Derivative Financial Instruments and Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2011

Derivative Financial Instruments and Fair Value of Financial Instruments [Abstract]

DERIVATIVE FINANCIAL INSTRUMENTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS

NOTE 15 – DERIVATIVE FINANCIAL INSTRUMENTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS

Palmarejo Gold Production Royalty

On January 21, 2009, the Company entered into the gold production royalty transaction with Franco-Nevada Corporation described in Note 10, Debt and Capital Lease Obligations, Palmarejo Gold Production Royalty Obligation. The minimum royalty obligation ends when payments have been made on a total of 400,000 ounces of gold. As of September 30, 2011, a total of 272,973 ounces of gold remain outstanding under the minimum royalty obligation. The price volatility associated with the minimum royalty obligation is considered an embedded derivative financial instrument under U.S. GAAP. The fair value of the embedded derivative at September 30, 2011 and December 31, 2010 was a liability of $179.4 million and $162.0 million, respectively. During the three and nine months ended September 30, 2011, mark-to-market adjustments for this embedded derivative amounted to a loss of $14.5 million and $17.4 million, respectively. The Franco-Nevada warrants were contingent options to acquire 316,436 common shares of Franco-Nevada for no additional consideration, once the mine satisfied certain completion tests stipulated in the agreement. On September 19, 2010, the Company exercised these warrants and received the related shares, which were sold for net proceeds to the Company of $10.0 million. The Franco-Nevada warrants were considered a derivative instrument. During the three months ended September 30, 2010, mark-to-market adjustments for this embedded derivative and warrants amounted to a loss of $15.2 million and a gain of $1.1 million, respectively. During the nine months ended September 30, 2010, mark-to-market adjustments for this embedded derivative and warrants amounted to a loss of $46.8 million and a gain of $3.5 million, respectively. For the three months ended September 30, 2011 and 2010, realized losses on settlement of the liabilities were $11.9 million and $4.8 million, respectively, and for the nine months ended September 30, 2011 and 2010, realized losses on settlement of the liabilities were $29.1 million and $11.6 million, respectively. The mark-to-market adjustments and realized losses are included in fair value adjustments, net in the consolidated statement of operations.

Forward Foreign Exchange Contracts

The Company periodically enters into forward foreign currency contracts to reduce the foreign exchange risk associated with forecasted Mexican peso (“MXP”) operating costs at its Palmarejo mine. At September 30, 2011, the Company had MXP foreign exchange contracts of $24.6 million in U.S. dollars. These contracts require the Company to exchange U.S. dollars for MXP at a weighted average exchange rate of 11.95 MXP to each U.S. dollar and had a fair value of ($3.8) million at September 30, 2011. The Company recorded mark-to-market losses on these contracts of $4.1 million and $3.8 million for the three and nine months ended September 30, 2011, respectively, and $0.3 million and $(0.9) million for the three and nine months ended September 30, 2010, respectively, which is reflected in fair value adjustments, net. The Company recorded realized gains (losses) of ($0.1) million and $1.0 million in Production costs applicable to sales during the three and nine months ended September 30, 2011, respectively, and $0.4 million and $0.9 million during the three and nine months ended September 30, 2010, respectively.

Gold Lease Facility

As of September 30, 2011, the Company had no gold leased from Mitsubishi International Corporation (“MIC”). At December 31, 2010, the Company had 10,000 ounces of gold leased from MIC, which it delivered to MIC on March 22, 2011. The Company accounted for the gold lease facility as a derivative instrument, which was recorded in accrued liabilities and other on the balance sheet.

On December 12, 2008, the Company entered into the gold lease facility with MIC. Pursuant to this facility, the Company may lease amounts of gold from MIC and is obligated to deliver the same amounts back to MIC and to pay specified lease fees to MIC that are equivalent to interest at current market rates on the value of the gold leased. Pursuant to a Second Amended and Restated Collateral Agreement, the Company’s obligations under the facility are secured by certain collateral. The collateral agreement specifies the maximum amount of gold the Company may lease from MIC, as well as the amount and type of collateral.

Concentrate Sales Contracts

The Company enters into concentrate sales contracts with third-party smelters. The contracts, in general, provide for a provisional payment based upon provisional assays and quoted metal prices. The provisionally priced sales contain an embedded derivative that is required to be separated from the host contract for accounting purposes. The host contract is the receivable from the sale of concentrates at the forward price at the time of sale. The embedded derivative, which is the final settlement price based on a future price, does not qualify for hedge accounting. These embedded derivatives are recorded as derivative assets (in Prepaid expenses and other) or derivative liabilities (in Accrued liabilities and other) on the balance sheet and are adjusted to fair value through earnings each period until the date of final settlement. At September 30, 2011, the Company had outstanding provisionally priced sales of $30.1 million, consisting of 414,767 ounces of silver and 7,679 ounces of gold, which had a fair value of $27.4 million including the embedded derivative. At December 31, 2010, the Company had outstanding provisionally priced sales of $35.7 million consisting of 647,711 ounces of silver and 12,758 ounces of gold, which had a fair value of approximately $37.4 million including the embedded derivative.

Commodity Derivatives

At December 31, 2010, the Company had one outstanding forward gold contract of 10,000 ounces at a fixed price of $1,380 per ounce, which was settled on March 22, 2011 for a gain of $0.5 million.

As of September 30, 2011, in connection with the Kensington term facility described in Note 10, Debt and Capital Lease Obligations, Kensington term facility, the Company had outstanding call options requiring it to deliver 182,500 ounces of gold at a weighted average strike price of $1,889.05 per ounce if the market price of gold exceeds the strike price. At September 30, 2011, the Company had outstanding put options allowing it to sell 205,000 ounces of gold at a weighted average strike price of $947.19 per ounce if the market price of gold were to fall below the strike price. The contracts will expire over the next five years. As of September 30, 2011, the fair market value of these contracts was a net liability of $32.9 million. During the nine months ended September 30, 2011, 32,500 ounces of gold call options at a weighted average strike price of $1,755.42 per ounce expired. The Company recorded unrealized losses of $19.9 million and $18.2 million for the three and nine months ended September 30, 2011, respectively, included in fair value adjustments, net. In addition, 28,750 ounces of gold call options were settled in September, 2011 and the Company recorded a realized loss of $2.4 million related to the transaction. During the three and nine months ended September 30, 2010, the Company recorded unrealized losses of $0.1 million and $6.7 million, respectively, included in fair value adjustments, net.

In connection with the sale of the Cerro Bayo mine to Mandalay Resources Corporation, the Company received the right to 125,000 ounces of silver to be delivered in six equal quarterly installments commencing in the third quarter of 2011. The first installment of 20,833 ounces was received on September 30, 2011. The Company recognized a mark to market gain of $0.8 million associated with this silver in the three months ended September 30, 2011. The Company recognized a mark to market gain of $0.4 million associated with this silver in the nine months ended September 30, 2011. The silver had a fair value of $3.1 million at September 30, 2011, and a fair value of $3.9 million at December 31, 2010.

As of September 30, 2011, the Company had the following derivative instruments that settle in each of the years indicated in the table (in thousands except average rates, ounces and per share data):

	2011		2012		2013		Thereafter
Palmarejo gold production royalty	$	8,422	$	24,865	$	25,097	$	76,792
Average gold price in excess of minimum contractual deduction	$	485	$	497	$	502	$	493
Notional ounces		17,348		50,004		50,004		155,617
Mexican peso forward purchase contracts	$	7,800	$	16,800	$	—	$	—
Average rate (MXP/$)	$	12.49	$	11.70	$	—	$	—
Mexican peso notional amount		97,385		196,568		—		—
Silver ounces receivable from Mandalay	$	382	$	1,535	$	—	$	—
Average silver forward price	$	18.35	$	18.42	$	—	$	—
Notional ounces		20,833		83,333		—		—
Silver concentrate sales agreements	$	16,417	$	—	$	—	$	—
Average silver price	$	39.58	$	—	$	—	$	—
Notional ounces		414,767		—		—		—
Gold concentrates sales agreements	$	13,676	$	—	$	—	$	—
Average gold price	$	1,781	$	—	$	—	$	—
Notional ounces		7,679		—		—		—
Gold put options purchased	$	900	$	2,880	$	1,800	$	720
Average gold strike price	$	887	$	923	$	928	$	991
Notional ounces		15,000		68,000		45,000		77,000
Gold call options sold	$	—	$	2,160	$	1,800	$	720
Average gold strike price	$	2,000	$	1,839	$	1,827	$	1,960
Notional ounces		2,500		58,000		45,000		77,000

The following summarizes the classification of the fair value of the derivative instruments as of September 30, 2011 and December 31, 2010 (in thousands):

	September 30, 2011
	Prepaid expenses and other		Other non- current assets		Accrued liabilities and other		Other long- term liabilities		Current portion of royalty obligation		Non-current portion of royalty obligation
Silver ounces receivable from Mandalay	$	989	$	244	$	—	$	—	$	—	$	—
Forward foreign exchange contracts		—		—		3,786		—		—		—
Palmarejo gold production royalty		—		—		—		—		39,766		139,659
Put and call options, net		—		—		5,910		27,025		—		—
Concentrate sales contracts		169		—		2,828		—		—		—
	$	1,158	$	244	$	12,524	$	27,025	$	39,766	$	139,659
	December 31, 2010
	Prepaid expenses and other		Other non- current Assets		Accrued liabilities and other		Other long- term Liabilities		Current portion of royalty obligation		Non-current portion of royalty obligation
Gold lease facility	$	—	$	—	$	2,213	$	—	$	—	$	—
Gold forward contract		425		—		—		—		—		—
Silver ounces receivable from Mandalay		531		1,063		—		—		—		—
Forward foreign exchange contracts		328		—		323		—		—		—
Palmarejo gold production royalty		—		—		—		—		28,745		133,258
Put and call options, net		—		—		1,471		13,277		—		—
Concentrate sales contracts		1,703		—		23		—		—		—
	$	2,987	$	1,063	$	4,030	$	13,277	$	28,745	$	133,258

The following represent mark-to-market gains (losses) on derivative instruments for the three and nine months ended September 30, 2011 and 2010 (in thousands):

		Three months ended September 30,						Nine months ended September 30,
Financial statement line	Derivative	2011			2010			2011			2010
Sales of metal	Concentrate sales contracts	$	1,466		$	(1,672	)	$	4,339		$	(1,773	)
Production costs applicable to sales	Forward foreign exchange contracts		(65	)		459			1,045			987
Fair value adjustments, net	Gold lease facility		—			(2,079	)		(132	)		(4,808	)
Fair value adjustments, net	Forward foreign exchange contracts		(4,089	)		279			(3,791	)		(913	)
Fair value adjustments, net	Forward gold contract		—			1,238			35			1,238
Fair value adjustments, net	Silver ounces receivable		(554	)		447			(90	)		447
Fair value adjustments, net	Palmarejo gold royalty		(26,464	)		(19,969	)		(46,505	)		(58,481	)
Fair value adjustments, net	Franco-Nevada warrant		—			1,118			—			3,451
Fair value adjustments, net	Put and call options		(22,244	)		(142	)		(20,568	)		(6,816	)
		$	(51,950	)	$	(20,321	)	$	(65,667	)	$	(66,668	)

Credit Risk

The credit risk exposure related to any potential derivative instruments is limited to the unrealized gains, if any, on outstanding contracts based on current market prices. To reduce counter-party credit exposure, the Company deals with financial institutions management deems credit worthy and limits credit exposure to each. The Company does not anticipate non-performance by any of its counterparties. In addition, to allow for situations where positions may need to be revised, the Company deals only in markets that management considers highly liquid.