Gold Producer Collar With Production Shortfall Risk
A South African gold producer expects to sell 20,000 ounces in six months. Spot gold is USD 2,350/oz and spot USD/ZAR is 18.4000/18.4500. The six-month USD/ZAR forward is 18.8500/18.9200. The producer's all-in sustaining cost is R780,000 per kilogram, and one kilogram equals 32.1507 troy ounces. The company wants to lock in a minimum ZAR margin for 70% of production while retaining upside on 30%. A bank offers a zero-cost collar for the 70%: buy a USD 2,250 put and sell a USD 2,500 call, both six-month, with ZAR conversion at 18.85. The producer is concerned about a stronger rand and lower gold price. It also faces a 10% chance of a 2,000-ounce production shortfall. The company's board prohibits speculative positions and requires any hedge to be matched to forecast production.
1. Calculate the ZAR revenue locked in by selling 70% of production forward at the quoted forward rate, and the unhedged ZAR revenue at current spot. Compare both with the all-in cost.
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70% of 20,000 oz = 14,000 oz.
Forward hedge: the producer sells USD, so it uses the forward bid of 18.8500.
- Revenue = 14,000 × 2,350 × 18.8500 = 14,000 × 44,297.50 = ZAR 620,165,000.
Unhedged at current spot 18.4500:
- Revenue = 14,000 × 2,350 × 18.4500 = 14,000 × 43,357.50 = ZAR 607,005,000.
All-in cost:
- Ounces per kg = 32.1507, so cost per ounce = 780,000 / 32.1507 ≈ R24,261/oz.
- Cost for 14,000 oz ≈ 14,000 × 24,261 = ZAR 339,654,000.
Both outcomes cover cost comfortably. The forward locks in about ZAR 280.5 million of margin on the hedged portion; the unhedged spot outcome gives about ZAR 267.4 million. The forward therefore protects the budget against a stronger rand or lower USD gold price, at the cost of giving up upside above the locked price.
2. Evaluate the collar payoff at gold USD 2,100 and USD 2,600 with USD/ZAR at 17.90, for the 70% hedged portion. Compare with the unhedged outcome for that portion.
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Hedged ounces = 14,000; collar conversion = 18.85.
At USD 2,100:
- The 2,250 put is in the money by 150; effective price = 2,250.
- Hedged revenue = 14,000 × 2,250 × 18.85 = ZAR 593,775,000.
- Unhedged at 17.90 = 14,000 × 2,100 × 17.90 = ZAR 526,260,000.
- The collar adds about ZAR 67.5 million.
At USD 2,600:
- The 2,500 call is exercised against the producer; effective price = 2,500.
- Hedged revenue = 14,000 × 2,500 × 18.85 = ZAR 659,750,000.
- Unhedged at 17.90 = 14,000 × 2,600 × 17.90 = ZAR 651,560,000.
- The collar is still about ZAR 8.2 million better because the contractual ZAR conversion of 18.85 is higher than the assumed spot 17.90.
The collar protects the downside but caps the gold price at 2,500. The producer retains 30% unhedged for upside.
3. Discuss whether the collar is compliant with the board mandate and what happens if production falls by 2,000 ounces. Include basis, margin and counterparty risks.
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The collar is a hedge, not a speculation, provided the hedged volume does not exceed forecast production. Hedging 70% of 20,000 oz = 14,000 oz is within the mandate. But if production falls by 2,000 oz to 18,000 oz, 70% of actual production is 12,600 oz, so the producer would be overhedged by 1,400 oz. That excess is effectively a speculative short position and would breach a strict mandate. The producer should either reduce the hedge ratio, buy back part of the collar, or use a flexible structure sized to a conservative production estimate.
Other risks:
- Basis risk: the collar fixes ZAR at 18.85, but actual USD/ZAR spot may differ; the unhedged 30% is fully exposed.
- Margin risk: the sold 2,500 call can move against the producer if gold rallies, requiring collateral even though the collar was zero-cost upfront.
- Counterparty risk: the collar is a bank contract, so the producer is exposed to the bank's creditworthiness.
A compliant approach is to hedge no more than about 65% of the conservative forecast, leaving room for a shortfall, and to document the hedge ratio and close-out procedure.