Stainless Steel Nickel Hedging

Transcription

1 Stainless Steel Nickel Hedging Presented by Catherine Markey and Robert Fig International Stainless and Special Steel Summit 08 September Munich

2 Nickel hedging a stainless example

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4 Origins of commodity price volatility Consumer Demand Production steps Volatility is inherent in commodity markets. Stems from lack of responsiveness of both demand and supply in short term

5 Volatility is inherent in commodity markets Inflexibility of supply: Economies of scale cheaper to add production in large quantities High fixed costs Development lead times Inflexibility of demand: Lack of substitutes Sensitive to business cycle Destocking in downturn Large price swings needed to force capacity offline during a surplus, and bring it back online during a shortage

6 Overview Volatility in nickel prices has a significant impact on a stainless producers results - hedging can help to mitigate a producers exposure Record Max Date: 16 May 2007 Price: $54,200 Record minimum Date: 5 Feb 2007 Stock: 2,982 tonnes

7 What is hedging?

8 What is hedging? Hedging Establishing a position in a commodity futures market (LME) which is equal and opposite to a transaction made on a physical market. Protects against adverse price movements Locks in an agreed profit margin Protects inventory value

9 Hedger vs. speculator A Hedger starts with a price exposure, buys or sells futures contracts, and therefore offsets the price exposure. A Speculator starts without price exposure, buys or sells futures contracts, and takes on price exposure

10 Long hedge rising price Short physical position Contracted price Long futures position Profit - + Loss Market price Contracted price Market price

11 Long hedge rising price Short physical position $22,000 Long futures position Profit -$21,000 + Loss $23,000 Contracted price Market price

12 Long hedge falling price Short physical position Contracted price Long futures position - + Market price Contracted price Market price

13 Long hedge - falling price Short physical position $22,000 Long futures position Profit - $21,000 + $23,000 Loss Contracted price Market price

14 So now you have decided to hedge.. What next?

15 The structures inside a corporate Risk Management principles are defined in a company policy, where all activity is overseen by senior management and the Board, where all instruments and limits are pre-approved and a clear, independent reporting mandate and structure put in place. Trading and reporting are separated with front, middle and back office which function independently of one another Ideally, hedging mandates would be sought by the front office, approved by senior management in a timely way and executed promptly All reporting of P&L and accounting would be handled by the middle office and all settlements handled by the back office.

16 Overview Six main exposures can be identified: 1. Transactional 2. Seasonal variation 3. Structural 4. Strategic 5. Opportunistic 6. Structured trading commodity finance

17 1. Transactional exposure Is systematically hedged at the same time the related commercial contracts is implemented Hedging offers customers a fixed price for the nickel content within the stainless contract Aim: to protect margins by matching the terms of a fixed price sale and the maturity of the LME hedge to correspond with the month of end-product delivery and restocking. Charges 40% Nickel 30% Labour 30% *based on EU domestic 304 stainless steel

18 Monthly Physical Pricing Typical pricing formulae: M 1 (pricing month before month of shipment) M (pricing month of shipment) M+1 (pricing month after month of shipment)

19 Average Swaps Buy/Sell Fixed Price for Floating Price Floating Price can be MASP (Monthly Average Settlement Price) or other agreed average (3 months buyer or seller, Cash Mean or 3 months mean etc.) Some producers currently use 21 st prev month to 20 th current month Currently OTC contract. LME contract launching Oct 2011 using MASP as Floating Price

20 Benefits of using LME average swap Stainless producer can offer Ni (and also Moly) percentage of alloy surcharge at a fixed price Stainless consumers and stainless product consumers can better market products at fixed prices when their supplier has guaranteed a fixed price for the nickel and moly

21 Offset hedge example XYZ Stainless Steel Inc. LME Sep Buy x tonnage December LMEnickel swap Fixed $21,500 - Floating Dec MASP Physical Sep Sold stainless steel deliverable base plus $21,500/mt Nickel content

22 December Monthly Average Settlement Price - $23,000/mt

23 Offset hedge example XYZ Stainless Steel Inc. LME Sep Buy x tonnage December LMEnickel swap Fixed $21,500 - Floating Dec MASP 31 st Dec Dec MASP is $23,000 Receive difference Fixed vs. floating $1,500/mt Nominal LME profit = $1,500 Physical Sep Sold stainless steel deliverable base plus $21,500/mt Nickel content 31 st December Sell Stainless base plus $21,500/mt Ni content Buy physical Nickel at MASP $23,000/mt Physical loss = $1,500/mt

24 2. Seasonal exposure Results from a seasonal drop in business flow - leading to a quotational period mismatch between purchases and sales of nickel contained in the final product 12 Thousand tonnes Excess Sold Excess sold forward as Jan LME swap 0 Purchases Nov Sales Dec Sales lower than purchases

25 Offset hedge example solution 1 XYZ Stainless Steel Inc. LME Dec Sell 400 lots Jan LMENickel swap Fixed $21,515 - Floating Jan MASP Physical Dec Long 2400 mt unallocated Ni inventory Valued at $21,500 - (current LME Cash)

26 Offset hedge example solution 1 XYZ Stainless Steel Inc. 31 st January LME MASP discovered as $20,000/mt

27 Offset hedge example solution 1 XYZ Stainless Steel Inc. LME Dec Sell 400 lots Jan LMENickel swap Fixed $21,515 - Floating Jan MASP 31 st Jan Receive difference Fixed ($21,515/mt) vs. floating $20,000/mt Physical Dec Long 2400 mt unallocated Ni inventory Valued at $21500 (current LME Cash) 31 st Jan Sell Stainless base plus $20,000/mt Ni content x 2,400mt Nominal LME profit = $1,515/mt Physical loss = $1,500/mt Overall profit $15/mt

28 Offset hedge example solution 1 XYZ Stainless Steel Inc. 31 st January LME MASP discovered as $25,000/mt

29 Offset hedge example solution 1 XYZ Stainless Steel Inc. LME Dec Sell 400 lots Jan LMENickel swap Fixed $21,515 - Floating Jan MASP 31 st Jan Receive difference Fixed ($21,515/mt) vs. floating $25,000/mt Physical Dec Long 2400 mt unallocated Ni inventory Valued at $21500 (current LME Cash) 31 st Jan Sell Stainless base plus $25,000/mt Ni content x 2400mt Nominal LME loss = $3,485/mt Physical profit = $3,500/mt Overall profit $15/mt

30 Offset hedge example solution 2 XYZ Stainless Steel Inc. December Excess inventory 2400 mt. XYZ decides to sell nickel and deliver to LME warehouse LME Cash price when metal goes on warrant $21,500/mt

31 LMEsword system participants LMEsword Electronic Instruction Warehouse Warehouse Agent Depository Other Instruction or Data Transfer Physical Movement/ Manual LCH. Clearnet London Metal Exchange LMEsword Member Warrant Owner Original Owner

32 Offset hedge example solution 2 XYZ Stainless Steel Inc. LME 15th Dec Sell 400 lots Cash LMENickel $21,500/mt Physical Dec Long 2400 mt unallocated Ni inventory Valued at $21500 (current LME Cash) 17th Dec Deliver warrants to broker and receive settlement $21,500 x 2400 mt.

33 3. Structural net exposure Nickel exposure includes all assets and liabilities at risk i.e. when only one side of the input-output cycle is known. It is made up of: + Inventories (at risk since the resale price is unknown) + Future physical purchase commitments at a known price (at risk since the resale price is unknown) - Future physical sale commitments (at risk since the purchase price is unknown + Net LME position = STRUCTURAL NET EXPOSURE Structural net exposure is the average observed un-priced quantity of nickel which can be represented as the permanent inventory (in stocks, WIP & metal contained in end-product).

34 Structural net exposure (cont d) Hedging structural net exposure should not be systematic due to recurrent cash costs related to the nickel forward price structure Rolling of maturing positions by borrowing generates extra revenue when the market is in contango Raises costs when market is in a backwardation.

35 Carries SELL BUY BORROWING IN A CONTANGO EARNS MONEY

36 4. Strategic hedging Strategic exposure to nickel corresponds to the global tonnage consumed by the company, either as primary metal or secondary metal contained in scrap Decision is usually taken at senior management level to capture rare price advantages by buying at exceptionally low prices and selling at exceptionally high prices. E.g. An opportunity would have existed in May 2007 when cash nickel reached $54,200mt and dramatically declined to reach $8,804mt in December N.b. Cash price could only be captured if metal was on warrant in an LME warehouse. Undertaken with clear mandates of expected profits and losses

37 Strategic hedge using options Hedging with futures: The party has an obligation to make or take delivery of metal or to close their position

38 LME traded options contracts The purchase of an option gives the buyer (of the option) the right but not the obligation to buy or sell an underlying futures contract for a fixed delivery date at a fixed price

39 LME traded options contracts A call option The right to buy A put option The right to sell

40 LME Nickel prices 2008 x 1, Nickel price (cash) x 1, J F M A M J J A S O N D 2008 LME Cash Price (U$/MT) Source: Thomson Reuters Datastream

41 TAPO Put Oct 2008 ABC Stainless producer has commitments to buy 5,000 mt a month Nickel for 2009 at LME MASP LME Nickel price for 2009 is currently $16,200 ABC wish to guarantee maximum nickel price of $22,000 for year by buying 5,000 mt./mth. TAPO calls Call premium = $800/mt

42 LME Nickel prices 2009 x 1, Nickel price (cash) x 1, J F M A M J J A S O N D 2009 LME Cash Price (U$/MT) Source: Thomson Reuters Datastream

43 Price fix TAPO hedge LME Physical Day 1 ABC buys 5,000mt/mth TAPO calls strike $22,000 for January to Dec 2009 premium $800/mt

44 Price fix TAPO hedge January monthly average settlement price $11,307

45 Price fix TAPO hedge LME Physical Day 1 ABC buys 5,000 mt/mth TAPO calls strike $22,000 for January to Dec 2009 premium $800/mt Jan 31 st MASP $11,307 TAPO call is effectively abandoned Nominal LME Loss $800 Jan 31 st ABC buys 5,000 mt/mth at MASP $11,307 Final purchase price $11,307 + $800 = $12,107

46 Price fix TAPO hedge June monthly average settlement price $14,960

47 Price fix TAPO hedge LME Physical Day 1 ABC buys 5,000 mt/mth TAPO calls strike $22,000 for January to Dec 2009 premium $800/mt Jun 30 th TAPO call is effectively abandoned June 30th ABC buys 5,000 mt Nickel at MASP $14,960/mt Nominal LME loss $800/mt Final purchase price $14,960 + $800= $15,760mt

48 Price fix TAPO hedge December monthly average settlement price $17,066

49 Price fix TAPO hedge LME Physical Day 1 ABC buys 5,000 mt/mth TAPO calls strike $22,000 for January to Dec 2009 premium $800/mt Jun 30 th TAPO call is effectively abandoned June 30th ABC buys 5,000 mt Nickel at MASP $17,066/mt Nominal LME loss $800/mt Final purchase price $17,066 + $800 = $17,866/mt

50 Average LME settlement price for 2009 $14,253/mt

51 Selling an option A major reason for selling options, is to reduce the cost of buying other options. Assuming that this option purchase is the primary hedge objective The MinMax Maybe suitable for both hedge buyers and sellers

52 MinMax s The consumer minmax Buys calls and sells puts Setting a maximum price that can be paid but limits any downside participation The producer minmax Buys puts and sells calls Setting a minimum hedge sale price but limits any upside price participation

53 Consumer MinMax Price $ Consumer buys out-of-the money (it may buy futures if declared) calls and pays premium At the money Consumer sells out-of-the-money puts and receives a premium (it may have to buy futures if the option is declared) $0

54 MinMax s Variations and variables Zero - Cost the norm but not essential Ranges range the further from being ATM the wider the available Ratios doesn t have to be 1 : 1

55 Minmax s example FORWARD MARKET Oct 2008 for 2009 $16,200 A. Zero cost hedge: Sell 1200 tonnes of $12,700 puts and buy 1200 mt $22,000 calls B. 50% cost hedge: Buy 1200 tonnes of $22,000 calls at $800 and sell 1200 tonnes of $11,300 puts for $400 C. 50% tonnage hedge: Buy 1200 tonnes of $22,000 calls at $800 and sell 600 tonnes of $14,900 puts at $1600 (zero cost)

56 Price fix TAPO hedge LME Physical Day 1 ABC buys 5,000 mt/mth TAPO calls strike $22,000 for January to Dec 2009 and sells 5,000mt/mth $12,700 puts Zero cost Jan 31 st MASP $11,307 Cash settlement paid to broker $12,700 - $11,307 = $1393/mt Jan 31 st ABC buys 5,000 mt/mth at MASP $11,307 Final purchase price $11,307 + $1393 = $12,700 Nominal LME Loss $1393

57 5. Opportunistic exposure Catching short term price movements on the LME Arbitraging physical market (both primary and scrap) on brand and location basis against official LME price

58 6. Structured trading commodity finance STCF has become significantly more important for companies since the crisis of It allows companies to use their raw inventory stock, WIP and metal contained in finished product to seek collateralised loans Banks will provide loans against this material usually incorporating strict covenants including transfer of title and a debtor hedge commitment to protect against any downside risk in the commodity, which would put the loan at risk.

59 Disclaimer The information contained within this presentation is for illustrative and educational purposes only and should not be relied upon in making any investment decision. Whilst every effort has been made to ensure the information is up-to-date and correct, the LME cannot guarantee that it is completely accurate and free from human error.