Hedging Gold Inventory with Gold Futures
A practical gold hedging guide for businesses with gold inventory
Gold prices can be highly volatile. A business exposed to these price movements can see tremendous impact on its profitability. Jewelers, refiners, and bullion dealers aim to protect their gross profit margins by hedging gold contained in their inventory. Here we offer a practical guide to hedging with gold futures. This guide is meant to offer tactical direction on how to implement your gold hedging program. Your implementation should align with your company’s broader commodity hedging strategy.
Gold futures – the basics
Gold futures are contracts to buy or sell gold in the future. Key aspects like the settlement date, quantity, location and quality of the underlying gold are standardized. Futures are traded on a regulated exchange. Settlement takes place through a clearinghouse. Gold hedgers can access transparent live gold futures prices quoted on the exchange. This transparent market structure offers gold hedgers even footing with the largest financial institutions.
Since futures are settled through a clearinghouse, every market participant has the same counterparty. To ensure the clearinghouse is always able to honor its obligations, the exchange requires all participants to post margin. All participants, settle mark-to-market changes daily. The amount of mark-to-market a company may need to fund can’t be reliably predicted in advance.
There are several gold futures contracts traded on various global exchanges. For gold hedgers in North America, the Comex 100 oz gold contract is commonly used. The contract is traded on the CME Group’s Comex division under the symbol GC. The Comex gold futures contract is actively traded for February, April, June, August, October, and December for each year. The bid/ask spread for the most active contract is usually 10 cents wide during the North American business day. This may be preferable to the bid/ask spreads offered on forwards in the OTC market.
A helpful recent development is the introduction of the Comex 10 oz micro gold futures contract. This contract trades under the symbol MGC. This contract has attracted sufficient liquidity to be a reliable, smaller scale version of the GC contract. Consequently, a company employing a mix of both contracts can efficiently hedge gold within a 10 oz tolerance.
Hedging gold inventory – the short hedge
Companies often hedge gold inventory using a short hedge. This involves selling gold futures in an amount equal to the company’s net gold inventory position. Once in place, the value of the company’s net gold inventory position should move inversely to the short hedge. Consequently, the company’s profit margins may be less impacted by swings in the gold price.
Net gold exposure means all gold inventory excluding any leased gold, plus any gold contracted for purchase from suppliers not yet received, minus gold inventory contracted for sale, but not shipped. For most companies, the net gold inventory position is changing constantly as they buy and sell inventory. Consequently, the company adjusts the quantity of futures contracts it is short to mirror these inventory fluctuations.
While the short hedge protects against movements in the gold price, it does not reduce basis risk. Basis risk in this context means the inventory specific price drivers. For example, a specific jewelry piece may see its premium over gold rise or fall based on fashion appetite. Equally, a gold dealer’s coin premiums remain unhedged.
Rolling the gold hedge
Most gold hedgers don’t intend to deliver gold when the gold futures reach their settlement period. Rather, the short gold futures position is typically “switched” to later dated contracts. For example, a hedger short October gold futures would switch into December contracts. The process of switching is simple. Essentially the hedger buys back the October contracts and simultaneously sells the same number of December contracts. This can be accomplished by trading the switch, or differential between October and December futures in this case.
Gold futures are typically, though not always, in contango. Contango simply means that the gold futures price is higher than the spot market price. Or, that further dated gold futures prices are higher than shorter dated futures. Using the example above, the December futures are more valuable than the October futures. Typically, a gold futures contract price will converge with the spot gold price as it nears its final days of trading.
Why would someone agree to buy a futures contract at a price higher than spot? The answer is driven by the cost of storing and insuring gold. Contango also tends to include the opportunity cost of money. If an investor buys a physical commodity and stores it, they must pay for the commodity at the time of purchase. If instead the investor buys a futures contract, they put up margin but do not need to pay for the commodity until taking delivery. Therefore, the investor may invest that money and potentially earn interest.
Example of a hedge using gold futures
A bullion dealer has inventory of coins totaling 2,300 oz gold. The dealer has priced an additional 200 oz coin buy from a wholesaler, for coins to be delivered the following week. The dealer has orders of 270 oz from its customers. The orders have been priced, but not yet shipped to their customers. This leaves the dealer with a net long inventory position of 2,230 oz gold (2,300 + 200 – 270).
Let’s assume spot gold is trading in the spot market at $1,533 per oz and December futures are trading at $1,540.60
The dealer does not want to be exposed to gold price moves and elects to hedge with gold futures. To execute, the dealer sells 22 of December Comex 100 oz gold futures (GC) and sells 3 (MGC) 10 oz contracts.
What if gold goes up $100?
The value of the dealer’s net inventory position rises $223,000 (2,230 oz x $100). The value of the December futures contracts would decline in value by $223,000 (2,230 oz x $100). Consequently, the dealer is not directly impacted by the price movement. The dealer would be required to cover the mark to market loss in the hedge account. This may require the dealer to incur additional borrowing costs and may impact liquidity.
What if gold goes down $100?
The value of the dealer’s net inventory position declines $223,000 (2,230 oz x $100). The value of the December futures contracts would increase in value by $223,000 (2,230 oz x $100). Consequently, the dealer is not directly impacted by the price movement. The dealer would be credited the $223,000* mark to market gain in the hedge account. This liquidity may be used by the dealer as business needs dictate (e.g. repay debt).
The importance of contango
For the gold hedger, contango typically provides a positive carry. How? Each time the hedger buys a near dated contract and sells the later dated one, they are “buying low and selling high”. This contract roll, or contango earnings can help offset the company’s inventory funding costs. Clearly, if the gold futures market was in backwardation (the opposite of contango) then this would be a cost to the company.
How significant is this positive carry on the short hedgers position? Gold contango often approximates Libor. The reasons for this are technical and beyond the scope of this paper. You can observe contango in real time. It’s evident by looking at the gold futures prices and switch prices in your futures trading account. For example, at the time of this writing the nearest three gold futures contracts were trading as follows.
October 2019 bid at: $1,534.30
December 2019 bid at: $1,540.60
February 2020 bid at: $1,546.50
Consequently, by switching from being short October gold futures to December futures, a hedger may pick up $6.30 / oz. This assumes they hold the December to near its maturity. The transparency of the futures market provides hedgers with live, real time visibility into gold futures prices and contango. This information is visible on the free online trading platform offered by futures professionals like Kilo Futures. Futures exchanges like the CME do charge for this live data, but for most hedgers the cost is minimal.
A word of caution. While gold futures prices are typically in contango, this is not always the case. Periods of backwardation do occur which could result in negative carry on a gold hedger’s futures position.
Bullion trading platforms
Some bullion dealers, jewelers, and metal refineries hedge gold inventory using bullion trading platforms. OTC bullion trading platforms tend to offer gold hedging to the exact oz. Often, they come with API access so dealers can connect the system to their websites or pricing pages. These are helpful features. However, dealers would be wise to compare these platforms to futures trading electronic platforms. It’s important to distinguish between “over the counter” or OTC platforms, from futures trading platforms.
Recall the discussion above about the positive impact of contango for short gold hedgers. It’s worth calculating the total dollar value of this over the course of the year for your business. Now consider that when using OTC bullion hedging platforms, you are likely not receiving any of the contango. Some platforms do pay a contango yield. Again, it is worthwhile to compare the amount with the futures market. Why? Because OTC platforms typically only pay a portion of it to hedgers. This is a key revenue source for the platform provider, and it comes directly out of your pocket.
It is also important that you know the creditworthiness of the OTC platform provider. Why? Because unlike futures you are fully exposed to the platform provider honoring their side of the trade. There is no clearinghouse standing between you and the platform provider.
Many futures trading platforms can also offer robust API access to connect your website’s back-end pricing infrastructure. Through this API your gold inventory pricing can be updated in real time. While futures don’t allow for exact oz hedging, you can hedge to within a 10 oz tolerance. This is usually sufficient for all but the smallest companies.
An additional liquidity consideration – borrowing base credit on your hedge account
Most companies don’t have unlimited liquidity. Consequently mid-market companies typically aim to have as much available liquidity under their credit lines as possible. This usually means negotiating the highest advance rates they can against assets like receivables and inventory. Some companies considering hedging with gold futures may not be aware that they can pledge their hedge account to their bank. Some banks may give hedgers borrowing base credit against the liquidation value of a company’s hedge account.
The futures industry has developed a standardized security agreement that may be used for this purpose. With this agreement in place, some banks may give borrowing base credit for gold hedge account liquidation value. This is unlikely to be the case for companies using an OTC bullion hedging platform.
Many companies hedge gold inventory using gold futures. The strategy aims to establish equal and offsetting positions in order to reduce exposure to volatile gold prices. It is critical that gold hedgers understand the impact of contango and its beneficial impact on net inventory funding costs. Equally, hedgers must be aware of the margin requirements and how they can impact a company’s available liquidity. Hedgers with limited available liquidity may want to evaluate if hedging gold with options is a suitable alternative strategy.
The concepts outlined here may be unfamiliar to some readers, but they are rather straightforward at their core. If you would find it helpful to explore the usefulness of hedging with gold futures for your company, let’s talk.
We hope you’ve found this a practical and useful guide to analyzing your hedging needs. Please let us know if you have any suggestions on how we can improve it, or any of our resources. If you would find it helpful to explore your company’s hedging requirements please contact us. We would be grateful for the chance to help.
* Excluding commissions and fees