Reducing your exposure

Base metals prices have been volatile this year, with changes in supply and demand triggering considerable price gains and falls, as have perceptions about the outlook for these metals.

For example, Indonesia’s plan to ban the export of nickel ores at the start of the year was well-telegraphed. Chinese companies and traders stockpiled vast quantities of nickel ore and nickel pig iron (NPI) ahead of the ban.

Quite logically, the ban would not cause any immediate shortage, and, therefore, prices should not have responded quickly to the supply disruption. But nickel prices raced higher to $21,625 per metric ton in May this year from roughly $13,900 at the end of 2013.

Although this is an extreme case, aluminum and zinc also have surprised on the upside this year, and tin has surprised on the downside, all of which highlights the price risk in the markets and shows there is no room for complacency in commodity prices.

The table below shows the extent of price rises and falls so far this year; such moves can have sizeable effects on businesses exposed to metals prices.
 

The expertise and added value of a business that handles scrap metals tends to be in the processing of the metal. If such companies are exposed to price fluctuations while working the metal, their margins are at risk. Regardless of whether price moves are advantageous or disadvantageous to such companies, they will not want the success of their businesses to depend on factors over which they have no control—notably, how metal prices move.
 

Mitigating risk

Businesses can mitigate their price risk by hedging. There are many ways to hedge—some simple and some very complicated. A simple hedge for a recycler, for example, would be to buy scrap metal on a price linked to the spot price of the metal while selling the same amount of metal content for a date in the future. If it takes one month to process the metal, the processor would look to sell one month forward. Once the scrap metal has been processed and is ready to sell, the recycler would sell its product on the basis of the spot price and buy back the hedge. For example:

July 15

• The physical deal – Buy 25 metric tons of copper scrap at a basis London Metal Exchange (LME) price of $7,130.
• The hedge – Sell one lot of LME copper for the August date at $7,132.
   

Aug. 11

• The physical deal – Sell 25 metric tons of processed scrap at a basis LME price of $7,010.
• Unwind the hedge – Buy one lot of copper for the August date at $7,008.

If no hedge had been put on, the basis price while the recycler held the metal would have dropped $120 per metric ton. However, with the hedge, the recycler’s $120-per-metric-ton loss caused by the adverse price movement was offset by $124-per-metric-ton profit on the hedge.

Hedges can be finely tuned for specific dates, can involve buying and selling on the basis of monthly average prices or can involve options. While these variations can be expensive, the expense can be offset by granting options, though this adds another layer of complexity and possibly risk.

For the purpose of this article, however, it is important to grasp the concept of a simple hedge and how it enables a business to reduce its exposure to price movements and concentrate on adding value.
 

Hedging strategically

A business that does not engage in hedging is in many ways speculating that prices will move in its favor.

While it could be argued that there is much knowledge about where prices are headed and, therefore, times to hedge and times when it is less necessary, this year has provided many good examples of commodity prices moving with more volatility than had been forecast.

Zinc prices, for example, ran higher earlier in 2014 when the market bought into the idea that a supply deficit was on the way, which is likely to be the case. The dilemma is determining when the market will react.

In the case of zinc, the market is seen swinging into a supply deficit as we near the middle of 2015. Why the market started to anticipate the shortage two years in advance is difficult to fathom. There is no shortage of zinc currently; LME stocks are high and it is likely that there are also large stocks of zinc held off warrant.

What seems to have happened is that market sentiment turned bullish on the medium-term outlook for the metal, and prices ran higher. The run higher then became self-sustaining until prices were too attractive for producers who hedge to ignore—they sold into the strength.

At FastMarkets we repeatedly said over the summer that zinc prices, as well as those for nickel and aluminum, were running ahead of the fundamentals. It provided producers with a medium-term strategic hedging opportunity. With prices now falling, consumers are likely to get another opportunity to hedge-buy too.

The oscillations in price, taken with a good understanding of a market’s outlook, can provide some good opportunities to put on strategic hedges. Strategic hedging is different from day-to-day, or order-backed, hedging, as in the example of the simple hedge above.

Strategic hedging can facilitate long-term pricing. For example, an auto manufacturer will know if it is likely to use X metric tons of aluminum per year. If prices fall to unsustainable levels, even if it hedge-buys 50 percent of its likely requirement, it will get some price advantage when prices recover.

A mining company or producer can take advantage of price rallies that move well above what is fundamentally justified. We have seen evidence of this during the run-up in prices over the summer.

By monitoring the metals markets and looking at all the information that the market produces, it is possible to get a better understanding of what different players in the market are doing.

Examining how forward spreads on the LME change can help identify when the selling is selling forward. This is likely to be hedge selling by producers, therefore it is likely to cap the upside. Conversely, a run-up in price is either fresh buying or short-covering.

If a rally is being driven by short-covering, nearby spreads tend to tighten because traders need to buy nearby dates to close the shorts they put on previously.

For example, if shorting the three-month date and then covering the short after two months, a contract will need to be bought one month out. If this is happening in volume, the time spread for the one-month forward date will tighten.

Seeing this happen can provide some confidence that short-covering is driving price; by its very nature, the buying may peter out once the short-covering has run its course. These observations help those looking to hedge to get the timing right.

The metal markets are truly dynamic and often irrational. When prices are oscillating at these times, seemingly without rhyme or reason, it can be advantageous to reduce exposure to price risk by hedging. At other times, when prices are at extremes, the markets offer strategic hedgers with infrequent hedging opportunities.
 

Looking to the fourth quarter

Many cross-currents are at play moving into the fourth quarter of 2014. The metals that made strong gains earlier in the year are largely correcting—prices had seemingly run ahead of the fundamentals. And whereas China and Europe were perceived as positive factors at the start of the year, supporting firmer prices, slower growth in these regions is now producing headwinds. The U.S. looks strong but is unlikely to be able to support strong metal prices alone.

FastMarkets will publish its fourth-quarter forecasts in October; these should be available to nonsubscribers at www.fastmarkets.com in November.

The author is head of research at FastMarkets Ltd., based in the U.K. FastMarkets and BullionDesk.com provide delayed free and live subscription-based metal market news, data and research. More information is available at www.fastmarkets.com.