HEDGING FOR MINERS, IS IT THE RIGHT PATH?

It has been about a month since the 2023 LME week took place in London. One of the topics several market players asked me about was my metals price perspective for 2024. We discussed about which levels miners, smelters and traders were using for their next year’s budget -but in summary-, it was very hard to reach a consensus about it. I continued this interesting debate with a few of them during the days to follow and as usual, hedging stepped in during the conversations.

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Depending with whom you are discussing, hedging could be a very controversial topic. Most of the miners that are hesitant to engage in this type of contracts prefer to remain exposed to the metals prices and benefit from the market volatility that will drive their share price. They prioritize their operational side that will allow them outweigh their business risks and reach certain level of reasonable financial stability. In other cases, the complexity of these transactions together with some documentary barriers keep market players away from this field.

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Nevertheless, I believe hedging has not been properly advertised to the industry during the last years. On one hand, the simplest transactions can lack of compelling financial elements necessary to warrant implementation. The achievable targets can be not good enough, or simply the cost of a safe bet is too high. On the other hand, some of the exotics and more complex instruments could still resemble the enduring impact of the derivatives role on the financial crisis of the late 2000’s.

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However, the scope of hedging or more precisely, the use of financial derivatives, can go beyond the traditional applications for a risk management strategy. Conceptually, hedging is targeted to secure price stability that will allow companies to protect profits by reducing the impact of market volatility.

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THE USE OF HEDGING (FINANCIAL DERIVATIVES) WITH METAL PRICES

Elaborating a bit on the definition stated above, the simple hedging transaction of fixing a price for future sales could be enough for some market participants. But the same concept could be too rigid for other market players that see in it a failure to capitalize from market opportunities given by price fluctuations.

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Without trying to exhaustively list the uses, we may classify them as follows:

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TRADITIONAL HEDGING:

When we speak about hedging, the first thing that comes to our minds is to fix a price. And actually, this is how many miners successfully use hedging. There is no exact recipe for how to do this the right way but as long as you have all the internal green light from the directors, finance, commercial, accounting and anybody else that could be directly connected with the decision, you should be ok. It is a bit more complex than that but you basically have to adhere to the company’s and market regulations ensuring full compliance in all the possible fronts. It has to be clearly defined who will decide, approve, execute, register, pay (if applicable), review and audit. All participants along the chain must understand the transactions, especially those who liaise with the accounting, legal and tax issues. The best hedging transaction could be shadowed by a poor documentation backup and can even be lost in its economic result if the tax regulations are not properly understood.

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But going back to the result itself and the hesitancy on hedging for the stiffness on its traditional concept, fixing a price is not the only way to mitigate price risks. You can also buy options which will have a cost, or even move to zero cost collars which will give you a price range instead of a fixed level where you can still exploit a market upward trend. Collars have been an instrument well used by many miners but mainly on the Zero cost version which will give you a floor (always lower than the fixed price alternative) but will grant you a ceiling up to which you will benefit from the price swings. Collars can be tailor made and depending on the price targets a company may have, you can add a bit of cost and either amplify the ceiling or move the floor upwards. In any case you will need a financial intermediary that could construct these financial structures and don’t forget…. to have them properly approved, executed and documented.

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As the collar can be tailor made, a wide variety of adventurous structures can be created based on the price preferences a miner can have. Besides the traditional swaps and collars, we can use flexi-collars, extendibles, accumulators, or many others with barriers, knock-in’s, knock-out’s, etc. Some of them are very risky structures and need a very high level of expertise not only to construct them but also to monitor them. The mark to market valuation can also be tricky and some financial institutions use millions-of-dollars’-worth software to manage their positions. At the end, all these structures are built based on vanilla derivatives combined in a particular way and are mainly managed on an Over The Counter mode.

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TREATMENT CHARGE AND ESCALATORS:

On the miner-smelter or trader negotiations for treatment charges (TC), metal price hedging strategies can also be applied provided escalators are involved. This is much related to zinc concentrates and the hedging of escalators allows miners to receive improved terms on the TC provided the buyer (usually a trader) has a way to secure the handling of this component. The miner can concede a higher escalator ratio in exchange for a more competitive TC. The escalator should be hedged mainly through options or option-related instruments to avoid the impact on the TC discount amid a price increase. It is a win-win deal where the miner benefits from the lower TC and the merchant receives a substantial risk flexibility to trade with.

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PRE-PAIDS

The last but not least is the financial side of the “hedging” applications. To fix a sale price in the futures market is in theory to agree to sell a certain amount of metal at a fixed quote on the expiration date. Most of the transactions don’t end on a real delivery of the metal and are liquidated in paper. The basic Pre-paid transaction consists in fixing the price for a later ‘delivery’ but you are paid in advance when you agree on the transaction by using your hedging credit lines as collateral (preferably un-margined). As no physical delivery will take place, you will have to offset the transaction like any other hedge in paper. However, the price difference between the start date and the expiration date could prompt a higher financial cost for the reimbursement of the funds received at the beginning. Therefore, you must simultaneously offset the transaction on the start date to reduce the price spread to the minimum possible. This price spread will eventually be your interest rate cost. This structure will be very useful nowadays when the cost of funding is at record highs and will also allow you to diversify the payables’ side of your balance sheet.

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Hedging has many applications for price risk mitigation, but to use them will depend on each company on a case by case basis. The important fact is to know that they exist and to understand them in case at any time they may become useful.

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