HOW LOW WILL GOLD GO?

The curse of hedging that blighted gold in the 1990s is making a comeback, and threatens to loom over the market like Banquo’s ghost.

London-listed gold producer Petropavlovsk has said it will pre-sell 55pc of its future output planned for the second quarter of 2014, at an average price of $1,408 an ounce. This is the first time that a big producer has hedged more than half its future sales.

"We have a huge investment programme and thought a little price protection in the short-term will let us sleep better at night," said chairman Peter Hambro.

Tyler Broda from Nomura said this may signal the return of "structural hedging" across the industry, with other companies scrambling to lock in forward contracts. "This could increase the pressure on the spot gold price over the coming years," he said. The risk is a vicious circle as hedging leads to lower prices, leading to more hedging.

The process pushed gold down steadily at the end of the 1990s to an average of $271 an ounce in 2001, though there were many other forces at work, including sales by the Bank of England and other Western central banks.

"It was hedging that killed gold prices the 1990s," said Ross Norman from Sharps Pixley. "Every time there was rally, the producers seized on the chance to sell forward. It was most unhelpful."

Mr. Norman said it was the unwinding of hedge books a decade ago that unleashed the bull market. This process could now go into reverse if hedging spreads. "We don’t think it will. The forces that led to the bull market will prevail," he said.

Gold is already under heavy pressure as the dollar recovers and markets start to anticipate a more hawkish Federal Reserve. Investors have been pulling 20 tons a week from exchange traded funds. The spot price fell $26 to $1363 yesterday (5/21), falling from $1695 on January 1^st and $1470 less than three weeks ago (5/03).

Petropavlovsk operates in Russia’s Amur region. It has already hedged a large part of its sales for this year, but the new details go further.

Mr. Hambro said the hedging move is a not a bet that gold’s bull market is over. "The reason why gold rose to dizzy heights and is still high is because the world is in a terrible mess. That has not changed. Only a tiny fraction of our 25 million ounces of resources and reserves is hedged," he said.

The central banks of Russia, China and the emerging world are still net buyers. "We receive requests regularly from sovereign wealth funds interested in acquiring gold, and they want physical not paper," he said.

Mr. Hambro said an "enormous number" of mines across the world are losing money and will have to close, putting a floor under the market. The average cost of the industry is $1,300, though the "marginal" cost is nearer $900. A fifth of mines are already under water.

Big players such as Barrick and Anglo-Ashanti had to write off billions after hedging too much of their output and missing out on the first phase of the bull market. "I don’t think anybody will want to go through that again soon," said Mr. Hambro.

Petropavlovsk has a heavy debt load of $1.1bn, mostly stemming from a cutting-edge investment in a pressure oxidisation (POX) gold refining facility. The company claims its new POX process will be is akin to the shale revolution in natural gas and should yield a bonanza once it comes on stream [it should be interesting to learn what Skye thinks of it on the Forum-JW].

But falling gold prices have strained finances, just as they have for so many gold producers.  How long can they last, and how low can gold go?

Ambrose Evans-Pritchard is the International Financial Editor of the London Telegraph.