Aluminum Premium Hedging
Premium hedging in metals is a relatively new concept that was only introduced by the CME in 2012 for the US aluminum market, followed in 2015 with their Rotterdam duty paid and duty unpaid contracts, and then in 2016 for their CIF Japan premium. And given my prior posts about how refined traders make money through premiums, the concept of hedging premium risk can be confusing - “So we’re not making money on the price of aluminum and now we’re not taking risk on the premium either??”. For those of you who have exposure to these markets, getting to grips with the premium swap is crucial to enhance your knowledge and ultimately your ability to trade effectively.
Premiums for physical aluminum contracts in the US, Europe, and certain parts of Asia, are often agreed to using a premium set by a publication. For the US, this is the Platts Aluminum MW US Transaction premium, and it is quoted in US cents/lb. For Japan, this is the Platts CIF Japan Spot Premium for Aluminum, and it is quoted in US dollars/mt. For Europe, this is the Fastmarkets (previously Metal Bulletin) Aluminum P1020A, in-whs Rotterdam Duty Paid and Duty Unpaid premiums, and they are quoted in US dollars/mt. Reporters for these publications will discuss the market and transactions with traders, consumers, and producers to try and ascertain the premium for their region. They will use these discussions as the basis to set the daily premium for their respective publications.
Buyers and sellers of metal agree in advance to use whatever premium is set by these publications for their contracts. For example, a trader in Europe may agree in August to buy 2000MT of P1020 aluminum ingots from a producer to be delivered in September, with a premium that will be defined by the Fastmarkets Aluminum P1020A, in-whs Rotterdam Duty Paid premium for the average of September. At the time of purchase, this premium is an unknown figure that could increase or decrease depending on the physical market over the following month. This is called a floating premium purchase or sale. In this example, it is only one month between agreeing the deal and realizing the premium. However, many long-term deals are booked using unknown floating premiums that might have 6-12 months or even longer between the date of agreeing the physical contract and the premium being fixed.
While physical contracts with this structure are commonplace in the aluminum industry, they come with an inherent risk. Companies are agreeing to buy or sell metal at a premium they may not known for months. This is where the ability to hedge that premium risk comes into play.
CME premium contracts are swap contracts that are financially settled. One leg of the swap is executed at a fixed number, and the other leg of the swap is linked to the above publication's daily premiums for each of the respective markets. They are the same tonnage size as the aluminum contracts that trade on the CME and LME: 25MT. What this means, is that if you are selling ten lots of September CME aluminum European duty-paid futures contracts at $350/mt, you are also agreeing to buy ten lots at whatever the Fastmarkets Aluminum P1020A, in-whs Rotterdam Duty Paid September average premium is at the time of publication.
So why would a trader consider using these swaps to mitigate their risk? Let’s say a trader in the USA is long 1,000 mt of physical aluminum that they bought from a producer at a fixed premium of 20 cents/lb. The metal won’t be delivered for another month, but as luck would have it, the aluminum market has tightened since they bought at 20 cents/lb, and premiums have gone up to 25 cents/lb. Your sale is pricing over the following month’s Platts average. If you take no action on the CME, you are at risk of the market cooling and your profit decreasing from the 5 cents/lb you would get on today’s spot market (25 cents spot sales minus your 20 cent purchase premium). To prevent this from happening, you enter into a CME premium sale at 25 cents. Per above, this means that you are agreeing to sell at 25 cents, and buy at whatever the following month’s Platts average ends up being. Essentially, you have converted your physical sale premium from an unknown number (the following month’s average) into a fixed sale at 25 cents. The four trades you have transacted are shown in the table below. Even if the premium for the following month crashes to 17 cents/lb, you are still making your 5 cents/lb margin.
5c/lb margin locked in
The trader has locked in their profit between the CME fixed sale and the fixed premium purchase. The physical sale premium is perfectly offset against the second leg of the CME swap where they are buying over the same premium as the physical sale. Typically, traders will enter into this type of contract if they think that the market is peaking and don’t want to risk premiums falling. They may also be happy with the current margin they could make using CME Premium contracts and not want to take the risk premiums could decrease. Similar to outright price hedging, their upside is also capped in this scenario. If premiums actually carried on increasing, they would not see any of that upside. Remember, hedging is a risk mitigation tool. The risk here is that premiums will decrease, so you hedge to protect yourself against a move you have no control over. Premium swaps can equally be used to hedge against floating purchase premium risks that end consumers and traders face by buying fixed CME swap contracts, instead of selling them.
CME premium swap positions must be carefully managed to ensure that they are matched with physical QPs, failure to do so will lead to creating risks rather than mitigating them. We discuss all of these nuances in depth in our courses.
