Hedging Without Futures
When it comes to commodity hedging, futures markets provide a clear and relatively simple method of mitigating price risk. However, for some commodities, hedging using futures may not be viable, or it might not be the best option for those products. Let’s first look at some of those scenarios that lead to companies taking an alternative approach to risk mitigation, then we will discuss how they might proceed without using futures to hedge.
For a futures contract to act as a hedge for a commodity, the price of that futures contract must be highly correlated with the price of the underlying physical commodity. For example, if a company trades refined copper, the price of the physical copper contract will be set using the futures market as a basis for the price. Therefore, there is a 100% correlation between the physical commodity and the futures price. If the price of LME or CME copper increases or decreases between the physical purchase and sale, the price of the physical sale contract will directly reflect this change.
However, some prices for physical commodities are not highly, or even slightly correlated with the equivalent futures markets. Take scrap lead-acid batteries in the United States for example. A scrap lead-acid battery is approximately 50% refined lead by weight. You’d be forgiven in thinking that a good hedge for a scrap battery purchase in the US would be to sell LME lead futures equivalent to the tonnage of the 50% lead contained in the purchase. But the price of scrap batteries in the US trades almost independently from the price of lead on the LME. If you were to use LME lead futures as a hedge for your physical scrap batteries, you could well get a scenario where the price of scrap batteries decreases between your purchase and sale, but the price of LME lead increases, which would lead to a loss on the physical and on the futures trades, detailed in the below chart.
Hedging has not mitigated the price risk in this case
As discussed in prior posts, the aim of hedging using futures is to offset any price change between physical purchase and sale, in this example, the futures hedge actually created additional losses.
Another scenario where hedging using futures is not simple is when the commodity does not have a liquid enough futures exchange to properly execute the required volume of contracts. Exchanges are always looking to expand into new markets to increase their flow of business. However, it often takes time to build a critical mass of participants that make trading futures seamless. And sometimes exchanges will pull the plug on contracts that simply aren’t generating enough interest to create a functioning price-setting mechanism. For example, there is vastly more physical steel traded globally each day than steel futures contracts executed. If a trader wanted to execute a 10,000mt (400 lots) aluminum trade on a single cash settlement, they would be able to do this relatively easily. However, if a trader wanted to execute futures for 10,000mt (1,000 lots) of LME steel futures on a similar settlement, there would (at the time of writing) likely be nowhere near enough liquidity to do so. For companies that trade commodities with low liquidity on their corresponding futures exchanges, hedging can be a lot trickier and require a lot more forward planning than high-volume commodity futures.
There are also commodities where there simply is not a corresponding futures exchange to trade on. A lot of ferrous and minor metals will trade based on prices printed in publications such as Platts or Fastmarkets. Here, the various reporters at those publications will phone their producer/consumer/trader contacts and try to ascertain the daily, weekly, and monthly prices that are being traded in the market. Physical contracts for these commodities will take whatever price is printed in these publications at the time. Since no futures exchange exists, these companies cannot use futures to hedge their price risk.
Even when physical prices are highly correlated to the futures markets, and there is plenty of liquidity to execute a hedge, a company may still not use futures to mitigate price risk.
Most companies will perform a netting of all of their physical QPs before executing futures hedges. Put simply, this means that they will take all of their physical contracts that are set to price on a single-day cash settlement, a partial average, a full month average, etc., and combine them to give a single position - either buying or selling futures, or taking no action on the futures market at all. If a physical purchase and sale for the same commodity have exactly the same QP, a company will not sell futures for the physical purchase, and buy futures for the physical sale, they will simply use the physical contracts to offset the price risk. Even if the tonnages don’t match, for example, if they are buying 500mt of zinc on the following day’s cash settlement, and selling 300mt on the same, they will simply sell futures for the balance of 200mt zinc that is not offset. Netting contracts like this saves on broker commissions and initial/variation margin consumption. There is no point in executing futures hedges for the sake of price mitigation if the physical contract QPs are already perfectly offsetting all of a company’s price risk.
So what can a company do to try and mitigate its exposure to price volatility if hedging using futures is not a viable option?
Some companies that trade these products do so because they believe they have market insights that allow for profitable trading. They will either go short at a certain price in the hopes that by the time they cover their sale, the price will have dropped and they will make money. Or they believe the price of the commodity will increase, so will go long physical in the hopes that by the time they sell it, the price will increase.
Other companies may have geographical or situational arbitrage opportunities and be able to buy and sell commodities simultaneously at differing prices, locking in a profit margin without being exposed to further changes in the price. These are known as ‘back-to-back’ trades.
In illiquid futures markets, companies may try to layer into their hedges so as not to spook the market and drive the price up or down due to their trading actions. For example, if a company needs to execute 100 lots of futures contracts and the current liquidity is only 20, they might do multiple trades of a smaller number of lots over the course of a day, or even multiple days after fixing the price of their physical contract.
In less liquid futures markets, iceberg trading is common whereby only a few lots of a much larger order are shown at a time. Let’s say you want to sell 100 lots of LME tin at $35,000/mt. If try to execute all 100 lots at once, it reduces the chances of getting filled because all other participants can see your very large order. However, if you iceberg this order 5 lots at a time, it might be more successful. Once the first 5 lots are filled at your target, the order is automatically placed again so that it may look like a fresh order to the rest of the market and is (hopefully) less likely to cause a price crash if you are selling or a spike if you are buying.
While using futures is by far the most common way of hedging a company’s price risk, it is not always straightforward. Making sure that you fully understand your specific markets and the various nuances between them is imperative to protect company margins.
