Newsletter XXXIX - October 19th, 2024

Aluminium & Copper: this week sentiment:

Monday October 14th (9780 to 9638 – 2633 to 2580): ?corrections and less volatility

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Tuesday October15th (9595 to 9527 - 2596 to 2574): Commodities markets down across de border

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Wednesday 16th (9648 to 9527 – 2604 to 2573): and up again!

Thursday 17th (9673 to 9443 – 2600 to 2546): and down again!

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Friday 18th (9666 to 9492 – 2619 to 2552): and up again after fresh positive China news!

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?Economic data

·????? Markets are losing confidence in China’s stimulus measures.

·????? UK inflation closer to the Eurozone's 1.8%.

·????? USA Retail sales in September exceeded expectations, rising 0.4% MoM compared to August 0.1%

·????? The ECB cut interest rates for the third time, lowering them from 3.5% to 3.25%.?

·????? USA Initial jobless claims for last week also came in lower than forecast.

·????? China's CPI figures indicate continued deflationary environment.

Federal Reserve:

Market bets (92%): 25 BP interest rate cut (November) .

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LME Copper and Aluminum:

Again, a very volatile week with correction episodes followed again by Friday’s news about a bit more optimism on China.

Aluminium 2612 vs. 2636, Copper 9627 vs. 9729?

3 month. Contango curves:

Aluminum contango 36 vs. 10 last week. The short-term squeeze October November gone and contango looks normalized.

?Look how amazing the evolution of cash to 3 months during the first half of October:

And the aluminum curve:

?Copper contango 131 vs. 134 last week.

Zinc $3092 vs. 3155, Nickel $16894 vs.17877,

Lead $2073 vs. 2085 and Tin $31325 vs. 33206

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Currency Movements:

The US$ continues its strength against Euro and flat against British pound moving from 1.0963 to 1.0868; British pound moving from 1.3038 to 1.3048

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Stock Market Performance: incredible the 3 the same!

The S&P 500 +0.84% (5864 vs. 5815), the DOW is +0.96% (43275 vs. 42863), and the NASDAQ +0.80%(18489 vs. 18342).

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HEDGING - THE BEGINNING - PART V: How Long To Hedge?

The Seven Basic Questions You Need to Answer Before You Start – THE END. (Complete version)

?Introduction

The first step in designing a hedging policy is to answer several fundamental questions. Let's begin with the first one.

?1. Why Hedge, and What Should You Hedge?

?To explain this, let’s look at a simple example:

- An American aluminum cable producer sells 100% of its production to Spain, priced in euros at a fixed rate.

- The sales price is fixed annually, every October.

- The primary input for cable production is Primary Aluminum.

- The cost of aluminum fluctuates, adding variability to production costs.

- Other cost components do not present significant risks.

- The company's functional currency is the USD.

?Why and What to Hedge?

The primary reason for hedging is to manage the "price risk" associated with aluminum, as it’s a commodity prone to significant price volatility.

?See last year's volatility as an example:

Additionally, hedging is necessary to manage the euro/dollar exchange rate risk, since sales are priced in euros.

See last year's volatility for the euro/dollar exchange rate:

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?Fluctuations in commodity prices and exchange rates can directly impact profitability. However, how much impact is considered acceptable is subjective.?

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Why Hedge? To Manage Risk:

When defining hedging strategies, you enter a subjective realm.

"Impact" or "alteration" of profitability doesn’t have a set standard; it’s up to the management team to decide how much risk they are willing to tolerate.

This decision will depend on their risk aversion and whether they want the company to be fully hedged or remain partially exposed to market movements.

Risk tolerance is a core part of strategic policy and varies by business.

Hedging aims to eliminate as much price risk as possible from commodities or currency fluctuations, under the right conditions.

?This is why we hedge—to mitigate the risks that could otherwise disrupt the profitability and stability of the business.

2. How Much Should You Hedge?

A concise answer is that you should hedge the total amount exposed to commodity price risk.

?Creating a "Risk Map" is essential. This can range from simple to complex.

?For example, the above-mentioned case of an aluminum cable producer (Hedging consumption):

?if sales and monthly aluminum consumption are fixed, the map is straightforward. With 1000 tons consumed monthly, you’d hedge 40 lots per month (1 LME lot = 25 tons).

?For example, an aluminum smelter.

?For a smelter producing 50,000 tons monthly, a more complex map is needed.

?Consider production, inventories, fixed-price sales, and cost components like alumina or energy before determining the total risk exposure.

?Production: 50.000 tons

- Tons of sales at a fix price

+ Tons of Aluminum Inventories

- Equivalent tones for Value of Purchases of Alumina priced in Aluminum

- Equivalent tones for Purchases of Energy priced in Aluminum

?And finally, management decides how much risk to hedge.

3. Reactive or Proactive Hedge?

?When you are about to execute a hedge, you may encounter two distinctly different situations:

·????? Hedge of a specific transaction or Compensatory Hedge

·????? Hedge of a continuous operation or Strategic Hedge

?a.??? The Compensatory Hedge or Reactive Hedge?is the type of hedge that we put in place to offset (eliminate) the risk of one or several specific and one-time transactions.

What does this mean?

For example, if you are a trading company, you purchase 2,000 tons of aluminum at a fixed price of $2,500 (cash price), and immediately negotiate with a client to sell it based on the QP (quotational period) that will be determined on the third Wednesday of October. To compensate for this risk, you would specifically go short (sell) by setting a futures contract for the third Wednesday of October (40 lots).

This is what we call a Compensatory or Reactive Hedge. This way, a compensatory, proactive hedge is established, which I also like to call a “Mirror Hedge.”

Why mirror? Because the structure precisely reflects the exact risk that needs to be covered.

If you plan to distribute the sale among several clients with different QP dates, you will execute as many hedges as necessary. Your risk will be completely mitigated. Once again, your profit will be the differential between the premiums paid during the purchase and the premiums agreed upon during the sale, plus any contango (if present) between the cash price and October, or minus any backwardation (if present) during that period.

b.The Strategic Hedge or Proactive Hedge is the type of Hedge that we put in place to offset (eliminate) the risk of a non-specific transaction but an ongoing exposure.

?What does this mean?

?For example, let's consider the case of a copper mine (the same example can apply to an aluminum smelter).

?Suppose the mine has a certain amount of copper reserves that it will start selling from January 2026. In this scenario, the mine has good estimates of its monthly availability for sale and has partial pre-sale agreements for 2026, but nothing yet for subsequent periods.

?Clearly, there is exposure to a decline in copper prices.

?Management has decided that they want to ensure a revenue stream that will cover fixed operational costs, variable costs, amortization, and debt payments over the next 5 years.

?Unlike the previous case, a compensatory or reactive hedge cannot be established since the exact QP (quotational period) of future sales is not yet known.

In this situation, the company will set up a hedge for each and every month (5 years = 60 months) on a month-by-month basis, known as a calendar hedge. Most likely, they will place the hedge on the most liquid day of the LME price structure, which is a short position for the third Wednesday of each month from 2026 to 2031 (hedging is possible for up to 10 years).

?This way, a compensatory, proactive hedge is established, which I like to call an “Umbrella Hedge.”

?Why umbrella? Because the structure covers the overall (global) risk, like shielding from rain, rather than addressing each specific risk individually (tip by tip).

But it doesn't end there.

?As sales operations are finalized, the hedge will need adjustment. This means, if necessary, converting the short position from the third Wednesday into a short that precisely mirrors the exact risk intended to be covered.

4. When to Hedge?

?To answer the question, I will divide the response on when to hedge into the following outline:

1. If it's the very first-time hedging is being implemented.
2. If a hedging policy is already in place.

a.??? If it's the very first-time hedging is being implemented.

Let’s briefly review the genesis of the decision to adopt a hedging policy.

I've encountered all kinds of experiences, from large multinational corporations to very small family businesses where the owners are directly involved in operations. Sometimes, decisions boil down to a single individual.

To clarify this topic, it’s important to understand the significant difference between roles and statuses when approaching hedging policies. The statuses, broadly speaking, are:

• Shareholders:?They make the ultimate decisions as the owners.
• Board Members:?They lead the company based on the mandates they receive.
• Risk Committee:?They implement the decisions made by the Board concerning risk management. The responsibility for designing and executing the hedging strategies resides here, and this status dictates the specific role.

It’s possible that the Risk Committee consists of individuals who are also shareholders and board members. However, their actions in the committee are not as shareholders but in their role as risk managers. This may seem mixed, but it’s not.

Therefore, all answers to any questions that arise will depend on the status from which they are given, fundamentally depending on delegation.

Now, when to start hedging can be more challenging when it's the first time. This also occurs in human relationships; all first times are more difficult—in love and in risk management.

The easiest scenario to address is in the case of?Reactive or Compensatory Hedging.?In theory, hedging should be executed "as soon as the risk arises." However, in practice, many organizations, particularly trading companies, allow traders to hedge within a permitted speculative framework. For example, executing the hedge minutes, hours, or even days before or after the risk materializes.

The most challenging scenario is establishing?Proactive or Strategic Hedging.?This can range from "right now" to "when prices reach a certain level."

The "right now" approach raises another question: intraday volatility is constant, so the "right now" strategy may need to be more flexible. I've seen situations where this is resolved more easily when, in a smaller organization (not by size but by decision-making structure), the shareholder themselves executes the SHORT or LONG hedge.

Decision-making is easier when a range limit is set. For example, a smelter may decide to hedge their exposure when aluminum is trading at $2,700, but only when it reaches a minimum of $2,800 (limit) and never below $2,600 (a stop).

b.??? If a hedging policy is already in place.

When it comes to Proactive or Strategic Hedging, the decision of when to hedge becomes much simpler when it involves continuation or renewal.

Setting policies that include the rollover of hedges further simplifies strategic hedging, as it allows for continuous renewal of the positions as they mature.

The range of possibilities for hedge rollovers is also quite broad. Here are some examples:

·?????? Strictly at maturity:?The hedge has served its purpose and is closed at expiration (lending, borrowing or closing the position).

·?????? In a contango market for a producer’s hedge:?In this scenario, a new hedge may be established earlier (advance renewal), and the expiring hedge is closed at expiration (similar to splitting a borrowing position into two moments).

·?????? In a backwardated market for a consumer’s hedge:?Here, a new hedge may be set up earlier (advance renewal), and the expiring hedge is closed at expiration (similar to splitting a lending position into two moments).

5. How to Hedge?

Note: I will not explain futures or options in detail here, as I have covered them extensively in previous newsletters. Instead, I will broadly discuss why one might choose one tool over the other.

Now… At the time of answering we would need to face the following aspects:

a. financial aspects:

- Short and long futures: These require the fulfillment of initial margins and variation margins.

- Initial margins are always a guarantee integrated with the broker and do not constitute a loss.

- Negative variation margins represent an accrued loss, which will be realized (confirmed) when the futures position is closed.

- Positive variation margins represent a gain to be realized, which will only be finalized when the futures contract is closed and, importantly, can only be collected on the prompt date. It doesn't matter if the future was closed before the prompt date.

- Purchased (long) options: The only obligation is to pay the premium.

- Sold (short)options: These require both initial margins and variation margins.

- Initial margins for sold options are calculated based on the probability that the sold option will be exercised. If the strike price is ATM (At the Money), the probability is 50%, and the initial margin required will be 50%.

- Variation margins for sold options will be the cost of buying them back at the end of each day.

b.technical aspects:

Futures Styles:

• Futures contracts always have a prompt date.European futures: The prompt date is a specific day. The future is traded at a fixed price for that one specific day, and whenever the position is closed (settled), it’s always for that specific date.Asian futures: The prompt period covers an entire month. The future is traded at a fixed price throughout the month and is settled based on the average price over that specific month.

Option Styles:

• American-style options: Although they can be exercised at any time before expiration, in practice they often function like European options, as there is seldom an advantage to exercising or abandoning them prior to their expiration date.
• Asian-style options: Unless closed (unwound) before expiration, these options are automatically exercised or abandoned based on the average official cash settlement price during the month in which they were established.

c.??? economic aspects:

Using Futures:?When you use futures, their inherent mechanism ensures that the established future price becomes the final price in your economic equation.

In other words, the price used for hedging will be the final price that determines the outcome of the protected business.

The exception would be if, instead of using a compensatory hedge (also known as a mirror or reactive hedge), you use a strategic hedge, also referred to as an umbrella or proactive hedge.

In this case, the final price in your economic equation will appear once you adjust this hedge to match the mirror hedge—when you know exactly how the price of what you're hedging will be determined.

It’s important to note that, many times, what begins as a strategic hedge may coincidentally end up being the final mirror hedge.

Using Options:?When you use options, you incur a cost that is generally quite high. It works exactly like your car insurance: you protect yourself against risk (as we've discussed in detail in previous newsletters).

Whenever you use options, you typically have two objectives:

1. To be protected from price risk at the coverage value you've chosen.
2. To aim for an improvement in your business outcomes, hoping to never exercise your purchased options and secure a final hedge price that is better than the one you're protecting. Otherwise, there’s no reason to incur the high cost associated with options.

d. strategic aspects:

It is imperative to have a market outlook.

I use this term so definitively because, in my view, "not having a vision" is still a vision.

In other words, my vision is that I have no idea where the market is heading. This is often the case among consumers and producers, and much less so in trading companies, where having a market outlook is a cornerstone of their business.

Now, assuming I’m ready to hedge, let’s broadly categorize the scenarios:

1. I don’t have a clear vision of where prices are heading: I use futures as a hedging tool.
2. I have a clear vision of where prices are going, but I’m not interested in speculating on it: I use futures as a hedging tool.
3. As a producer, I have a clear vision that prices will rise: I use long put options (always ensuring that the cost plus my price outlook result in a viable value).

Note: I’m not including short call options here so I don’t overwhelm you—too much (lol).

1. As a consumer, I have a clear vision that prices will fall: I use long call options (always ensuring that the cost plus my price outlook result in a viable value).

Note: I’m also not including short put options here so I don’t overwhelm you—too much (lol).

So… How to Hedge?

To wrap this up and leave you thinking, remember that you can always mix strategies based on your vision and risk appetite: combining futures with options in different percentages and at different strike prices.

In this question, I won't delve into the details of futures or options, as those topics have been covered elsewhere. Instead, I'll focus on the general reasons why you might choose one hedging tool over the other. When considering futures versus options, it's important to weigh financial, technical, economic, and strategic factors.

?6.How Long to Hedge?

?Let's continue with the previous examples.

?Aluminum Smelter:?

?Since production is continuous, the hedging horizon will be determined by the shareholders or the Risk Committee, depending on the scope of their delegated mandate.

The price structure of the London Metal Exchange allows hedging with futures up to 120 months for Copper and Aluminum, 63 months for Zinc, Nickel, and Lead, and 15 months for Tin.

The factors that influence how long to hedge can vary, including:

• The need to establish a fixed dividend policy over a multi-year period.
• Long-term debt commitments.
• The necessity to finance certain investments with internal capital.

?All these considerations are related to securing prices that help stabilize cash flows in order to meet these commitments.

Copper Transformer and Traders Matching Quotation Periods:

The answer here is much simpler. The hedging horizon is strictly limited to the risks identified in the Risk Map. No more.

7. Where to hedge, and through whom?

?Where?

Three different markets should be considered, pretty much depending the nature of the QP and markets used in the physical contract.

LME: ?At the London Metal Exchange (LME), non-ferrous metals such as Aluminum, Copper, Zinc, Nickel, Lead, Tin, Aluminum Alloy, NASAAC, Alumina, and Aluminum Scrap are traded, as well as ferrous metals and electric vehicle materials. Prices are quoted in U.S. dollars.?

CME: At the Chicago Mercantile Exchange (CME), Copper and Aluminum are traded, along with ferrous metals, precious metals, and other industrial metals, also in U.S. dollars. Aluminum at the CME has a small participation.

SHFE: At the Shanghai Futures Exchange (SHFE), metals such as Aluminum, Copper, Zinc, Nickel, Lead, and Tin are traded, as well as ferrous, precious, and other industrial metals, with prices quoted in Chinese yuan.

The principle is to use the market where "the unknown price will be discovered." While markets often show positive correlation, it is advisable to hedge in the futures market that corresponds to the contract whose risks you want to cover.

Through Whom to Hedge?

In none of these markets can you hedge directly without a broker. Brokers and authorized members are necessary for access to executing futures and options contracts. They provide the required access to electronic platforms and liquidity needed for hedging operations.

?Summary:

?We have finished with the key questions in designing a hedging policy, starting with why and what to hedge. It illustrates using an aluminum cable producer selling to Spain with exposure to aluminum price and euro/dollar exchange rate risks. The rationale for hedging is to manage these risks to stabilize profitability.

Different hedging strategies include reactive or compensatory hedges, which address specific transactions, and proactive or strategic hedges, which cover ongoing risks. The timing of the hedge depends on whether it's the first time hedging or if a policy already exists.

To hedge effectively, it's crucial to choose the right market (LME, CME, SHFE), and brokers are essential for executing contracts. Several factors influence the decision, including financial, technical, and strategic aspects.

10 Bullet Points:

1.??? Why and What to Hedge: Hedge to manage price risks in commodities and currency exchange fluctuations, which impact profitability.

2.??? Aluminum Cable Producer Example: Highlights the need to hedge aluminum price risk and euro/dollar exchange rate due to fixed annual pricing in euros.

?3.??? Types of Hedging Strategies:

·????? Reactive Hedging (Compensatory): Covers specific transactions, like a one-time sale.

·????? Proactive Hedging (Strategic): Addresses continuous exposure, such as covering future copper sales over five years.

?4.??? Market Selection: Use the market where the "unknown price" will be discovered (LME, CME, SHFE) based on the nature of the physical contract.

?5.??? Hedging Requirements: Hedging cannot be done directly; a broker is needed for access to futures and options markets.

?6.??? Risk Tolerance: Determining how much risk to hedge depends on management’s risk aversion and strategic policy.

?7.??? Timing the Hedge: Varies between first-time hedging and established policies; can involve immediate action or specific price triggers.

?8.??? Financial Considerations: Involves margins for futures and premiums for options, with different implications for cash flow.

?9.??? Technical Factors: Choosing between European or Asian futures and different option styles (American or Asian).

?10. Strategic Decision-Making: Requires a market outlook to determine the appropriate hedging tool and strategy based on price forecasts.

Stay Tuned for The Next LIVE EVENT October 21st ???8AM ET – USA: ?this same topic!

https://www.dhirubhai.net/events/lmehedging-thebeginningpartii7243646312733118466/theater/