay in the game and they hedge – but there are many more miners with debt and no hedging. In terms of the game, appropriate hedging can take out at least some of the bullets that debt puts in.

It’s also very important to note that the critics of hedging regularly ignore that Death by Dilution, when equity is raised to repay unhedged debt (invariably at much lower share prices than when it was raised) spilled more blood than hedging ever did.

Inappropriate use of hedging instruments, such as hedging your cost currency but not hedging your metal prices, particularly where the two are highly correlated over time, adds bullets but sadly its incredibly common!

For those of us wagering on the game, and those rare managers/players that don’t see Death by Dilution as a respectable end, assessing possible scenarios and trying to appropriately reflect the return from the game versus the uncertainty is all about understanding the number of bullets in chamber.

In an uncertain world where future metal prices cannot be known, hedging is one of the few things that can reduce uncertainty. Does hedging increase the potential cash flow if prices do go higher? Yes. That must be contrasted with the very simple fact that a hedged producer is always spinning the chamber with fewer bullets than its otherwise comparable peer.

It’s not that many years ago that mining CEOs were told by many fund managers that if they hedged they would be committing corporate suicide. They were told, hedge and we will trash your share price. Those fund managers making the threat to sell out of hedged producers were “certain” prices were rising and, in any event, they were playing the game with other people’s money so they were never in harm’s way. Nonetheless, many miners, particularly those in North America toed the line and eschewed hedging, but with prices falling many have needed debt to make ends meet. Death by Dilution has followed.

By contrast if we look at the share price performance of those gold miners that do hedge we see some interesting statistics.

Over the past 12 months four of the nine companies with the largest hedge positions** have delivered positive share price appreciation. Six of the top nine gold miners that hedge have outperformed the falling GDX and GDXJ. Eight of them have outperformed Barrick Gold and Randgold even after their recent announcement. Looking back over two years, three of the nine delivered positive appreciation and seven outperformed the GDX and Barrick.

Hardly corporate suicide.

I am not suggesting that hedging alone is what drives those differences. Rather I contend that the solid outperformance of peers on the bourse is a clear reflection that astute investors will always gravitate towards companies that are seen to acknowledge and manage uncertainty and are perceived as less likely to blow their proverbial brains out waiting for gold prices to rise.


**Nine largest gold producer hedgebooks: Goldfields, Newcrest, Polyus, Petropavlovsk, Regis, Harmony, Northern Star, Evolution, Saracen. All share price performance measured on USD basis.

*Sean Russo is managing director of Noah’s Rule, a specialist debt and risk advisor