Gross Vs. Net Tonnage
An important concept to familiarize yourself with, particularly for new starters in the industry is the difference between gross and net tonnage. The difference between the two with regard to hedging is as important as the difference between gross and net profits when assessing a company’s performance.
Some types of trading such as concentrates trading or scrap trading utilize payables (the amounts you will pay a supplier for the metal) that are percentages, either of the commodity and/or of the exchange price, based on the chemical analysis of that material. Concentrates hedging is also affected by moisture levels. When a metal concentrate is mined, it will contain a certain amount of moisture. No one is going to pay for water weight-so the payable, and therefore hedgeable tonnage is adjusted for this. The gross tonnage (including moisture) of a concentrates parcel is referred to as the wet metric tonnage (wmt). The tonnage you will calculate your hedging requirements from, adjusted for the moisture level, is referred to as the dry metric tonnage (dmt).
For example, a copper concentrate may only contain 25 percent copper, and the industry-standard payable for copper is 96.5 percent of that contained copper. A 10,000 wmt copper concentrate shipment with a moisture level of 8% would equate to a dmt of 9,200 (10,000wmt 92% non-moisture). Using a copper payable at 96.5 percent and 25 percent copper content would equate to a hedgeable tonnage of 2,225 to the nearest 25mt lot (9,200dmt 96.5% payable copper * 25% copper contained). Whenever you have a metal contract where the payable is less than 100 percent, you only hedge the metal contained, payable tonnage. In this example, that would be 2,225 mt or 89 lots of copper as shown in the table below.
A correctly executed hedge based on net, payable tonnage
There has been no impact on P&L from the price increase between physical purchase and physical sale. Now, in reality, the cash flow for the physical trades will be very slightly different from that of the futures. As discussed in our recent article on the perfect hedge, there will always be a slight difference between the exact physical tonnage and the hedged tonnage but for illustrative purposes, I have kept them the same here.
If you were to hedge this contract on the gross wmt instead of the payable, contained copper on the dmt, you would actually be creating price risk instead of mitigating it. As seen in the table below, this could easily cause large losses. By hedging the full wmt of the concentrates shipment of 10,000 wmt, you have over-hedged by 7,775 mt or 311 lots, creating a large exposure. The price has risen $1,000/mt between pricing the purchase and the sale. You are only able to charge 96.5% of 25 percent of the 9,200 dmt on the sale so while you gain $1,000/mt on the 2,225 mt of payable physical, you have lost $1,000/mt on 10,000 mt of futures, creating a hedge loss of $7,775,000.
An incorrectly executed hedge based on gross tonnage
Often staff are in such a rush to send hedging orders that they overlook these details and it can have catastrophic consequences if systems are not in place to prevent these errors. While speed is often key when it comes to hedging, it is worth taking your time to ensure you understand a concept fully, ask questions (multiple times if you need to), and have a colleague double-check your work if there is any doubt in your mind that you are correctly executing a hedge.
