Testing Your Metal: Hedging to Manage Price Risk
Global metal markets have experienced profound changes over the past ten years, creating vast opportunity, as well as unparalleled challenges for both lenders and borrowers in the industry. To fully appreciate the evolution that has occurred and its impact upon the markets, one must look back in time to understand the changes that have occurred and what they portend for the future.
The copper market provides an excellent example and is representative of the base metals complex overall. Following the bursting of the dotcom bubble in 2000 and the onset of economic weakness, the spot price of copper on the New York Commodity Exchange fell to 60¢ per pound in November 2001, as global demand fell precipitously, causing inventories to rise to record high levels. Although the outlook at the time was decidedly bearish, with expectations of depressed prices for years to come, the copper market inexplicably began showing signs of strength.
Initially it was not clear what was driving the markets in early 2002, but before too long, it became apparent that China was embarking upon a long-term growth plan that would require massive quantities of all industrial raw materials to support its ambitious programs. Indeed, China surpassed the United States as the world’s largest consumer of copper among other metals that year, with its share of global consumption today in excess of 40%.
Coincident with the stronger fundamental environment sparked by China and reinforced by a global economic recovery, inventories of metal fell sharply, causing prices to begin trending higher. By the end of 2003, the price of copper had reached $1.00 per pound, with the base metals complex overall moving up. Along with the vastly improved outlook, speculative trading also accelerated as did market volatility.
By May 2006, the monthly average price of copper on Comex had risen to $3.75, up $3.15 or almost 500% from just five years earlier, while the daily Spot price traded well over $4.00 per pound. The price of aluminum on the London Metals Exchange more than doubled from 58¢ to $1.30 within the same period, while zinc saw a near five-fold increase, rising from 34¢ in 2001, to $2.00 by 2006.
As we know only too well, however, nothing goes up indefinitely and as the financial crisis unfolded in 2008 with panic selling in all markets, prices fell unrelentingly, taking a severe toll on many organizations and putting some out of business entirely, with their lenders also incurring significant losses.
What lessons can we learn from these events? First and foremost, it is incumbent upon any lender, and particularly those providing asset-based financing, to insure their loans are protected. Just as any lender requires a homebuyer to carry insurance as protection against losses before a mortgage is issued, so too should a financial institution require that its client have an adequate price protection plan or hedging program in place.
While hedging is one of the most important aspects of price risk management, it is also one of the least understood tools available to an organization. Further, while on the surface hedging is very straightforward, often times it is mistakenly confused with speculating.
For example, with copper trading today at $3.50 per pound, a producer with its cost of production at say $1.50 per pound is enjoying a gain of $2.00 for every pound produced. If the company wanted to lock in the gain on some portion of its production, it could do so by selling forward, or establishing a short position in the futures market. If the market subsequently rises, it will not participate in the gain but will have locked in a profit. Alternatively, that same producer may take the view that with prices well above the cost of production it has no interest in hedging. Thus, if the market declines, it will experience an opportunity loss until the price falls to the $1.50 level, beyond which it becomes a cash loss. Therefore, the question of whether a producer should hedge or speculate on prices depends not only on its cost of production, but also on the operating philosophy of senior management, in conjunction with the conditions of its borrowing terms.
Manufacturing companies on the other hand face very different circumstances, with the elements of market risk exposure varying across the sector depending on how closely aligned the price of their product is to changes in metal market prices. For instance, the price of a car will not change from day to day regardless of changes in the price for copper, aluminum, lead, tin, nickel or zinc, all of which are contained in an automobile.
A wire and cable manufacturing company, or brass mill, on the other hand experiences an immediate impact from daily movements in metal prices. This is because typically its selling price, as well as inventory valuation, is tied directly or indirectly to Comex or London Metals Exchange prices. In the simplest of terms, once a company in this category buys metal for production, or holds metal in inventory, it is facing market risk until the finished product is sold.
To protect against falling prices a company can employ a number of approaches to mitigate the risk. Ultimately, the objective is to establish an offsetting position to their physical metal. This can be accomplished by entering into “firm fixed priced” sales to its customers, establishing a short position by selling futures contracts or purchasing price insurance in the form of a put option.
With each alternative, there are benefits as well as drawbacks that must be weighed to determine the appropriate course of action.
Entering into a firm priced sale with customers is the most straightforward approach, but in all likelihood, the total of these sales will not be enough to reduce all of the exposure. Additionally, the company faces the risk of its customer failing to meet its purchase obligation for any number of reasons.
Using the futures market to manage price risk exposure provides the most flexible and strongest level of protection as the exchanges stand behind and guarantees all trades. It must be recognized though, that cash is required to support a futures position in the form of initial margin, or a good faith deposit, as well as variation margin if the futures account falls into deficit when it is marked to the market on a daily basis.
It will also be necessary to learn the “mechanics of the market” in order to understand the implications of contract expiration, for example, and terms such as contango and backwardation which represent the market structure and will have a direct bearing on the outcome of the hedging program.
The use of options as a hedging strategy should be viewed as buying price insurance. That is to say, by paying a premium, or the cost of the option, one can protect a specific price, for a specific period of time. Also, while futures contracts create an obligation to close out the contract subsequent to it being entered into, options provide the right, but not the obligation, to offset the initial transaction.
There are many other aspects of both futures and options that require further explanation to gain a deeper understanding of these instruments, but the key point here is to highlight how they can be used to manage price risk.
The following examples will help to illustrate how the futures market can be used to mitigate a company’s price risk exposure on inventories.
In the example below, the market is in a contango structure wherein the forward months are at a premium to the nearby month. By selling a forward month, the contango is locked in, helping to offset the cost of financing, while at the same time compensating for the decline in price.
Example 2 demonstrates the impact of a backwardation market structure wherein forward prices trade at a discount to nearby values. In this instance, while the overall hedge resulted in a net loss of 5¢ due to the backwardation, if no hedge had been in place, the company would have experienced a 30¢ loss.
Of course, if market values from the financial crisis of 2008 were used, the impact would have been more dramatic as copper fell $2.83, or almost 70% from $4.08 on July 2, to $1.25 on December 24. More recently, the price of copper fell from $4.19 at the end of August 2011 to $3.14 on September 30 representing a $1.05, or 25% loss of value in just one month, with other metals also sharply lower. And given the continued erratic movements in most markets of late, it appears volatility will remain with us going forward.
It cannot be emphasized enough that price risk can and will have a significant impact upon an organization’s profitability and by extension the profitability of their lender.
Here are a few questions you should consider when reviewing an asset-based loan:
- Is there a clear understanding of the difference between speculating and hedging?
- Have reports been created to summarize and assess price risk exposure?
- Has a plan been developed to hedge price risk?
- Are you able to independently test and verify the exposure of the company?
- Does the credit facility recognize the potential need for cash to support a hedging program?
There are many other considerations to be taken into account, but the issue here is to establish a clear understanding of market risk and how it will be controlled. With a properly structured hedging plan in place, you can be confident that your client and your asset-based loan will be protected.
John E Gross is president of JE Gross & Co., a metals management consultancy firm established in 1987. Over the past 35 years, Gross has worked with global leaders in the metals industry in a variety of senior level positions, enabling him to provide a deep and diverse level of expertise to his clients. As the manager of trading at Hudson Bay Mining & Smelting, he was responsible for sales of precious metals and related hedging activities. He became a futures broker with Johnson Matthey specializing in metals on Comex and the London Metals Exchange, and was vice president of Strategic Metals for the North American operations of BICC Cables Corporation. His work focuses on developing hedging strategies for companies in the metals industry and assisting financial institutions to insure the necessary policies, procedures, controls and reporting systems are in place to protect lending arrangements. He is a graduate of Hofstra University and is a Vietnam Veteran. He is a member of the ISM, was a director of The American Copper Council and served on the Comex advisory committee. Gross is very active in industry affairs and has written extensively on metal markets. He can be reached at john [dot] gross [at] jegross [dot] com