Ashanti - the full story.

Everyday, at the Obuasi gold mine in western Ghana, the price of gold is written on a small black board that is circulated among miners. Everyday, miners from Obuasi prayed for gold prices to go up, ignoring the adage, 'Be careful what you ask for; your wishes might come true'. The surge in gold prices at the beginning of October may have been the answer to the miners' prayers but it was a nightmare come true for Ashanti Goldfields, their employer.

Exposure to derivatives, known as 'exotics', brought it to its knees eventually forcing it to give banks to whom it owed money, 15% of its equity at a knock-down price. It forced Sam Jonah, Ashanti's chief executive, to confess "I am prepared to concede that we were reckless. We took a bet on the price of gold. We thought it would go down and we took a position."

Obuasi miners were not the only ones to have been dumbfounded by this paradox; the banks and the managers seem to have been caught totally off-guard.

Although fairly new to Africa, derivatives and commodity price-linked scandals have an air of deja vu. Many first-class international banks made mistakes in the past and paid the price for them, the most famous example being Britain's oldest merchant bank, Barings, being driven into bankruptcy.

But if errare humanum est (to err is human), persevering

in the same type of mistake is a crime that banks involved in the Ashanti turmoil may be guilty of. Unless they can argue that the problems faced by Ashanti were both exceptional and idiosyncratic

.

To understand if this was the case, let us try to unravel the facts from heated rhetoric that ensued after the first warnings that Ashanti was unable to pay sums due to its bankers.

These warnings brought down the share price of Ashanti - in New York it fell from $10 to below $4 in two days, until trading of the shares was suspended on 6 October.

The following day, the 17 banks with which Ashanti had transacted its derivatives business agreed to a temporary moratorium on their claims. The management of Ashanti was still hard-pressed to explain what had actually happened and to find money quickly.

These were closely linked, since a thorough understanding of the problems was necessary for Ashanti to decide on the most adequate lifeline

.

Ashanti said that it had been actively hedging its position in order to protect profits against falling gold prices. Its hedge book consisted of gold forward contracts and options and when the fall in gold prices unexpectedly reversed, the value of the hedge book suddenly fell to a negative $572m.

Based on gold prices of around $325 per ounce, Ashanti owed around $270m to its bankers in margin calls and other cash deposits.

Nothing exceptional so far. Margin calls are the rule for both exchange traded and over-the-counter (OTC

) price derivatives transactions. They are based on the cash value between mark-to-market of the hedge book and aimed at protecting those at the other end of the derivatives' contract to make sure they get their money when the value of the hedge book decreases. Ashanti knew beforehand the timing and level of payments potentially due on its hedge book should gold prices go up.

Who had been careless?

And so did the banks. Which means that both had been careless, at the very least, unless of course they can claim that the magnitude and direction of gold price movements at the beginning of October were unthinkable.

The surge in gold prices followed the decision made by central banks

in Washington to put a five-year moratorium on new loans and sales of gold from their reserves. Gold sales and gold loans from central banks had been a contributing factor behind the steady fall in gold prices of the past few years. Thus investment funds

that had shorted gold hurried to buy it back. As a result, gold prices shot up by more than $70 an ounce in four trading days.

Banks could have been forgiven for being bad at forecasting gold price movements. After all, hedging is meant to deal with this type of uncertainty. But they made another mistake; expecting Ashanti to withstand any loss in its hedge book - its `paper' transactions - since this loss would have been compensated by commensurate

gains on the actual sale of its gold - the `physical' transactions. But this reasoning would have failed to take into account two elements. First, the volume of Ashanti's hedge book (10moz) was particularly large and represented roughly 10 times its current annual gold production, even taking into account that its gold production was due to rise significantly in the next few years.

As a comparison, Gold Fields of South Africa, which produces around 4moz a year, used to hedge only 1.8moz - until it actually closed most of its hedged position in the aftermath of Ashanti's turmoil, Another example is Ghana's Glencor Mining which hedged 236,000oz of gold, representing half its expected production over the next four years. Conversely

, Canada's Cambior, which had forward sold 2.7moz of gold, equivalent to roughly four times its annual production, ran into problems similar to those of Ashanti and saw its shares dip from C$8 to C$2.5.

The second reason why being a gold producer did not save Ashanti is that margin calls are due immediately, while most of its gold is still in the ground. The fact that the call options sold by Ashanti and its forward sale contracts were theoretically covered by its gold production proved meaningless when confronted with reality. Going one step further, the question is whether or not a gold producer should hedge at all.

Do people who invest in gold mining companies speculate on the price of gold? Yes and no. Investors in the gold mining sector are generally bullish

about gold and many switched to gold producers who could be expected to benefit from the recent rise in gold prices, for instance Randgold Resources of South Africa. But in the long run, investors put their money into those mining companies whose expected profits are higher. To increase profits there are two levers: costs and revenues.

Investors in Ashanti were partly attracted by the company's cost efficiency. But they also seemed to relish the impressive average price constantly realised by Ashanti on the sale of its gold, thus implicitly condoning the practice of Ashanti that consisted in actively "enhancing revenues in the short term by an active hedging programme".

The snag is what Ashanti sometimes did was not hedging but speculating. In this case betting that prices would go down.

Hedging, on the contrary, is meant to reduce the uncertainty of the price realised on the sale of the gold. To do so, gold producers can either fix the price at an agreed level (through forward sales of gold) or they can establish a minimum level (a `floor') to the price that they want to realise on their sale (through the purchase of put options). In the first case, gold producers cannot reap the benefits of any increase in the price of gold after the date on which they entered into their `paper' contract. Moreover, when prices increase, the value of the forward sale contracts decreases. In other words the market sees the contract as holding an unattractive price for gold, it becomes less saleable

and its price falls. This, in part, explains the loss of value of Ashanti's hedge book.

Ideally, one should enter into a forward contract when the forward curve is upward looking and prices are relatively high. Unfortunately, this is not always possible.

The other alternative (put option) leaves producers with the `upside' but is expensive. Combine these two basic building blocks and you can design complex hedging programmes tailored to the objectives and resources of any particular gold producer. But if a gold producer wants to retain part of its `upside', and thus give investors some exposure to potential upward movements in gold prices, then the hedging programme has an overall cost.

What Ashanti did was to fund this cost largely through the sale of call options. When the price of gold surged, so did the value of these call options and the second element, the margin calls, reflected the fact that these options were more likely to be exercised to the detriment

of Ashanti. Selling call options enabled Ashanti to show higher all-in revenues in the short-term but this strategy was extremely risky since the obligations of Ashanti on the call options had no ceiling and were not supported by cash reserves

. Perhaps it would have been wiser for its finance director, Mark Keatley, to pay cash for a larger part of the cost of hedging and not treat his finance department as a profit centre.

Going back to investors' expectations, yes they want exposure to gold prices, but they also want sound managers, not speculators. It was nicely put by Bobby Godsell, chief executive of AngloGold, "Some people divide companies between hedged and unhedged, but what is important is why, how and how much people hedge."

While this debate was raging, Ashanti had to give the banks something or else risk bankruptcy. One alternative was to lure investors to put cash in the company. The only serious candidate was Lonmin, heir of the gold, platinum and coal mining activities of the former Lonrho conglomerate, with a conditional offer to buy Ashanti on the basis of an exchange of shares. Lonmin already owned 32% of Ashanti.

One condition of its offer was that banks agreed permanently to waive

their rights to margin calls on Ashanti's existing hedge book. The other condition was that the government of Ghana supported the deal. After intense negotiations, and despite various signs to the contrary, at the beginning of November, the government of Ghana rejected Lonmin's offer.

Another alternative would have been for Ashanti to sell some of its assets. Approaches were made by several mining companies, including South Africa's AngloGold, Barrick Gold Corp. and Canada's Placer Dome

, who expressed a provisional interest in acquiring certain assets. Offers were specifically made for the Geita mine due to start production in Tanzania next year with a projected annual output of 500,000oz but Ashanti felt the sale of these assets would go against its long-term strategy and declined. "Geita is this company's future, the gem," said Sam Jonah.

In the end, Ashanti signed a deal whereby the 17 banks would waive their rights to future margin calls for at least three years and accept much reduced rights thereafter, in exchange for warrants that could be exercised at $4.75 a share, giving them potential ownership of 15% of the company.

"I want to stabilise the company before moving forward on anything else," explained Jonah. This deal could generate $94m in cash and give Ashanti the breathing space needed to consider its other possibilities - including resuming discussions of a merger with Lonmin and securing financing for the development of the Geita mine.

Doesn't this seem a high price to pay for peace of mind? First, the value placed on Ashanti by the bank's offer is markedly below Lonmin's initial offer of $7.5 per share. True, Lonmin's bid was made when the share price was higher. The offer was also for the whole company and was unacceptable to the government of Ghana which wanted to retain control. On the other hand, the margin calls holiday may not be as valuable as it appeared. For a start, management could have investigated other funding choices, such as standby loans or cash or near-cash reserves to meet some of the margin call obligations. Ashanti could have elected to minimise the occurrence of margin calls by paying cash for a large chunk of its hedging components.

The terrible truth is that, by the time the deal was signed with banks, margin calls that would have been due by Ashanti based on existing arrangement were zero. Gold prices had fallen again and the value of its hedge book, based on gold prices at $292 an ounce, had bounced up from a negative $572m to a negative $219m, actually less than its former agreed margin limits or $230m.

Moreover, as noted by Sir John Craven

, Lonmin's Chairman, the increase in the gold price has made Ashanti a better business, although one with short-term problems.

One danger is that since the banks have ended up with such a good deal on Ashanti stock, some in the financial sector may be tempted to allow other commodity producers to expose themselves to unreasonably high derivative positions.

Goldman Sachs acted as adviser to Ashanti with regards to its `strategic options' and was one of the 17 banks at risk from the derivative business. It was also one of a syndicate of banks that lent $270m to Ashanti to finance its activities. But according to

Goldman Sachs there was "absolutely no conflict of interest" because it did not advise Ashanti in any negotiation with its counterparties

although as the Financial Times points our it was also a leading counterparty

. Maybe so, but questions remain about playing both sides of the fence. As for Ashanti - and for that matter other commodities and metal producers in Africa - it should perhaps consider more transparency in its hedging strategy.

Eureka aims for 65,000ozs of gold

Open pit mining at Delta Gold's Eureka mine (some 150km north of Harare at Guruve) began in January, with a gold processing plant to be completed this month. At full production, it will be Zimbabwe's second largest gold producer with an annual output of 65,000oz. Developing the mine has cost about $24m but it came in on time and budget. It is a low risk open pit, heap leach operation with underground potential.

Recent further exploration discovered significant high grade underground resources and a feasibility study is due next year. The government has promised to improve telecommunications in the area and to provide a road to Guruve, while Delta has worked with local farmers to build a water storage dam to supply the community and the mine.

Elsewhere in Zimbabwe, Delta's operations have not been going so well. At Kwe Kwe, the company built a small carbon-in-leach (CIL

) processing plant, and while trial operations were satisfactory, overall results were disappointing. It became apparent that processing would have to move to the small scale Chaka plant and during the year 8,322oz of gold was produced there.