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Anchit Palta

Summary of the Case: American Barrick Resources Corporation came into existence in the year 1983. Since the time of its inception it has been one of the worlds fastest growing and most financial gold-mining firms. Mr. Peter Munk, a Canadian entrepreneur, was behind the establishment of the American Barrick in 1983. He was the Chief Executive officer at the organization. The firms market capitalization grew from $46mn in 1984 to $5bn in 1992 with production growing from 34000 ounces to 1.325mn ounces. The proven and probable reserves increased from 322,000 to 26mn ounces. American Barrick, in addition to growing fast was also one of the most profitable gold mining concerns over the world. The high profitability of American Barrick can be attributed to: Acquisitions of gold mines during the 1980s when the gold prices were low Finding reserves of gold, that were much larger than anticipated, at gold mines it had acquired Cutting costs at various mines and producing to capacity Conservative financial policies by issuing little debt and hedging program used to safeguard itself from the risk of declining gold prices The hedging program at American Barrick was one of kind and was not used by any of the gold mining firms of its time. Most of the gold mining concerns were not hedged against the gold price fluctuations. The profitability of the firms depended mostly on the quantity of gold that they produced. In order to keep growing American Barrick had acquired a number of gold mines from 1983 to 1992. The details of the acquisitions can be noted below: 1983: The company acquired a number of Alaskan and Canadian gold mines 1984: Acquired the Camflo mine which produced 30000 ounces of gold annually. The acquisition also helped American Barrick gain skilled technical staff. ABXs president and COO since 1985, Robert Smith, was also from the Camflo Mines. ABX also acquired an interest in the Pinson Mine 1985: Acquired the Mercur Mine near salt lake city, which was the largest acquisition till that time 1986-87: Acquired the Goldstrike mine and surrounding properties in Nevada. By this time the reserves of American Barrick were estimated at 600,000 ounces. American Barrick discovered reserves on its Goldstrike Property, its total reserves in 1992 were estimated at 20.1 million ounces. The latest acquisition of the firm was the Meikl Mine. The development project demanded $180 mn in capital investments. The projected yield from the mines was 400,000 ounces of gold annually for the 11 years beginning 1996.

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Strategies used by American Barrick to Manage Gold Price Risk Gold Financing: American Barrick used multiple ways of financing acquisitions including issuing of common stock, taking bullion loans and issuing gold notes. ABX used common stock to finance the acquisition of the Renabie mines in Ontario. The additional $18mn were raised by establishing the cullaton gold trust that paid investors 3% of the mines if the gold prices were at or below $399 and 10% if they were $1000 thereby. American Barrick acquired the Mercur Mines through Bullion Loans taken from Toronto Dominion Bank. It received 77,000 oz. of gold which it sold at market price for $25mn of revenues. ABX had to payback this loan in 4 and years at a 2% interest rate. This loan had been collateralized by the assets of ABX and its guarantee. ABX also issued 2% gold indexed notes worth $50mn, in 1987. The gold price at this time was $400. The investors had to pay $1308 for each note and in return received $26.16 every year in addition to the right of redeeming the notes any time between 26Febrary 1988 and 26 February 1992. The holder could choose to receive either cash or gold bullion of value equivalent to 3.2150 oz. or 3.3804 oz. depending on the time at which the redemption was done. Forward Sales: Under this scheme ABX was able to sell a set quantity of gold at a future date at an agreed upon price. The quantity to be sold was typically 10,000 ounces or more. American Barrick would also be paid a premium, known as contango, for selling gold at a future date. Typically the contango was the difference between the gold lending rate and the dollar lending rate. American Barrick was thus protected against the fall in prices of gold however it could also not fully take advantage of the rise in prices of gold. ABX sold the first forward contracts in 1984-85 when the gold prices had fallen, with the anticipation of a further decline. The prices of gold however started to increase and thus ABX had to forego the profits it could have made on the risen prices. Options and Warrants: Options were a smart move by ABX after it had faced the potential difficulties with forward contracts during 1984-85. Under this, ABX bought put options and sold call options. It financed the put options by the premium it got after selling the call options. ABX adjusted the exercise prices and the ratios of call/put options to determine the degree of participation in the gold price rise. For e.g.: it bought the $420 put option with the premium it got from selling a $550 call option. It was thereby able to enjoy any price rise within $420 to $550 and was hedged against any decline in the price from $420. Spot Deferred Contracts: These contracts differed from future contracts in the sense that in a forward contract there is only one date and price set for delivery. However, in case of a spot deferred contract, a set of dates (rollover dates) are decided for delivery by the contracting parties. ABX got into these contracts where the price 3
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for only the first rollover date was established. The first rollover date was typically at the end of the first year of the contract. ABX could deliver on the contract at the rollover date (if the contract price was higher than spot price) or else could roll the contract to the next rollover date. The price for the next rollover date was based on the prior contract price plus the prevailing contango at the next rollover date. Though the trading partners called for ultimate delivery by the end of 3-4 years, owing to its large reserves it was able to negotiate the delivery dates till up to 10 years. Such luxury was not enjoyed by any of its competitors. The amount of gold hedged with SDC increased from 1.035 million ounces to 4.341 million ounces. The problem faced by American Barrick American Barricks estimation of the production of gold from Meikl Mines had turned out to be far lower than the actual capacity. In addition to that, ABX explored areas around the Goldstirke property which further increased the amount of gold it could produce. ABX had hedged the risk of estimated production and now faced the question of how to hedge the additional capacity. In addition to this the gold prices and the interest rates were at an all-time low, which further made the task of entering into forward contracts, SDCs and options more difficult for ABX. Gold prices were also not expected to rise in the near future. ABX was faced with question of whether the firm should continue to hedge all its production for the next 3 years and if so, how would it hedge the additional production of gold?

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Q1. In the absence of a hedging program using financial instruments, how sensitive would Barrick Stock be to gold price changes? For every 1% change in gold prices, how might its stock is affected? How could the firm manage its gold price exposure without the use of financial contracts? Ans. Without hedging programs American Barrick would be exposed to wide fluctuations in spot gold prices. These changes in spot prices would affect the profitability of the company. As investors mostly prefer a steady performing company so, without hedging Barrick stock would also fluctuate with gold prices and production levels. 1992 Pre Tax Earnings (Exhibit 2) Reduction in Earnings if Gold was sold at Spot Price (From exhibit 2 and 12) Revised Pre Tax Earnings (A-B) Tax@21.46% After Tax Earnings (C-D) 222,744,000-------------------A (345-422) X 1280320 =-98,584,640-------------------B 124,159,360-------------------C 26,644,599-------------------D 97,514,761

So we observe that without hedging the after tax earnings of American Barrick would reduce from $222.7 million to $97.52 million.

Measuring sensitivity for 1% change in spot gold prices: COMEX Price (Exhibit 12) 1% of COMEX Price Amount of Gold (Ounces) (Exhibit 12) Additional Pre-Tax Income (EXF) Tax @ 21.46% Additional After Tax Income Percentage change in Income

1992 345 3.45---------------------E 1,280,320--------------------F 4,417,104 947,910 3,469,194 3.56%

So, with every 1% change in spot gold prices the net income changes by 3.56%. American Barrick can manage its gold price without using financial contracts by diversifying its business.

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Q2. What is the stated intent of ABXs hedging program? What should be the goal of a gold mines price risk management program? Ans. The Hedging program at ABX had evolved out of the conservative financial practices followed throughout its life time, The intent of the program was to protect the firm from any fall in the prices of gold. The firm was willing to sacrifice any potential profits that may have arisen from a rise in prices of gold in order to protect itself from the fall in prices. ABXs hedging program became stronger after the events of 1984-85 when ABX found unexpected reserves of gold. ABXs program in 1992 was fully protected against price declines for all the production during the next 3 years and 20-25% for the decade. It might be argued that the goal of a Price Risk Management program is to create value for the shareholder. But it is neither that nor is it insuring the investors or managers. The primary goal of such a program is to ensure that gold companies have enough cash which they can invest further to create value. Thus a price risk management program shall not be looked at as creating value for the shareholders because it might do so only when the price of gold falls in the future. Hedging might actually lower the value delivered to the shareholders in case the price of gold rises. Another goal of price risk management is to manage volatility around business and financial results. If changes in prices of gold lead to large imbalance in the supply and demand of funds then a firm can think about hedging aggressively whereas on the other hand if the price changes do not cause any such imbalances, little or no hedging may be a safer bet. In case of a firm that is high on debt, hedging might help in increasing the value of the firm by an amount equal to the bankruptcy cost. It can be explained as follows, if the firm experiences a sharp downturn in cash caused by un-hedged exposure and it is forced to file bankruptcy in that case risk management increases the value of the firm by an amount equal to its bankruptcy cost multiplied with the probability that it remains un-hedged A firm with very little debt on its sheets can also benefit from hedging although it may seem at first that it wont. A firm with very little debt can hedge its production and use debt to raise capital. The hedging in this case serves the purpose of equity. The debt raised also gives tax benefits to the firm.

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What would convince you that a price risk management program created value for its shareholders ex ante?

Ans. The firm used derivatives to ensure that it is protected against falls in the price of gold over long term and in the short term the company expected to capitalize on its expectations of movement in gold price Through its price risk management strategy, American Barrick was able to fetch prices higher than those prevalent in market which ultimately generated higher revenues and hence greater shareholder value In 1984 and 1985 used forward contracts to study ways to protect the firm against adverse price movements Beginning in 1987, by executing a collar strategy and by adjusting the exercise prices of puts and calls American Barrick was able to foresee the degree the degree to which it could participate in gold price rises By 1990 firm saw spot deferred contracts as a way to profit from increased gold prices and yet set a minimum gold price In addition to this if we look at the Exhibit 3, we find out that the percentage return for American Barrick was more than 200% when compared to other gold firms that have not used a hedging program for mitigating their risk.

Differential EPS
160.00 140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00 -20.00 1984 1985 1986 1987 1988 1989 1990 1991 1992 Differential EPS

References Rethinking Risk Management by Ren Stulz, Ohio State University

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A Framework for Risk Management by Kenneth A.Froot, Harvard Business School, and David S.Scharfstein and Jeremy C.Stein, Massachusetts Institute of Technology

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