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Digging beyond Gold: Gold price risk management

Cont

ents

India and gold . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

Gold consumption . . . . . . . . . . . . . . . . . . . . . . . . . .2

Gold reserves and inventories . . . . . . . . . . . . . . . . .3

Dipping prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-5

Regulation and policy change . . . . . . . . . . . . . . . . .6

Mitigating price risk . . . . . . . . . . . . . . . . . . . . . . . . .7

Challenging landscape . . . . . . . . . . . . . . . . . . . . . .8

How EY can help . . . . . . . . . . . . . . . . . . . . . . . . . . .9

Case studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10

Point of viewIn the coming years as the Indian economy expands so will the income levels of the world’s largest working class, which will keep the gold consumption rate high.

India and gold

In India gold is central to all personal life events. Gifting gold is a deeply ingrained part of rituals in Indian society — weddings alone generate approximately 50%1 of the annual gold demand. The predisposition to possess more and more gold is not going away. India’s demographics are driving constant growth in demand, with

1. More than 140 million people coming out of poverty in the last 10 years1

2. More than 15 million weddings per year in India1

3. More than half of the population is under 251

1,063,300,000

USD 476.6 Bn

60.44

Source: Bloomberg

20142000Population growth

GDP

Consumer confidence index

1, 236,345,000

USD 2,066.9 Bn

91.58

1 | Digging beyond Gold: Gold price risk management

1. World gold council website, http://www.gold.org/jewellery, accessed 9 September 2015.

Digging beyond Gold: Gold price risk management | 2

Point of viewIt is quite evident from the graph that India has been historically a high consumer of the yellow metal but the recent increase in consumption of gold by China has contributed toward the rise in price. Together these two countries accounted for 54% of global demand in the rst quarter of 2015.

Gold consumption

Gold is India’s second-biggest expense on the import bill after oil, and purchases of US$54 billion two years ago forced the then Government to raise the duty on the metal to 10%2 but it had a limited impact. In spite of these measures, India, the world’s second-biggest gold consumer after China, paid US$34.32 billion to import around 930 tons of gold in the year ending March 2015.2 This adds to the country’s current account de cit, since India produces very little gold.

Country-wise production vs consumption of gold (MT)January 2014 to June 2015

Source: Bloomberg

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India China US

Production (2014-15)

Consumption (2014-15)

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD2015

Gold

pric

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SD/t

oz.

)

Gold

con

sum

ptio

n (M

T)

Total gold consumption

Source: Bloomberg

India

China

Gold price

2. Gems and jewellery export promotion council of India website, http://www.commerce.nic.in/eidb/Icom.asp, accessed 9 September 2015.


Point of viewProducers, investors and consumers of gold need to keep an eye on inventory levels as any abnormal inventory declines or increases may signify events behind the scenes that are likely to ultimately affect the gold price.

The Indian Government needs to assess their policy of high dependence on the US dollar against holding more gold in their reserves.

Gold reserves and inventories

Indian gold reserves and gold assets (558 tons)3 are held or controlled by the central bank. Compared to the US and China (8,133 and 1,658 tons)3, these are quite low for a country that has been historically the highest consumer. In recent years, the Chinese Government has been pulling out of its dollar exposure after the nancial crisis of 2008 and has started investing in gold. In 2000, 55% of their foreign exchange reserves were in US dollar. The percentage dropped to 33% in 20144.

As seen from the charts above, as Chinese demand for gold increased from 2010 to 2013, it was funded by withdrawals of gold from the Commodities Exchange (COMEX), a division of the Chicago Mercantile Exchange or CME. As the demand started to slow down in the latter part of 2014 to 2015, we see a build-up of inventories at COMEX.

Comex Gold inventory

Source: Bloomberg

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Gold

pric

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SD/t

. oz)

Com

ex i

nven

tory

(Mn.

oz)

COMEX Gold Inventory

Gold price

3. “Gold reserve,” Wikipedia, https://en.wikipedia.org/wiki/Gold_reserve, accessed 9 September 2015.4. http://marketrealist.com/


Dipping prices

Price volatility acts as a source of risk to commodities related businesses, since it instils a large degree of uncertainty over the actual nances involved in the business. Some of the factors affecting volatilities in prices are movements in US dollar, gold demand from countries such as China and India, gold supply from China, the US and South Africa, changes in domestic regulations, economic factors and interest rate movements. Gold prices have come off considerably from the peaks in 2012–13 when it ticked approximately US$1,700 to US$1,100 in July 2015. Low realizable prices are a matter of concern for gold miners and re ners with average production cost at US$983/oz. as shown in the table below.

Source: GMFS, Thompson Reuters

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. oz)

USD

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)

Gold prices vs. volatility

Gold volatility

Gold price (avg.)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: Bloomberg

Costs Average cost (USD/t. oz)

Mining 331

Ore processing 258

General and administration 123

Mine site cash cost 712

Smelting and re ning 15

By-product credits -20

Royalties 41

Total cash cost 749

Depreciation/amortization, Inventory change 234

Total production cost 983

Corporate administration, interest 107

Extraordinary costs 106

Sustaining capital expenditure 118

All in cost for 2014 1,314


Point of view

Dipping prices

As gold prices are reducing, production costs have remained under control in 2015, since miners and re ners are operating their assets ef ciently and the US dollar remains rm against currencies of miners and re ners.

From the Indian buyer’s perspective, at current prices there is still some room for prices to consolidate before “total production costs” becomes dif cult to be met. Moreover, a recovering US economy and increase in interest rates will further bring down gold prices.

Gold production costs in US$/oz. (world) 2013 2014 YTD 2015*

Total cash cost 770 749 690

Total production cost 995 983 935*

All in cost for 2014 1,741 1,314 1266*

Source: GFMS, Thomson Reuters*estimated on miners maintaining similar margins and costs in 1Q and 2Q15

Any indication of a recovery in the US will further dent gold prices as increased rates and a recovering US economy are expected to translate into better returns in xed income and equity markets. Moreover, the slowdown in China, stability of the Eurozone and continuous decline in energy prices indicate further consolidation toward lower gold prices than current levels. The only respite in prices can be from global economic shocks such as currency adjustments or re-valuations.


Point of view

Regulation and policy change

Discontinuing GML increased premiums in the local market, which affected processing margins and did not help the gold jewelry industry, since it was burdened with additional cost of borrowing. Too much of regulation and changes in policy can disrupt the way gold is procured and can affect margins adversely.

In 2013, the RBI introduced restrictions on gold import, which were primarily in the form of discontinuance of Gold Metal Loan Schemes (GML) in light of increasing current account de cit and to curb speculative transactions in the yellow metal. Subsequently with easing of current account de cit, the RBI in May 2014 allowed GML but maintained the stand of 20:80 rule on the jewelry manufacturers who import gold/procure from nominated agencies. This caused the industry to start paying premiums as demand continued to be strong. With changes in regulation, the industry will start seeing discounts against LBMA prices as seen in the past.

The Forwards Mark Commission (FMC) has restricted hedging the gold price risk on one of the major Indian commodity exchanges to 2.5 MT to control speculation in gold. Hedging above 2.5 MT requires approval from FMC and is evaluated on case-to-case basis. To address the concern, the RBI allowed jewelry manufactures to hedge price risk on the yellow metal in international exchanges (which is still restricted and is allowed on case-to-case basis).

Source: Bloomberg

Indian differential against LBMA Gold price (USD/t.oz)

-250

-200

-150

-100

-50

0

50

100

150

Oct

-05

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-06

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-06

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-07

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-08

Sep-

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9

Dec-

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-10

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-10

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-11

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-11

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-12

Apr

-13

Sep-

13

Feb-

14

Jul-1

4

Dec-

14

May

-15

GML allowed under 20:80 rule

GML discontinued


Mitigating price risk

Former US federal bank chairman Ben Bernanke said that “nobody really understands gold prices and I don’t pretend to really understand them either5.” There are many indicators that help to determine the direction that gold prices will take such as relationship between gold and the real interest rates in the US, US debt, consumers, producers and actions by central banks.

Given the ever transforming nature of business, companies have started taking pragmatic approaches to align or transfer price risk existing in the nancial supply chain back to suppliers or customers. Risk mitigation strategies have evolved over a period of time and companies are looking at innovative ways to align the pricing aspect and avoid risk exposures. Paper markets are not the rst choice to mitigate risks and companies are resorting to controllable techniques of natural hedge within the value chain instead of incurring high cost of hedging. Some of the techniques adopted by leading companies are:1. Business plan is reviewed to assess the possibility of aligning

price-ins and price-outs whereby bringing in natural offsets;2. Production processes and volumes are controlled to ensure

price-outs are in line with desired pricing levels; 3. Trade and payment terms are modi ed to ensure alignment in

payables and receivables and4. Vertically integrate whereby margins can be controlled

effectively, where a retailer could purchase metal re ner or lease out a gold mine.

Possible hedging strategies to lock in the price of gold are:1. Fixing price at a pre-determined levels for a full period till

physical retail sales. Instruments used: Fixed price swap or futures contract

2. Fixing price at a pre-determined levels for a partial period, where hedge expires prior to physical retail sales, companies’ use this strategy only when there is a backwardation in the international market. Instruments used: Fixed price swap or futures contract

3. Setting a minimum oor price to gain protection from decline in prices where the locked-in price will not fall below an agreed strike price (minimum price), also referred as “ oor price”. Instrument used: Plain vanilla put option

4. To pay zero premiums and retain some bene t from increased prices, by buying a put and selling a call simultaneously. Instrument used: zero cost collars.

The above strategies need to be in sync with the working capital and inventory cycles of the business.

5. CNBC.com – Feds statement to the US Senate


Challenging landscape

With the challenging and changing regulatory landscape, the gross margins of jewelers came under severe pressure. Without the GML schemes, interest cost for companies increased, as free cash ows reduced, thereby affecting their interest coverage ratios. As interest paid to purchase gold and nance costs increased, a decline in the net pro t margins was noted across the industry. Cash conversion cycle also increased, since companies did not receive favorable terms similar to GML and had to price out gold purchases earlier than expected. Hence, it pointed out the need for an effective hedging program to align companies pricing-in and pricing-out with the help of nancial instruments. Using these nancial instruments led to additional cost and reduction in margins of 3%–4% p.a., which jewelers usually passed to the end customers.

The exchange traded hedging options for jewelers in India is primarily limited to futures traded on one of the major commodity exchanges of India (most liquid as compared to other exchange traded options available in India). However, the exchange only provides hedging contracts for alternate months, hence, increased hedging cost for long hedge periods, low liquidity and limited quantum of hedging will mean companies cannot hedge their exposure completely and accurately. Domestic bourses have very low liquidity, trade in spot market only, have compulsory physical delivery or have closed gold hedging contracts, which is not helpful to hedgers. On top of the lack of availability to hedge price risk, the limitations from the RBI and FMC have put the industry in dilemma on their sourcing mix, on procurement plan from spot or under GML, on their quantum of hedging with domestic versus international exchanges and their unhedged exposure.

Controlling unquenchable thirst for gold has been a challenge for the Indian regulators and policy makers, since it has not been successful and only encouraged the trade by the sly, evidenced by the steady rise in the value of illegally brought-in gold seized by the Indian Customs. From INR438.7 million in 2011–12, the

gure increased to INR1.05 billion in 2012–13, and further to INR6.87 billion in 2013–14. The gure is reported to have crossed the INR10 billion mark in 2014–156. The Indian budget of 2015 has announced several steps to monetize gold. The new gold monetization scheme is aimed to encourage the common person and help earn interest on gold lying idle.

• Gold Deposit Scheme: This scheme proposes to replace the existing Gold Deposit and Gold Metal Loan Schemes.

• Sovereign Gold Bond: This scheme is an alternative to purchasing gold metal and develops an alternate nancial asset, a Sovereign Gold Bond.

• Gold coins with Ashok Chakra: This scheme will help in reducing the demand for coins minted outside India and also help to recycle the gold available in India.

These are rational steps taken by policy makers, but nothing has been formalized yet. Hence, it becomes more uncertain especially with talks of replacing the GML scheme.

6. “The gold fever,” The Hindu website, http://www.thehindu.com/opinion/editorial/steady-rise-in-illegal-gold-import-in-india/article7252351.ece, accessed 9 September 2015.


How EY can help

Put in place an effective price risk management or margin protection program

Support management in getting regulatory permission to hedge on domestic as well as on international market

Assist management in setting up a hedging desk and its procedures

Provide hand holding support to implement robust risk management procedures

Provide periodic management updates and assist in management reporting

Develop an effective risk management framework to protect margin risks

Assist the management in developing various hedging strategies to minimize gold price risk

Evaluate pros and cons including cost of hedging on domestic exchanges vis-a-vis international exchanges

Evaluate various options available for price risk management

Provide the technical accounting basis for adoption of hedge accounting in accordance with Indian accounting standard, IND-AS 109 or International accounting standard, IFRS-9

Review effectiveness of existing hedging policy, if any

Assess volatility in margins on quarter-on-quarter basis and identify the root cause

Help in formulating a robust supply chain and nancing strategy for domestic purchase, and import of gold metal loan

Risk management framework

Hedge desk set-up

Hedging process benchmarking

Support in regulatory approvals

Managment reporting

dashboards

Hedge accounting implementation

Hedge effective testing


• Able to identify operational gaps existing in the hedging program

• �Able to improve hedge accounting implementation by adopting change measures in hedging strategy and accounting

• �Addressed the concerns pertaining to margin volatility

• Reviewed gold hedging operations

• �Reviewed the transactions relating to broker selection and counterparty selection

• �Analyzed pro t and loss due to hedging and its impact on physical trade on LME

• �Developed MIS and SOP framework

Client experience

Client experience

Case studies

Client issueThe client is a leading player in the jewelry industry. Gold is one of the key raw materials to produce jewelry items. Given the high volatility in gold prices, the client engaged the assistance of EY to ascertain the effectiveness of its hedging activity. The objective of the client is to lock margins between the purchase and sales.

What we did• Analysis of exposure pro le to understand underlying exposure attributes and

margins

• �Review of existing hedging activities undertaken by the company to determine the extent of achievement of economic objectives

• �Review of hedge accounting strategy adopted by the client to understand the implications of how the economic hedging is re ected in books of accounts

Case study 1

Case study 2

Client issueThe company had set up a gold hedging desk primarily to cover import exposures from its jewelry and watches business. As operations grew bigger, the company took our assistance in formalizing the framework, documenting SOPs and developing MIS framework.

What we did• Assistance in decision making

• �Independent evaluation

• �Improved MIS reports resulting in better hedging decisions and exposure recognition systems


Main heading

POV text comes here.

Point of view

Reach out to usMihir SanghviDirect Tel : +91 22 6192 3768Mobile : +91 75060 40940Email : [email protected]

Sulagna DasguptaDirect Tel : +91 22 6192 3545Mobile : +91 90 2297 7118Email : [email protected]

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Shanil ManwaniDirect Tel : +91 22 6192 3592Mobile : +91 80806 84840Email : [email protected]


Main heading

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Point of view

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