Hedging Sales Revenue by Commodity Production By: Andrew Volz, Solutions Consultant, Reval April 8, 2010 CONTENT Executive Summary Introduction Life Cycle of the Producer Evaluate the Ability to Hedge Key Consideration: Producer Price Leverage Strategies for Phases in the Producer Life Cycle: The Initial Bank Financing Stage Utilizing Scenario Analysis to Test the Economics of Derivative Strategies Income Generating Stage Conclusion
Executive summary This paper examines the issue of hedging sales revenue by commodity production, more specifically, production from commodity mining companies. Commodity producers face an evolving business cycle that, at various stages, requires them to implement markedly different hedging strategies. If managed properly, these strategies should capture the right blend of volatility and certainty in order to retain attractive amounts of risk for debt holders and equity investors. This paper will focus on the use of different types of derivatives and the stages in the life cycle where they are most appropriate. Introduction As consumers typically hedge more often than producers, the majority of articles and white papers tend to focus on commodity hedging from the perspective of commodity consumers hedging inputs to production. This is particularly true for mining companies. Historically, mining companies have been driven by their investors to keep the sales prices of their products un-hedged in order to capture the underlying commodity price volatility in the value of their equity. In stark contrast to most consumers who want to avoid commodity volatility at all costs, producers embrace this volatility because their investors demand it. For investors, equity investments in producers are one of the easiest, safest and least costly ways to invest in the commodity markets. The plight of most producers is polarized from a hedging perspective, as the demands of investors who crave volatility are diametrically opposed to lenders who abhor it. Lenders often encourage and sometimes require producers to hedge, as this helps to ensure the availability of sufficient operating revenue to service financial obligations. About the author Andrew Volz, Mr. Volz assists financial professionals in corporate treasury and accounting departments, ensuring that they have the right technology solutions for their hedge accounting, compliance and derivative risk management needs. A member of Reval s Hedge Accounting Technical Taskforce (HATT), Mr. Volz specializes in derivative valuations and in the technological impact of evolving derivative regulations. He was previously a Product Manager for Reval and a Trade Desk Manager at Citigroup. He is a CFA Level 2 candidate and holds a Bachelor of Science in Business from the University of Connecticut.The author can be reached at andrew.volz@reval. com. ABOUT REVAL Reval provides an award-winning Web-based platform that auto mates corporate financial risk management for a wide range of interest rate, foreign exchange, commodity and credit derivatives. continued on next page 2010 Reval.com, Inc. All Rights Reserved 2
As producers are often faced with these two polarizing forces, the need for prudent risk management is heightened and will dominate hedging decisions. The stage of the business cycle at which the producers are involved will be just as crucial to the decision making framework. About the author (continued) Life Cycle of the Producer Commodity producers typically have two distinct phases in their life cycle: the initial bank financing stage and the income producing stage. In order to understand the reason for these two individual stages, we must first understand the producer s business model. A producer s business model is centered around receiving the initial financing to mine a commodity, as it requires a large capex investment to first start the mine. Once these capital expenditures have been made, and the producer begins production of the commodity they will sell to consumers, the producer then enters the income generating phase of the business life cycle. Regardless of the stage in the life cycle, commodity produces hedge revenue to guarantee an acceptable level of revenue for goods sold. Consumers also manage their commodity risk profile in the same manner. Consumers attempt to protect their net income (i.e. the bottom line). Because of these polarized forces, companies should employ different hedging strategies and derivative types at each stage of the life cycle. Prior to deciding on the types of derivatives and hedging strategies to implement, it is critical that the producer perform a careful examination of all required factors to ensure an effective hedging program. The examples below demonstrate how different strategies can be attractive to different investors during the various stages of the business life cycle. Evaluate the Ability to Hedge When hedging commodities as a consumer or a producer, evaluating whether or not hedging (economic) and hedge accounting are available is dependent on the same set of factors. The world s leading corporations and financial institutions use this SOX-compliant Software-as-a- Service to support and execute hedging strategies from exposure capture through performance measurement and to comply with international and domestic accounting standards, including ASC 815 (FAS 133), ASC 820 (FAS 157), IAS 39 and IFRS 7. Reval deploys rapidly and integrates easily with treasury management and ERP systems. The company s SaaS platform and team of financial experts are also available on an outsourced basis through Reval Center. Reval was founded in 1999 and is headquartered in New York, with regional centers based in Philadelphia, Chicago, San Francisco, Toronto, London, Frankfurt, Graz, Sydney, Hong Kong, and Gurgaon. For more information, visit www.reval.com or email info@reval.com. 2010 Reval.com, Inc. All Rights Reserved 3
FACTOR 1: CAN A COMPANY ACCURATELY FORECAST AND MEASURE THE EXPOSURE? The ability to accurately forecast the exposure is paramount to any hedging program. With an accurate forecast and the proper use of derivatives, the results of a hedging program are locked in at inception. The biggest risk during this stage is over-hedging, as carrying an over hedge is similar to a speculative derivative portfolio. For this reason, many hedgers layer derivatives as the time until the exposure decreases and becomes more likely to occur. This is also a key factor during the initial financing stage of the life cycle, when exact timing and amount of sales may be more difficult to forecast. FACTOR 2: IS THERE A MARKET TO HEDGE? Regardless of the accuracy of the exposure, the derivative end user must still decide which financial products best fit its needs. Available derivatives can be limited, especially in certain metals markets as well as with coal. The liquidity along the forward curve and the desired derivative type will drive a major portion of the cost of a hedging program. FACTOR 3: DOES THE COST OF HEDGING OUTWEIGH THE BENEFIT? In some instances, the limited availability of derivatives will force a company into the OTC market. The primary benefit of this market, flexibility in structuring, also leads to its primary drawback, illiquidity and higher premiums. As the producer progresses through the stages of its life cycle, it will realize the benefit of using a blended strategy of OTC and exchange traded products to control to costs of its hedging program. Key Consideration: Producer Price Leverage Producers hedge top line revenue and can experience leverage to higher prices. Positive price leverage is a rapid increase in profits brought on by an increase in the sale price of the product. For example, consider a copper mine whose cost to produce one Metric Ton (MT) of copper is USD $4,000, and the current spot price of copper on October 22, 2008 is USD $4,286. To simplify, assume that the producer has an annual production of 1,000 MT sold every October and no additional costs. At the current price, the producer has top line revenue of USD $4,286,000 and earnings of USD $286,000. An investor purchasing equity in the company on October 22, 2009 would be buying the projected USD $286,000 in: earnings for the next calendar year along with the assumption of future cash flows. Therefore, the company is currently valued in relation to these estimates at current market price levels 2010 Reval.com, Inc. All Rights Reserved 4
As detailed by the actual prices of copper over the one year time frame from October 2008 October 2009, prices increase by 53%. Assuming there is no increase in the cost of extraction, the company now has earnings per MT of USD $2,565.5 (up from USD $286). This equates to a dramatic increase of approximately 900%. An investor who purchased equity in an un-hedged mining company would have realized a strong return on investment, whereas a company that was 100% hedged might actually have lost money due to the increasing cost of broader commodities and inputs (i.e. fuel and power) that could accompany such a large movement in copper prices. Obviously, leverage is never one sided. If prices fell by 53% to USD $2,014, the producer would be losing roughly USD $2,000 per MT and would be more apt to warehouse production or stop it altogether and take fixed costs as a loss until prices were to turn. This is why tremendous benefit can be gained by hedging and, more so, by hedging with the right strategy for the situation. Strategies for Phases in the Producer Life Cycle: The Initial Bank Financing Stage To arrange initial financing (i.e. bank loans or debt) for begin production, a producer is often required to guarantee that the revenue received from the production estimates will be sufficient to cover the principal and interest payments required by the financial institution(s) providing capital. For example, if a mine requires USD $5,000,000 per period in operating revenue to cover costs (i.e. operating and financing costs) and estimates production at 2,000 MT per period, a minimum sale price of USD $2,500 per MT would be required to cover the costs. Producers at this stage of the life cycle usually prefer options due to the inherent downside risk associated with using linear instruments such as swaps, forwards and futures. A missed forecast in an option strategy will forfeit the premium, a known capital amount, whereas a missed 2010 Reval.com, Inc. All Rights Reserved 5
forecast hedged with a swap, future or forward instrument will have a variable potential loss based on the settlement price of the indexed contract. For this reason, option strategies generally make more sense during this stage. Three strategies to be examined for this stage in the business life cycle are a swap, purchased floor strategy and collar strategy. The strategies listed below will allow the producer to determine the amount of risk to retain, balanced against the premium required if hedged with options or the potential loss of profit if hedged with a swap. STRATEGY 1: Swap A fixed price swap will lock in the future sale price of the specified quantity for the specified date. The benefit of the swap is that it is simple to account for and requires no initial net premium investment. The drawback is that a 100% hedged sale quantity has all price leverage removed, as well as the potential for loss in a missed forecast due to the linear nature of the swap. From the example above, a fixed price swap entered into at USD $4,286 locks the sale price one year out, locking in the expected revenue from sale at the original USD $286,000. In the figure above, the blue line demonstrates the movement in the forward price over the life of the swap, while the red arrows show that the movement in the value of the swap perfectly offset changes above and below the fixed price. 2010 Reval.com, Inc. All Rights Reserved 6
STRATEGY 2: Purchased Floor Option By purchasing a floor, a producer can offset falling commodity prices at the time of sale, with gains produced from the option position. The benefit of the floor strategy is retaining the upside potential lost in a swap, forward or future. The drawback is the initial premium investment required as it is not recovered if the contracts are not exercised. In the copper hedging example discussed in Strategy 1, the economics of hedging the sales with a floor is shown as follows: An at the money October floor purchased in October 2008 for settlement in October 2009 would cost the company USD $782,243, or approximately USD $782 per MT. This option is particularly expensive due to high volatility at that time (approximately 47%). The cost of this strategy can be dramatically reduced by means of market timing exercises with implied volatility fluctuating between 25% and 55%. For example, the same option would have cost USD $585,497 with 35% volatility implied. The chart below displays the economics of the floor with respect to the 2008 and 2009 copper prices. Strike + premium indicates the price at which the producer can continue to receive profit increases The strike is the level at which the option was purchased The break even downside indicates the worst case price on the downside at the strike the premium 2010 Reval.com, Inc. All Rights Reserved 7
STRATEGY 3: Don t want to pay a high premium? Buy a put and sell a call the collar strategy A collar will reduce the initial net premium investment required by the put option strategy relinquishing the upside profit above a particular market price level. Flexibility in positioning the strikes allows the trader to decide where to place the protection and where to forfeit the upside. Collars essentially provide bands of protection and profit forfeiture as detailed in the example below. In this example, a reasonable collar strategy would have yielded the following economics: The collar is break even on day one, requiring no premium investment The floor protects on the downside below USD $3,843 The cap forfeits on the upside above USD $5,000 The results yields closer protection on the down side with partial retained upside and no premium 2010 Reval.com, Inc. All Rights Reserved 8
Utilizing Scenario Anaysis to Test the Economics of Derivative Strategies During this stage of the business life cycle, scenario analysis can be an extremely valuable tool used to quantify the level of risk and explain how various derivative strategies can be deployed to mitigate this risk. Step 1: Stress test the exposure to examine the monetary impact of price movements. In this case, a 10% shift and a 50% shift have been applied to one year s worth of copper sales (i.e.1,000 MT per calendar month). 2010 Reval.com, Inc. All Rights Reserved 9
Step 2: Stress test the what-if derivatives to determine the appropriate strategy for the same price movements. Key observations from the stress test: 1. This stress test has quantified a maximum 50% movement in the sale price of copper; thus, the producer canexpect an approximately +/- USD $5mm to USD $24mm potential impact to revenue if unhedged. Variants of these hedging strategies can allow the producer to tailor the risk profile appropriately between price risk and forecast risk at the initial stage. Using this information, the producer can tailor a hedging strategy that satisfies creditor requirements from a revenue certainty perspective. 2. At first, the floor position will respond slowly to changes in the underlying price, as the delta is less than 1. This will increase throughout the life and is less of a concern as long as the option is held to maturity, as it will eventually provide the worst case rate below the strike price at expiration. Additionally, the loss shown on the floor during rising prices is primarily made up of loss of time value (premium) which will be lost in any circumstance over the life of the option. Both points are also important from an accounting perspective as P&L volatility will been realized if this strategy is employed to hedge a balance sheet exposure - the exposure will initially move by larger rations than the options. To eliminate this volatility from the income statement, the producer will want to seek cash flow hedge accounting, allowing the movements to be parked in equity. 2010 Reval.com, Inc. All Rights Reserved 10
3. The swap demonstrates complete elimination of upside and downside price risk provided that the forecasted sales are accurate. With a missed forecast and large market movement, the swap can potentially cause a direct loss of up to USD $25mm. The collar position also exposes the producer to forecast risk above the level of the sold cap. For this reason, the pure floor position will be the least risky during the initial financing stage in the business life cycle. Income Generating Stage As the business matures, it will benefit the producer to roll its strategies from a pure option-based strategy into a blended strategy that utilizes a combination of options, swaps, futures, and forwards. This is due to the initial premium required to be paid for an option contract combined with the removal of volatility cost from the hedging program. The roll-over will generally take place after an offtake agreement has been finalized. In an offtake agreement, the producer enters into a contractual agreement to provide the mined concentrate to an investment grade partner who agrees to purchase specific quantities at specific times. This agreement eliminates the sales forecast risk and leaves the company with only price and production forecast risk to manage. As stated earlier, a prequalification for hedging should be an accurate production forecast and only price risk should remain post offtake agreement. As rolling from a pure option driven strategy becomes more important at this stage, the following strategies will be more applicable: STRATEGY 1: Swap The swap example above may be employed at this stage when forecasts are more accurate as there is less risk of forecast error, resulting in a direct loss on the derivative. STRATEGY 2: Participating forwards Participating forwards use a varying notional of purchased and sold cap/floor options with the same strike to hedge downside risk, while still retaining some positive earnings leverage on the upside. The strike rate is structured such that no initial premium is required and, therefore, is not typically exercised at market. Thus, the floor component will be below the current forward rate. The rate at which the forward is struck provides the producer with a worst case rate while still allowing participation in any positive price movements. STRATEGY 3: Blended Option and Futures, Forward, Swap or Partial Hedge Strategy Another possible strategy is to blend option strategies with non-option derivatives or to hedge only a percentage of the forecasted sales. For example, the producer could hedge 50% of sales with a swap and then hedge an additional 50% with a floor. This strategy would yield similar results to the participating forward strategy depending on where the floor was struck. Flexibility exists in how the derivative strategies are structured, allowing the producer to retain the desired amount of risk and, therefore, the desired amount of possible profit uplift. 2010 Reval.com, Inc. All Rights Reserved 11
Utilizing Scenario Analysis during the Income Generating Stage Stress testing will be used during the income generating stage, as the producer tests the economic effects of market shifts on the company s exposures and derivatives. However, as the company has matured, it is also important to manage earnings volatility by predicting both the economic characteristics of a hedge and the accounting impact of thehedge on P&L. For a company that is not only hedging but also seeking hedge accounting treatment, stress testing can be leveraged to predict P&L volatility. To effectively quantify the impact of various market stresses, it is necessary to know which relationships are pure economic hedges and which are designated for hedge accounting treatment. With this information, it is possible to separate P&L impact by the following table: The following example demonstrates the difference of accounting impact between a hedge accounting relationship vs. a purely economic hedge relationship. 2010 Reval.com, Inc. All Rights Reserved 12
Key observations from the stress test: 1. The economic impact of the hedge is the same whether or not it is designated in a hedge relationship. However, hedge accounting virtually eliminates P&L volatility by shifting the change in the derivative value to equity. 2. In the swap example, a small amount of ineffectiveness is recognized in earnings due to the basis on the exposure/hypothetical, but overall a very highly effective hedge is demonstrated. It will benefit producers to test their relationships on an ongoing basis to ensure the relationship is maintained. Conclusion The ability to customize derivatives allows producers considerable flexibility when structuring hedging programs. With this flexibility, virtually any risk objective can be met. Therefore, the decision to hedge or not to hedge will likely be based on other business considerations which often are driven by the stage in the company s life cycle. Producers should also continually evaluate their market, learn what their industry peers are doing, and ultimately determine if a competitive edge can be achieved from hedging. In many ways, a competitive edge is determined by the polarized forces of debt equity holders. The producer s overall goal should be to create a flexible hedging strategy that can accommodate all potential scenarios encountered now and in the future. The recent volatility in commodity, credit, FX and interest rate markets has shown that timing a hedging program effectively is paramount to achieving good results (e.g. airline fuel hedging). For this reason, all producers should have a solid understanding of the risks applicable to their business and the most effective and efficient hedging strategies leveraged to mitigate these risks. 2010 Reval.com, Inc. All Rights Reserved 13