Hedging Vs. Leaving It To Chance
For most commodity companies, hedging is not a choice, the concept is ingrained in their trading philosophy in order to protect their margins (and their lenders) against movements in the outright prices of the commodities they trade. Some of you may have questioned why hedging is so important to the long-term survival of companies. Given that the commodity prices trade on exchanges independent from the companies that trade them, failing to hedge against these movements can cause catastrophic losses. Despite what some traders may tell you, they have negligible sway over outright prices, and even the best speculative traders are wrong about price direction almost as often as they are right.
Let’s say your company is physically buying a commodity, 1,000 mt of refined copper cathode for example, and you agree on a price of $8,000/mt. Hedging that purchase would mean that at the same time as fixing the price of the physical material, they sell 1,000 mt of copper futures at the same price of $8,000/mt. Conversely, if they were selling 1,000 mt of physical refined copper cathode at $8,000/mt, their hedge would be to buy 1,000 mt of copper futures at $8,000/mt. In these examples, we are keeping it simple and are not taking into account different prompt dates or the forward curve - these concepts will be discussed another day! For now, let’s assume the hedge price is the same as the physical price.
Using the example of physically buying the copper cathode at $8,000, let’s say they sell those same 1,000 mt of copper three weeks later. The copper price at the time of fixing the sale is $7,500/mt. To hedge the sale they would also buy 1,000 mt of copper futures at $7,500/mt. As shown in the table below, they have mitigated the risk of the copper price falling between physical purchase and sale.
If they neglected to hedge their purchase and the same scenario occurred, the copper price decreased by $500/mt in between fixing the purchase and the sale, they would have lost $500/mt as shown in the following table.
Now, imagine that same risk being taken on every single ton of the hundreds of thousands, if not millions of tons these companies trade per year. Should prices move against them, the losses would be impossible to absorb and they would collapse.
Hedging your price risk does mean that if the price of copper were to increase from $8,000/mt to $8,500/mt from the time of your physical purchase to your physical sale, you would not receive that $500/mt gain from the price increase. But the point here is that you have no idea whether the copper price will move up or down in that period. Hedging allows companies to protect themselves against unknown price movements that are often drastic. Price moves of 5%, 10%, or more are common on base metals, particularly if longer periods elapse between pricing purchases and sales.
Hedging allows companies to become price agnostic - this does not mean they don’t care about the price of a commodity, which also impacts financing costs, margins on futures positions, and a host of other factors - just ask your finance department if they’d prefer a copper price of $6,000/mt or $10,000/mt! But it does mean that if hedging is executed correctly, the profit of a trade will not be affected by subsequent movements in the price of that commodity…However, executing hedges correctly is where companies often struggle, leading to avoidable, costly, repeated mistakes. Perfectly Hedged LLC imparts this crucial knowledge on employees to ensure concepts are understood, procedures are followed correctly, and risks are properly mitigated.
