Should Baja buy Puts?  And at what Price?

Silver Stock Report

by Jason Hommel, October  18, 2007

Others are beginning to weigh in on the issue of Baja's hedges, and my involvement.

Baja Mining May Hedge Copper for Five Long Years - 17 Oct 2007

Baja Mining: Tin Foil Hats Have Their Uses - October 18, 2007

Baja Mining, Jason Hommel, and the psychology of markets…....A future case study - Oct 18

Stockhouse Baja Mining Board:

Open discussion is better than dealings behind closed doors.  

Numerous investors said that I neglected to do the math to see what would happen to Baja's profits in case the copper price went down.  Clearly, that's the point of hedges, to protect the bank's loan in case copper prices go down.  That is the entire reason, justification, and only rationalization, for hedging the copper.  So, let's see what price the hedges should be.

Again, Baja can hedge in 3 basic ways: 

1.  Baja can promise to deliver copper at set prices.  This is like shorting copper.  This is the basic and standard "hedge" that got Apex Silver and so much more of the mining industry into so much trouble, because if prices rise, they lose the difference.

2.  Baja can promise to deliver copper at set prices AND get an option to buy copper in case copper is above the set price.  This is like shorting copper to lock in copper prices in case copper prices go down, and buying call options to protect against losses in case copper goes up.  Buying extra call options is more expensive, of course, but you can see the benefit, because this would prevent Baja from losing $900 million in a year in case copper prices ran up to $18.25/lb. in the event of continuing, rising copper prices.

3.  Baja can buy the right, but not the obligation, to sell copper at set prices.  This is like buying puts, which are the right, but not the obligation, to buy a short position in copper.  This is actually cheaper than a standard short position, and comes with the added benefit of no danger and no mark to market losses in case the copper prices rise.

Of the three ways to hedge, the third way clearly appears best.  It is the cheapest, and it offers protection in case copper prices move up, which is why most investors have bought Baja Mining stock.  Many of the brightest people suggested that Baja should simply buy puts, so that they don't have any losses in case copper prices rise, and this seems like it could make everyone happy.  One man wrote:

Dear Jason Hommel,

I just checked the price of Dec 2008 copper options and the $3.00 puts are about 25 cents per pound and the $3.85 calls are about 32 cents per pound.

I checked out of the money options because I think one could negotiate that with the bank or one could live with a partial loss of profit if there is a large move up.

Overall, the cheapest solution is to buy the [$3.00] puts at 25 cents.  Of course, further out puts [a few years down the road] would be more expensive and probably also harder to buy.

There is a question about the depth of these option markets and what it would take to hedge a large amount of production.  Even if Baja bought puts for only 100 million pounds of copper, that would be 4,000 options.  I imagine that this order would have to be placed with several brokers in small pieces in different months and strike prices over a period of weeks or longer.

As the loan is paid down, the loan documents should allow the puts to be sold off, probably at a loss.  If the loss is, say, 10 cents per pound, the cost of the hedging is reduced to $10 million, which is far less than either the current hedging proposal or the dilution from sale of stock.

Jason Fane


Furthermore, many people asked me to also show the math, in case copper prices go down, and so, we will do that here.

Now, it seems rather axiomatic, and basic, that the lower the price of the put, the cheaper the put will be, and thus, the more money that Baja Mining will save when buying the most appropriate, and minimum basic hedge protection.  Any protection purchased that is more than the minimum is as unnecessary and as fraudulent as buying a $100 million dollar life insurance policy when you are making only $25,000 per year.

Given that the entire reason for hedges in the first place is that Baja must be able to "lock in" a certain minimum profit to make sure that the lenders get repaid, let's look at what the minimum price for copper that Baja needs, because that can be calculated fairly easily.

The loan is $515 million.

Let's assume that we want to guarantee the Baja will be able to repay that in 5 years, at a 10% interest rate.

A typical home mortgage calculator can be helpful in this regard to see how much Baja needs to pay per year.

I see that if someone had to pay a $515,000 loan over 5 years at 10%, they would need to repay $10,942/month.

So, we need to multiply that by 12 months, and then by 1000 to get to millions.

$10,942 x 12 x 1000 = $131,304,000

So, to guarantee things for the bank loan, we need to find a minimum copper price that will allow Baja to earn at least $131.3 million per year.

Let's look first, again, at how much Baja stands to earn, without any hedges at all:

Projected Annual Production: (At current prices.)
Copper:  122,873,000 lbs. x $3.65/lb. = $448,486,450
Cobalt:  3,383,140 lbs. x $30/lb. = $101,494,200
Zinc: 13,885,200 lbs. x $1.35/lb. = $18,745,020
Sub total: $568,725,670
Projected costs: Total operation costs are approximately $65,000,000/year
Total earnings/year (EBITA): $503,725,670

Wow.  $503.7 million is a lot higher than $131.3 million.  I have not yet done the math, but I'm sensing that the puts will be very cheap.  Are you with me?  Ok.  Let's do the math backwards now.

Earnings must be at least $131.3 million

Without any copper, what will Baja earn per year?
Cobalt:  3,383,140 lbs. x $30/lb. = +$101,494,200
Zinc: 13,885,200 lbs. x $1.35/lb. = +$18,745,020
Costs: - $65,000,000
Subtotal: $55,239,220

Now, Baja needs to be able to earn the difference on their copper:

$131.3 million minimum needed.
- $55,239,220 earnings on Cobalt and Zinc, but no copper.
= $76,064,780

Now, to earn a minimum of $76 million, on 122 million pounds of copper is very simple math.

$76,064,780 / 122,873,000lbs. = $.619 per pound.

Therefore, Baja Mining needs to be able to lock in copper prices at 62 cents per pound, and not be hurt if copper prices move above that.

The best way is not to promise to deliver copper at $.62/lb., but rather to buy puts, so that there is no obligation to do so, in case the copper prices remain higher.

And remember, if Baja buys puts to deliver copper at higher prices than that, it's as foolish as buying too much car insurance or too much life insurance.

Remember, there will also be profits from the manganese, so this is a very conservative, and high figure.  Extra profits from the manganese mean that there will be less profits needed from the copper.

I hope this clarifies.  Baja has no need to hedge.  No need whatsoever. 

There is not an analyst in the world who will predict that copper has a significant chance, or danger, of dropping below $.62/lb.

Furthermore, there is no market for puts at $.62/lb. copper.  Such puts are so "out of the money", that nobody in their right mind would pay for such a "privilege" as the right to sell copper at $.62/lb., since copper is now trading at $3.50, and in a range between $2.50 to $3.50 for the last year.

But this is the flip side of the entire problem.  There is no market for the hedges that Baja really "needs", just as there is no need for Baja to hedge!

So, let's make a market for Baja and the bankers, shall we?  We have just as much of a right to sell Baja "puts" as anyone else, especially if there is no market.

Since the market for $3.00 puts is $.25/lb., let me offer Baja puts at $.62/lb. for $.05/lb.  That sounds as reasonable, for starters. 

Baja Mining, here is my formal offer:

I will sell you puts for 122.8 million pounds of copper for $.05/lb., giving you the right, but not the obligation, to sell me copper at $.62/lb., for 5 years.

The full price: Pay me $.05/lb, x 122.8 million pounds, which is $6.14 million dollars per year.  I won't even raise my prices for the puts that you need up to 5 years from now.  Simply pay me $30.7 million dollars, and all your hedging needs will be solved.

Furthermore, this fully protects Baja against any potential $900 million hedging losses in case copper prices move up, because they will own puts, not futures contracts that would force them to sell copper too cheaply.

Potentially, I just saved Baja up to $2 billion dollars, or more!

But I hope you all can see how fraudulent my offer is.  I can basically make $30.7 million, with no risk. 

In a free market, I would have just as much of a right to offer those terms to Baja Mining as anyone else on my email list.  Go ahead, email the company with your competing offer!  Let's make a market for Baja's hedging needs!

But to be more legit, the hedging offer ultimately ought to go through a public exchange, such as NYMEX, where I place my "offer", and Baja "hits" my bid, (and any other competing bids) and my account (and others) fill with the cash.  But that would not make it any more legit, would it?

The other point is that raising the price of the exercise price on the puts to a more "reasonable" level, such as, to $2.50, does not make the offer more legitimate, either.  If the $.62/lb puts are fraud, so are puts at $.63, $.64, $.65, $1.65, $2.65, or any other price level. 

I hope you can see why I'm concerned.  Baja Mining has no legitimate need to hedge.  Baja mining has no need to pay somebody $30 million, more or less, for puts, or futures, or over the counter derivatives, in some back room deal.

In fact, some shareholders might want to think about filing a lawsuit against Baja, for an injunction, or court order, forbidding them from hedging any copper, zinc, or anything else.  The complaint could be a rather simple proposal of the situation, showing the minimum required hedges, as I showed above, and showing that there is no market for that "product," and no real danger of copper prices falling so low.

In fact, a really brilliant lawyer could take the case on contingency, and sue not only for an injunction, but maybe even sue for the right to recieve 1/3 of $30 million for offering put options; the other $20 million going to the rest of the shareholders listed in a class action lawsuit.

Now, to be clear.  I don't think Baja Mining is a sell.  Baja Mining is a screaming good buy.  It's a guaranteed cash cow. 

My point is simply this:  The milk ought to go to the shareholders.  No milk ought to go to any speculators, hedgers, or counterparties for any hedging that is not needed, and any hedging of anything more expensive than puts at $.62/lb. for copper can be proven to be excessive.

Clearly, Baja Mining could make a lot of money if they bought puts at $3.00/lb, and if copper goes below $3.00 per pound.  But I'm not running the numbers on that.  Why not?  Because the goal here is to make money through mining, not through excessive speculation in the futures market.  If we want to speculate in the copper futures market we are all free to do so on our own, and Baja Mining has no business gambling in the futures market with shareholders' money.  Furthermore, Baja Mining has no business gambling in the futures market with borrowed money, either.  Similarly, no public company ought to claim a right to borrow money, go to Vegas, and throw it all down on "black" at the roulette table.  And that's exactly what they would be doing if they excessively hedge, and buy "too much insurance".

The lenders ought to receive their basic interest rate, and nothing more from any complex, and unneeded, derivatives.

Let me put it another way.  Baja Mining will have among the lowest cost per pound of copper production in the world, a negative cash cost, since they will be earning money even if copper prices are zero.  Therefore, again, Baja Mining has no legitimate need to hedge the copper production.

Clearly, John Greenslade must be an extraordinarily brilliant man given that he told me that he and his advisors "fully understand the issues relating to hedging."  And I can now more clearly see why all of these hedge possibilities "will be the subject of discussion over the next several months." 

I bet the gentlemen who really know a lot about hedging are simply salivating over the commissions and money to be made by "helping" Baja Mining hedge.  And I bet their biggest problem is trying to figure out how to best milk this cash cow for the most possible money, and to do it in such a way as to look completely legitimate.   Don't you think so?

However, since I have now set the terms, John Greenslade and the directors may be held personally liable in case they hedge excessively.  And if there are any hedging losses beyond what could have been avoided if they had taken the advice contained herein, they may be able to be held personally liable for any hedging losses to the company.

My advice, unfortunately, is free, because my commission, unfortunately, is zero, because I have no "hedging product" to sell.  But my advice is better than those other advisors, and I hope the company takes it.  Don't hedge!  It's that simple.

Disclaimer:  I still own 588,700 shares of Baja Mining, and I have no plans to buy or sell any in the near future.  It's my largest position, at about 10% of my net worth, so I'm not buying more.  It's also one of my favorite stocks, so there no need to sell.  This is why I write:  to protect my investment, to educate investors, and to educate public companies on the dangers and issues surrounding hedging, and debt.  And Baja Mining is not paying me to write these emails.


Jason Hommel