POLYUS MOVE TAKES SHINE OFF GOLD / THE WALL STREET JOURNAL

Heard on the Street

Polyus Move Takes Shine Off Gold

By Helen Thomas

July 3, 2014 1:03 p.m. ET

When is a hedge not a hedge? When it is a "strategic price protection program."

That is what London-listed Polyus Gold, Russia's largest miner of the precious metal, has put in place to guard against falls in the gold price. It may be a necessary evil, enabling the Russian miner to keep investing in its delayed Natalka growth project. But it also highlights the difficulties of the gold-mining sector.

Hedging is a dirty word in gold circles. Locking in a price for future sales limits investors' exposure to potential price increases. Enjoying outsize gains as the metal's price rises is the main reason to hold mining stocks, even if it doesn't always work out that way. Hedges put in place in the 1990s led shareholders to miss out to some extent as gold prices soared after 2000. And the rise of gold-backed exchange-traded funds has given investors a readily tradable alternative to mining stocks.

Miners are shell-shocked after the metal fell 28% last year. Despite frantic cost-cutting, about 75% of the industry is burning cash at a $1,300 gold price, Citigroup estimates. Rising costs and acquisitions ate into returns even when gold was rising: The top 10 gold companies have burned through $16 billion in cash since 2000, notes Citi.

Polyus's complicated plan isn't as rigid as old-style hedges. Through options, the miner has secured a minimum price of $1,382 an ounce for three years for the equivalent of 18% of last year's output. But Polyus will benefit partially from any price increase up to $1,634. A second tranche provides protection at slightly lower prices for the equivalent of about 7% of Polyus' 2013 output. More of the miner's production is covered in a fourth year of the program.

But the agreements also contain potentially unwelcome obligations. Polyus must sell up to 1.3 million ounces of gold at a discount to the market should the price rise to certain levels. It has also committed to sell gold equivalent to 9% of 2013's output at a fixed price of $1,321 an ounce each year for two years. And insurance usually costs something, although Polyus says its structure involves no cash outlay.

Limiting exposure to a falling gold price should smooth Polyus' earnings and help it keep spending at Natalka. The miner invested more than three times its earnings before interest, tax, depreciation and amortization last year, notes Citi, translating into all-in cash costs per ounce above the industry average and current spot prices.

Pressing ahead with the project should mean higher production, lower unit costs and improving earnings to come. Even if it suggests a lack of confidence in gold's prospects, taking advantage of the recent rally to secure this deal may reassure investors Polyus will get there. But the need for extra protection also underlines just what a tight spot the industry is in.