To hedge, or not to hedge: that is the question

It is not uncommon for people to challenge the whole concept of hedging. Why create procedures, add the cost of a Hedging Desk, software, broker fees etc. Why do it, if prices are always going to increase? Since our sales and purchases are going to match, in the long run we are not going to lose money, and we can cut on costs, so away with the whole thing! Alternatively, we could actively manage our risk and take a position to make money instead of ensuring that we do not lose. Not hedge our purchases when we believe prices will go up, not hedge our sales when we believe prices will go down.

If only it was that easy! Let's look at the first option, which is to forego the whole idea of hedging. We are naturally hedged, more or less, right? Nothing can go wrong. But it will. You see, prices do fluctuate significantly, even in shorter periods. Customers will tend to book their metal in the dips. Suppliers, when they have the option to set the pricing date, will ask for it on the peaks. Not everyone, not every time, and they will certainly not choose the "perfect" moment always, but this is creating a bias and letting the company on the whim of its counterparties' skill (or luck). In simpler terms: On price rallies, sales tend to be slower. On price corrections, sales are higher. Purchases usually cannot be immediately adjusted and often are affected in the wrong direction – when it is the supplier who has the choice. But what if we limit the options of the customer or supplier, one might ask? We can certainly do that, but we will lose many of them to competitors who are more flexible. You have to satisfy the needs of your customers…

There's the answer, then: "let's take the second option, let us do our own speculation". Let's do hedge, by taking large, short or long positions, that will more than offset the "customer's" choice. But how wise and safe is that, for a big industrial company, with hundreds of millions invested, hundreds of jobs depending on it, and thousands of investors expecting something different from a serious industrial to the behaviour of a hedge fund? Suffice to say, the bigger and more serious a fabricator is, the less likely it is to act in that way. This type of hedging can lead to good results as easily as it can lead to disaster – in profits, and cash flows.

We must not confuse this type of hedging, of a "speculating fabricator" to the hedging of a mine or integrated smelter. This is different from their selling in the forward market. When they do, it is because they want to secure their profits and cash flows for the future when they see favourable prices well over their cost. At first thought this is safe, you only forego the possibility of getting even better profits in the future. In fact, such cases have even resulted in bankruptcies. Imagine building a mine that will produce 100.000tn of copper next year. You see that you can sell it forward at say EUR 8.000/tn, which is well over your cash costs, and you do that and open a large position. And then copper jumps to EUR 10.000 before you even start production. Margin call of EUR 200m. No cash because you're not producing yet… End of story, I'll let you imagine the rest.

So, hedging can also be dangerous. This starts to explain the last question one might have about "to hedge or not to hedge". This has to do with the other item that keeps popping up. Why are you hedging only the purchases and sales, and not your working inventory? You wouldn't have posted bad results last year when Aluminium (or Copper, or Zinc) prices dropped, and you had to write down your inventory.

Hedging your inventory, in fact, means that you are creating a permanent short position. A position that you'll have to carry forward, kick down the road, every three months or whatever period your LME future contracts that you used to create it have. This creates two issues:

The first issue is the volatility of cash flows. You will constantly have this large position reevaluated (margin calls) or carried forward, and this will generate cash (if prices drop) or demand cash (if prices rise). What are metals prices going to do, most probably, in the long run? I leave the answer to you.

When carrying forward your position, to maintain it to eternity, if the market is at a contango[1], this Is good. You're actually gaining some money that helps finance the inventory. However, the market often swings in backwardation[2], which is the second issue. Backwardation is usually much steeper than contango – and results in significant and permanent losses when you carry forward your positions.

In the beginning of 2009, after the big crash of 2008, I did a study to see what would have happened if we had hedged all our inventory, at around $2750, back in 2004 up to the end of 2008 when prices (after soaring all these years) fell significantly. It showed that we would have lost all those $2750, all the value of the copper, just from the backwardation losses and the added interest cost of the hedging results for the period. While trying to protect its value, we would have destroyed it completely.

Hedging your inventory might be a good idea if you do it before prices crash, but it would be a terrible idea if prices go up. It is like repurchasing your inventory every time prices rise. If you have not hedged it, nobody will be asking you fresh money for it. If you have, your broker will be calling you daily with margin calls. This creates one extra pressure on your cash flows, in addition to your receivables growing daily. The latter can be offset by increasing payables; nothing, however, offsets a working inventory that is hedged and is asking for more and more money every day.

You will, in fact, receive that money only on the day you shut down the business and liquidate everything. If you do not see that day coming soon, you should also not be worried about unhedged inventory dropping in value, because prices are «going south». Long term, they will recover. Inventory is considered a long-term asset by most metals fabricators. The fact that you can remelt it, and make something else, is key to that. Aluminium will never 'go out of style' like a carpet/phone/car will.

You probably realise by now, that ElvalHalcor is here to stay for a long time. It takes a conservative, non-speculative stance in risk management. It realises that it is cash flows, in the end, that really matter, rather than accounting results or write down losses that next year will become profits. So now, you understand why (and what) we hedge and why (and what) we do not.

And with this note, we conclude our informative series on metals, how they affect us, and how we protect ourselves against that.