Gold Hedges Can Tarnish a Miner's Stock

NEW YORK (TheStreet) -- If you think gold prices are going higher, avoid the fool's gold of mining stocks burdened by hedges on the precious metal.

Hedges allow a gold production company to sell product at a set price, which can guarantee a certain profit if gold prices fall. When the spot price soars, however, hedging caps the company's earnings potential. Barrick Gold (ABX Quote), AngloGold Ashanti (AU Quote), Kinross Gold (KGC Quote) and Apollo Gold (AGT Quote) are among the companies whose profits are potentially limited in this manner.

With gold futures trading over $1,000, hedging is a "dirty word" to many investors, says Matthew Piggott, a metals analyst at GFMS. Investors "buy mining companies as a play to get leverage to gold and if a producer has hedged away the leverage by fixing their revenue with hedging them...investors in general look down on that."

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A global hedge book analysis of the second quarter by GFMS shows that de-hedging declined in the past 10 years from 3,100 tons in 1999 to 458 tons this past June. Nevertheless, Piggott says that "anyone who hedged into the bull-run is still losing money."

Sometimes producers have no choice. They inherit hedges from mergers, and banks often require producers to hedge in order to secure project financing. Piggott says that required hedging by banks "is not a bad reflection on the company trying to secure the financing... A company with a good credit rating, strong balance sheet and positive cash flow each quarter may still be required to hedge."