Description
This is a documentation about the commodity, namely copper, price risk management strategies of a global manufacturing company.
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Table of Contents
Executive Summary................................................................................................................................. 3 Copper Industry in India.......................................................................................................................... 4 Hindustan Copper Limited ...................................................................................................................... 5 Company Profile:................................................................................................................................. 5 Risks and concerns .............................................................................................................................. 6 Hedging ................................................................................................................................................... 8 Copper Production Flow: .................................................................................................................... 8 Working:.............................................................................................................................................. 8 Hedging Strategies .............................................................................................................................. 9 Futures ............................................................................................................................................ 9 Trading Strips ................................................................................................................................ 10 Hedging Against a Price Decline in a Potential High Volatility Market by Purchasing Out-of-theMoney Puts ................................................................................................................................... 10 Using a Collar to Protect a Price Level While Mitigating the Cost of the Hedge .......................... 11 Establishing a Price “Floor” by Buying Puts .................................................................................. 12 Commodity Swap .......................................................................................................................... 13 Premiums for Physicals or Discounts for Scrap............................................................................. 13 Conclusion ............................................................................................................................................. 14 References ............................................................................................................................................ 15
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Hedging Copper Price Risks
Executive Summary
This report examines the commodity, namely copper, price risk management strategies of a global manufacturing company. The company buys copper as raw material and sells the copper products it manufactures to its customers for a price that includes a separate copper price component. For the most part, the company fixes the price for which it buys copper from producers to the market forward price. The copper price component in the selling price is also fixed beforehand so that customers know in advance the price they will have to pay. However, the price-fixed purchases and price-fixed sales do not automatically even each other out since sales and purchases occur at different times and at different quantities. Historically, the company’s price-fixed sales have always been somewhat higher than price-fixed purchases at each moment. This creates a physical net short position on copper, which is hedged in the forward market. Since the company’s current hedging strategy uses only forwards to fix the price of copper, it is not able to gain from a beneficial move in the copper price. If the price falls, they may have to pay a price substantially above current cash price at the expiration of their forward contracts, implying that their customers must pay a high price for their product as well. Price fixations can extend to very long maturities, which, while adding to the predictability of earnings, can harm the company’s competitive position during a period of falling prices. Competitors may have more flexible hedging strategies and thus be able to bring their prices closer to market price. An additional risk arises when large positions at brokers, especially if maturities are extended far, can have an impact on liquidity. Commodity brokers usually require a margin for the position held under their account. This margin is not significant when price changes are moderate, since the fair value of the forward contracts is fairly close to zero. However, if prices move considerably, the margin requirement increases rapidly for two reasons. First, the fair value, assuming a negative price change, prompts an incremental deposit. Second, amid large price fluctuations the increased volatility triggers an augment in the so-called initial margin. The initial margin is calculated as a fixed portion of the position in tons, but the portion is determined based on the underlying asset’s volatility and can change at any point. The use of options decreases these risks by adding flexibility in the pricing of copper and by reducing margin payments. Especially, it should be noted that brokers bear no credit risk when options are used since the premium required is paid up-front. The premiums can, however, generate significant cost to the hedger whereas for forwards no premium is required. Therefore, a strategy where part of the forwards are replaced by options seems reasonable, since premium payments are decreased by lower volumes but additional flexibility is incorporated in the pricing strategy. To obtain options, the company can purchase a traded option or create the option synthetically by entering into the forward market. Both alternatives create a cost to the hedger that should be of equal magnitude. To decrease the cost of hedging, the copper producer can enter in collar option strategy. This results in buying of puts and selling of calls. Similarly the copper company could enter into copper swap so as to fix the price of copper.
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Hedging Copper Price Risks
Copper Industry in India
India does not provide a big market for copper. Due to shortage of copper mines and a low percentage of productivity of copper in the mines, India suffers a loss in the level of production and it has to completely depend on the copper ore imports. Also, not many companies are indulged in the refining and extraction of copper from its alloys and ores. India produces copper from the imported copper ore that accounts to around 6 lakh tons of production. This production level is contributes to a mere 4% share in the total copper production in the world. Indian market is divided into three parts i.e. primary and secondary. Primary segment comprises of the producers that convert copper ore into refined copper. Three companies namely Hindustan Copper ltd, Birla Copper and Sterlite Industries constitute this primary segment. Secondary segment comprises the producers that manufacture value added products made from copper like wires, foil etc. The domestic consumption demand of copper is around 5.5 lakh tons in the country. A major percentage i.e. 10% of the total consumption in India is contributed by the two major telecommunication providers namely BSNL and MTNL. The rest of the demand is contributed by the construction and automobile sector. India has always been an importer of copper ore to satisfy the domestic consumption demand. The countries from the ore is imported into India are ? ? ? ? Chile Indonesia Australia Canada
But, due to the rise in the production of the three major players in the Indian market, the country is now emerging as a net exporter. The production of copper has significantly during the last few years that has enabled India not only to satisfy it is own domestic demand but export refined copper in small quantities. The prices of copper in Indian market are highly dependent on the prices in London Metal Exchange
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Hedging Copper Price Risks
Hindustan Copper Limited
Company Profile:
Hindustan Copper Limited (HCL), a public sector undertaking under the administrative control of the Ministry of Mines, was incorporated on 9th November 1967. The GoI holds 99.59% of the paid up equity capital of the company. It has the distinction of being the nation’s only vertically integrated copper producing company as it manufactures copper right from the stage of mining to beneficiation, smelting, refining and casting of refined copper metal into downstream saleable products. The Company markets copper cathodes, copper wire bar, continuous cast copper rod and byproducts, such as anode slime (containing gold, silver, etc.), copper sulphate and sulphuric acid. More than 90% of the sales revenue is from cathode and continuous cast copper rods. HCL’s mines and plants are spread across four operating Units, one each in the States of Rajasthan, Madhya Pradesh, Jharkhand and Maharashtra as named below: ? Khetri Copper Complex (KCC) at Khetrinagar, Rajasthan ? Indian Copper Complex (ICC) at Ghatsila, Jharkhand ? Malanjkhand Copper Project (MCP) at Malanjkhand, Madhya Pradesh ? Taloja Copper Project (TCP) at Taloja, Maharashtra While Khetri and Ghatsila are fully integrated units (mining, ore beneficiation, smelting and refining), Malanjkhand has mining and ore beneficiation facilities while Taloja has wire rod manufacturing facility only. The combined capacity of HCL’s smelting and refining capacity is 51,500 MT per annum of copper cathode. The installed capacity at Taloja is 60,000 MT per annum of wire rod.
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Hedging Copper Price Risks
Risks and concerns
Main business risks faced by the Company arise out of volatility of LME price of copper and hardening of the rupee against USD. To insulate itself from the LME price risk, the Company has introduced ‘hedging’ as a risk mitigation tool. Another business risk faced by the Company is on account of delay in achieving the projected mine capacities due to socio-political factors, higher capital costs and related issues. This may restrict MIC production and put pressure on operating margins. ? LME price and TcRc for copper: The prices they pay for copper concentrate and the prices they charge for their copper products are based on the LME price for copper. Nevertheless, they are also exposed to differences in the LME price between the quotation periods for the purchase of copper concentrate and sale of the copper, and any decline will adversely affect them. They attempt to hedge against such risks, but are still exposed to timing and quantity mismatches. Treatment and refining charges, or TcRc, for some of their longterm copper concentrate supply contracts are also negotiated as a percentage of the prevailing LME price. In addition, certain of their long-term copper concentrate supply agreements provide for price participation terms which are linked to LME prices. As a result, any significant volatility in the LME price for copper could adversely affect our revenue and profitability.
The level of TcRc has a significant impact on the profitability of their copper business. These have been volatile and cyclical in the past. They purchase copper concentrates at the LME price for the relevant quotation period less TcRc. While their TcRc is negotiated between their supplier and them, their TcRc is influenced by global TcRc, which is primarily the result of factors such as the supply and demand of copper concentrates, prevailing and forecasted LME prices and mining and freight costs. Their TcRc prices are also substantially influenced by the benchmark price set by certain large Japanese smelters. The TcRc in the past has been volatile and any significant decline will adversely affect their profitability. ? Exchange rate fluctuations: They produce and sell commodities that are typically priced by reference to U.S. Dollar prices, while a majority of their costs are incurred in Indian Rupees. As a result, our financial condition and results of operations are affected, directly or indirectly, by the exchange rates of the U.S. Dollar-Indian Rupee. If the U.S. Dollar declines in value relative to the Indian Rupee, our revenues generated from and the profitability of the products we sell could be reduced. While they hedge currency exposures from time to time, as part of their risk management activities, their profitability may be significantly affected by exchange rate fluctuations between the U.S. Dollar and the Indian Rupee. Further, their hedging arrangements may, at times, limit the benefits of favourable exchange rate movements. In addition, the policies of the Reserve Bank of India may change from time to time and this may impact our ability to adequately hedge our foreign currency exposures.
Showing mettle: Processors hedge price risks involved in smelting and refining too
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Hedging Copper Price Risks
? Changes in customs duties: It may have a material adverse effect on their results of operations and financial condition. The customs duties on imported copper have been reduced over the last few years. Imports of copper metal are currently subject to a customs duty of 10%. The government of India may reduce customs duties further in the future, although the timing and extent of such reductions cannot be predicted. Since they sell a majority of their copper production in the domestic market, any reduction in these customs duties will have an adverse effect on our results of operations and financial condition. In addition, if customs duties decline further, they could incur additional competition from foreign copper producers which may force them to reduce their prices or decrease their domestic market share and adversely affect their result of operations. ? The government of India and other state governments may further increase the royalty rates/ cess they pay for their mines. ? Operations are subject to extensive regulations and may be adversely affected by present or future violations or enforcement actions including regulations relating to pollution and protection of the environment and worker health and safety. ? We incur and expect to continue to incur significant capital and operating costs to comply with environmental regulations. We could also incur significant costs, including clean up costs, fines and civil and criminal sanctions, if we fail to comply with environmental laws and regulations or the terms of consents and approvals. ? Business faces natural disasters and operation risks that may cause significant interruption of operations.
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Hedging Copper Price Risks
Hedging
Hedging is a vital risk-management tool now used by industries all over the world—primarily by metal, agricultural and energy producers, as well as processors and consumers. Hedging allows these entities to manage the price risk of their physical material by having an equal and opposite position in the futures market.
Copper Production Flow:
Copper Ore Import /mined Smelting of the copper ore Refining of the Copper
Treatment Charges & Refining charges fluctuation Exchange rate risk.
Pure Copper
Copper Price Risk Exchange Rate Risk.
Converting in to Copper Products
Working:
Hindustan copper company, which imports copper concentrate & mine it in India as well. Typically, import-pricing mechanism is on 2MAMA basis (pricing is fixed on the average cash settlement price on the exchange of the second month after the month of arrival). Copper concentrate contains pure copper, as well as traces of gold and silver. In this business, if copper prices are high, then TCRC charges (treatment and refining charges) are low and vice versa. TCRC charges are paid for by the supplier. These charges could range from $15-150 per tonne—which is eventually the actual profit margin. Therefore, the processor has to first hedge his TCRC price risk and then his finished products price risk. The typical copper percentage in copper concentrate is about 30%. Therefore, the hedge should be limited to the extent of the copper, not the entire copper concentrate. So, if the copper concentrate imported is 1,000 tonnes, the actual copper may be just about 300 tonnes.
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Hedging Copper Price Risks
Assume the shipping vessel arrives on May 1 at the Indian port, and it is ready to be discharged on May 11. As per the norms, pricing will be done for copper on the monthly average of cash settlement price of LME copper and for gold and silver at the LBMA prices for the month of July (2MAMA). The cost of smelting and refining is paid for by the supplier, as pricing is done on the actual metal price, which, in our example, has been assumed to be 30% of the concentrate. In the first stage, hedging for TC and RC takes place when the smelting process is running. If the company is importing 1,000 tonnes of concentrate and it is found on testing that 30% is actual copper, then a total of 300 tonnes will be long-hedged (since he doesn't have the copper yet) over the smelting period. In other words,if the price of copper decreases, then the decrease in price is partly made up by increased TC and RC charges. Reverse movement in price is offset by decreased TC and RC charges. This helps the processor fix his returns and eliminate uncertainty. In stage two of the hedging process, the processor now has pure copper in hand, and therefore a short hedge is required for price fixation. Since the price to be paid to the supplier for the copper will be the average of the cash settlement price using 2MAMA, the price hedge on the futures exchange will start on July 1. The quantity to be hedged on a daily basis will be the total quantity smelted divided by the number of trading days in the month. In this case, it will be around 300/22 =14 tonnes a day. By selling 14 tonnes (or 14 lots on MCX) a day over the month, the processor almost fully hedged in so far as making payment to the supplier is concerned. For commodity producers and consumers, hedging makes sense because it is beneficial in helping control, reduce and manage price risk. A hedging programme will clarify at first which risks the company is willing to bear and the ones it needs to control or convert by hedging.
Hedging Strategies
1. Futures Market: Risks associated with fluctuations in the price of the Company's products, copper are minimized by hedging on futures market. The results of metal hedging contracts / transactions are recorded at their settlement as part of raw material cost or sales as the case may be. Portion of the cash flow to the extent of underlying physical transactions having not been completed is carried forward as receivables/payables till the completion of the underlying physical transaction. 2. Forward exchange contracts and currency swaps and option to hedge its risks associated with foreign currency fluctuations. In respect of transactions covered by Forward Exchange Contracts, the difference between the forward rate and the exchange rate at inception of contract is recognized as income or expense over the life of the contract. 3. Commodity Options: A multiple Collar option strategy can be used. It is a cost free strategy to hedge against copper prices 4. Commodity Swap.
Futures
Short Hedges One of the most common commercial applications of futures is the short hedge, or seller’s hedge, which is used for the protection of inventory value. Once title to a shipment of a commodity is taken anywhere along the supply chain, from wellhead, mine, or manufacturing plant to consumer, its value is subject to price risk until it is sold or used. Because the value of a commodity in storage or transit is known, a short hedge can be used to essentially lock in the inventory value. A general decline in prices generates profits in the futures market, which are offset by depreciation in the value of the physical inventory. The opposite applies when prices rise.
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Hedging Copper Price Risks
Precious Metal Producer’s Short Hedge The producer hedge is of particular use to precious metals mining companies, especially during periods of high price volatility. In addition, the concept of price and revenue forecasting has become important to producers because of the substantial cost and lead time required of new mining ventures. Because precious metals markets are almost always in contango, gold, silver, and platinum group metals futures have removed much of the risk associated with new mine price and revenue forecasting. Precious metals producers are able to use short hedges to help secure project financing. In February, an official of a new mining venture reviews the company’s most recent copper production plans. The sales and production projections suggest that the company will have 3,000 ounces of newly mined and refined copper available for sale the following July. The executive considers the current price of the August copper futures contract at $310.20 favorable, given the company’s total production costs, including interest and depreciation, of $180 an ounce. As a result, the mining executive decides to lock in a profit by hedging his anticipated production.
Trading Strips
Strip trading is a flexible strategy that copper futures market participants can use to lock in a single price for two to 24 consecutive months forward. The strip trade is executed by simultaneously opening a futures position in each of the months to be hedged through a single Exchange transaction during the open outcry session. The price of the futures contracts for the strip is typically the average of the current market value for those months, although strips can trade above or below the average, depending upon market conditions. A seven-month strip, for example, consists of an equal number of futures contracts for each of seven consecutive contract months, bought or sold for a single account, quoted and traded at a single price. In obtaining an average price for multiple months, the hedger can average his cash flow over a period of time. The futures positions assumed in a strip trade are like any other futures position. All futures contracts are based on physical delivery. Any part of the position can be liquidated by an offsetting futures trade, an exchange of futures for physicals (EFP), or, if desired, physical delivery through the Exchange clearinghouse. Strips let a hedger retain the flexibility to change a strategy by buying or selling additional futures contracts in any month, or liquidating the position of any month of the strip, something that cannot be done easily with over-the-counter instruments. Regular margin requirements apply to strip trades.
Hedging Against a Price Decline in a Potential High Volatility Market by Purchasing Out-of-the-Money Puts
On December 23, a copper producer considers hedging against a weakening market. He knows his cost of production is 65¢ a pound, and wants to protect the most margins at the least cost. He does not want to hedge with futures, which would effectively lock in a July futures price of 94¢ per pound, nor does he want to spend 6.5¢ per pound for a July at-the-money put. He does want to protect his profitability against a significant drop in the price to 80¢, so the producer decides to purchase a put with a strike price of 80¢ for which he pays a two-cent premium. He considers this to be the optimum cost-efficient price protection, while allowing participation in any favourable upward price move. The producer has decided to hedge against the markets becoming highly volatile by purchasing an out-of-the-money put.
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Hedging Copper Price Risks
If the market price drops sharply, he will net no less than 78¢ per pound (80¢ for the copper, less the two-cent premium for the option). If prices rise, the premium of the option is the cost of the price insurance; if the market goes to $1.20, the producer will realize $1.18 ($1.20-2¢).
Using a Collar to Protect a Price Level While Mitigating the Cost of the Hedge
Sometimes the cost of buying an option can be more expensive than a company’s balance sheet requires. A collar strategy allows a hedger the opportunity to lower the cost of the hedge, while creating a beneficial revenue stream. A copper producer’s collar strategy involves the sale of a call, which is offset by the purchase of a put. The call and put both have out-of-the-money strike prices and expire in the same month. The producer would sell half as many calls as he would buy puts. That way, if copper futures prices rise, he would only be exposed on half of his tonnage; if the price drops, he can tender all of the tonnage. With July futures prices at 94¢, for example, the producer is exposed to falling prices and needs to set a floor. The cost of the 86¢-put is 3.3¢ per pound. Rather than incur this expense, the company decides to sell out-of-the-money calls to generate revenue. The effect is to cap the upside potential while reducing the cost of downside insurance. The risk manager decides to buy 100 puts with a strike price of 86¢ and sell 50 calls with a 100¢ strike price for a premium of 4.3¢ per pound. A collar of 86¢ to $1.00 is now set. The minimum he will receive for his production is 86¢, the maximum, $1.00. The financial effect is illustrated below:
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Hedging Copper Price Risks
Summary of Results: In each case, the outright cost of the collar was $1.15 per pound; a premium paid for the put of 3.3¢, and a gain on the sale of the call of 4.3¢. However, because calls were sold on only half as many puts, the net gain was 2.15¢ per pound. In Case A, the purchase of the put enabled the producer to gain 6¢ over the market price; when prices fell to 80¢, he was able to exercise his 100 puts and sell futures at 86¢, thus taking full advantage of the protection offered by the put. After subtracting the cost of the collar, the effective price of copper was 84.85¢ per pound. The 50 calls that he sold were deeply out-of-the-money, and thus were not exercised. In Case B, futures prices remained stable, but the cost of the collar — the producer’s cost of insurance — was $1.15 per pound, giving him an effective copper price of 92.85¢. In Case C, the producer’s exposure to copper prices above $1.00 through his short call position becomes apparent when futures prices rise to $1.20. He gains 6¢ a pound on the rise of prices from 94¢ to $1.00 for the 50 lots covered by the short call. There is also a gain of 26¢ a pound on the 50 lots that are not covered by the short call, totalling 32¢, which is an average market gain of 16¢ per pound on 100 lots. The $1.15 cost of the collar yields a net gain of 14.85¢ per pound, for an effective copper price of $1.0885. Thus the collar allowed the producer to participate in the rising market, although some of the potential gain was given up because of his obligation under the short call and the cost of the collar itself.
Establishing a Price “Floor” by Buying Puts
On March 16, spot copper is trading at 90¢ per pound, but a copper producer is concerned that prices will be lower in December when he will have product to ship. Since December futures are trading at 75¢ per pound, the producer considers selling futures to lock in that price to guard against a decline. However, he fears that if the current supply tightness persists, prices could rise above that level since copper is in backwardation. He decides to use options instead of selling futures, buying a December put with a strike price of 70¢ for 3.0¢. On December 1, the copper refiner sells spot copper and liquidates his options contract. The chart below illustrates the results if the spot price has decreased to 60¢ (Case A) or if it has increased to $1.10 (Case B).
Summary of Results: In Case A, the producer receives only 60¢ for his copper, but the financial offset provided by the 7¢ options profit gives him an effective selling price of 67¢ per pound (he paid 3¢ for
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Hedging Copper Price Risks
the option, but sold it for 10¢). This is eight cents less than he would have received using futures alone to hedge, but the reason he chose to purchase the put is apparent in Case B. If the price increases, the producer receives $1.10 from the spot market sale, but he would have lost 35¢ on the sale of the futures while the put option with the 70¢ strike price — the right to sell futures at 70¢ — now has no market value because futures are trading at $1.10. There is a net loss of 3¢ — the options premium paid on the position, giving the producer an effective selling price of $1.07.
Commodity Swap
There are two types of commodity swaps: fixed-floating or commodity-for-interest. Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices. General market indices in the commodities market with which many people would be familiar include the Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board Index (CRB). These two indices place different weights on the various commodities so they will be used according to the swap agent's requirements. Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate (plus or minus a spread). In Commodity swap, one counter party make a fixed periodic payments to the second at a per unit fixed price for a given quantity of some commodity. The second counterparty pays the first a per unit floating price for a given quantity of some commodity. A copper producer wants to fix the price for its copper output for next two year. To obtain the desired outcome, the copper producer enters into a swap with a commodity swap dealer but continues its transactions in actual in the cash markets. Suppose at the time of deal the copper price is $0.620 per pound. The dealer has to make fixed payments for which he charges $0.0025 per pound. Hence the copper producer receives a fixed price of $0.6175 per pound. The copper producer will pay him the average floating spot price of copper. If the copper price decreases, the copper producer pays less and receives more from the dealer. As the result the net loss from selling copper at less price is covered with the profit from the swap deal. Hence the copper producer gets a fixed price for the copper produced.
Premiums for Physicals or Discounts for Scrap
Basis usually is not a major consideration in the precious metals markets, although differences in supply and demand conditions between market centres can cause a premium in the price of the delivered physical commodity to the price of the futures. Basis can be more problematic for copper market participants. Metal which does not meet the purity specifications of a metals futures contract (scrap copper, for example) will be priced at a discount to the futures contracts. On January 20, a scrap dealer buys five truckloads of No. 2 copper scrap over the scale from a collector at the March COMEX Division futures price less 21¢ per pound, the prevailing discount for scrap. At the same time, he sells March COMEX Division futures at 90¢ a pound, the current March futures price. The scrap dealer is able to use the futures market to protect his position even though he cannot deliver scrap against the futures contract. On February 1, the scrap dealer sells the five truckloads to the ABC Copper Refining Co. at the March COMEX Division copper futures price, which is now 86¢, less 19¢, the now-prevailing scrap discount, and buys back his hedge.
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Hedging Copper Price Risks
Conclusion
The report analyses the various strategies available with the copper producing companies to hedge their copper price risk. Copper price risk is one of the major risks faced in the copper industry. Depending upon the product available in their market, the companies can hedge its copper price risk and exchange rate risk. These strategies are risk management tools which work well in different situations. Some of the strategies are: 1. Forwards 2. Futures 3. Options 4. Collar option 5. Commodity Swap 6. Copper Scrap hedge Each strategy has its own cost and disadvantages. The company should look forward to the strategy which minimizes its risk and cost of hedge.
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Hedging Copper Price Risks
References
1. 2. 3. 4. 5. 6. 7. Sterlite industry website Hindalco website Hindustan Copper website Financial instruments to hedge commodity price risk for developing countries – Yinqiu Lu London meta stock exchange Iberian Minerals Corp - Hedge Policy and Position Dynamic Hedging of Copper options – Rahoitus, Maisterin tutkinnon tutkielma, Riikka Tuominen 8. FACTBOX-Hedging by copper producers – Reuters 9. Copper Market-COMEX Copper Future Trading and Options Trading 10. www.metalworld.co.in
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Hedging Copper Price Risks
doc_285556798.docx
This is a documentation about the commodity, namely copper, price risk management strategies of a global manufacturing company.
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Table of Contents
Executive Summary................................................................................................................................. 3 Copper Industry in India.......................................................................................................................... 4 Hindustan Copper Limited ...................................................................................................................... 5 Company Profile:................................................................................................................................. 5 Risks and concerns .............................................................................................................................. 6 Hedging ................................................................................................................................................... 8 Copper Production Flow: .................................................................................................................... 8 Working:.............................................................................................................................................. 8 Hedging Strategies .............................................................................................................................. 9 Futures ............................................................................................................................................ 9 Trading Strips ................................................................................................................................ 10 Hedging Against a Price Decline in a Potential High Volatility Market by Purchasing Out-of-theMoney Puts ................................................................................................................................... 10 Using a Collar to Protect a Price Level While Mitigating the Cost of the Hedge .......................... 11 Establishing a Price “Floor” by Buying Puts .................................................................................. 12 Commodity Swap .......................................................................................................................... 13 Premiums for Physicals or Discounts for Scrap............................................................................. 13 Conclusion ............................................................................................................................................. 14 References ............................................................................................................................................ 15
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Hedging Copper Price Risks
Executive Summary
This report examines the commodity, namely copper, price risk management strategies of a global manufacturing company. The company buys copper as raw material and sells the copper products it manufactures to its customers for a price that includes a separate copper price component. For the most part, the company fixes the price for which it buys copper from producers to the market forward price. The copper price component in the selling price is also fixed beforehand so that customers know in advance the price they will have to pay. However, the price-fixed purchases and price-fixed sales do not automatically even each other out since sales and purchases occur at different times and at different quantities. Historically, the company’s price-fixed sales have always been somewhat higher than price-fixed purchases at each moment. This creates a physical net short position on copper, which is hedged in the forward market. Since the company’s current hedging strategy uses only forwards to fix the price of copper, it is not able to gain from a beneficial move in the copper price. If the price falls, they may have to pay a price substantially above current cash price at the expiration of their forward contracts, implying that their customers must pay a high price for their product as well. Price fixations can extend to very long maturities, which, while adding to the predictability of earnings, can harm the company’s competitive position during a period of falling prices. Competitors may have more flexible hedging strategies and thus be able to bring their prices closer to market price. An additional risk arises when large positions at brokers, especially if maturities are extended far, can have an impact on liquidity. Commodity brokers usually require a margin for the position held under their account. This margin is not significant when price changes are moderate, since the fair value of the forward contracts is fairly close to zero. However, if prices move considerably, the margin requirement increases rapidly for two reasons. First, the fair value, assuming a negative price change, prompts an incremental deposit. Second, amid large price fluctuations the increased volatility triggers an augment in the so-called initial margin. The initial margin is calculated as a fixed portion of the position in tons, but the portion is determined based on the underlying asset’s volatility and can change at any point. The use of options decreases these risks by adding flexibility in the pricing of copper and by reducing margin payments. Especially, it should be noted that brokers bear no credit risk when options are used since the premium required is paid up-front. The premiums can, however, generate significant cost to the hedger whereas for forwards no premium is required. Therefore, a strategy where part of the forwards are replaced by options seems reasonable, since premium payments are decreased by lower volumes but additional flexibility is incorporated in the pricing strategy. To obtain options, the company can purchase a traded option or create the option synthetically by entering into the forward market. Both alternatives create a cost to the hedger that should be of equal magnitude. To decrease the cost of hedging, the copper producer can enter in collar option strategy. This results in buying of puts and selling of calls. Similarly the copper company could enter into copper swap so as to fix the price of copper.
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Hedging Copper Price Risks
Copper Industry in India
India does not provide a big market for copper. Due to shortage of copper mines and a low percentage of productivity of copper in the mines, India suffers a loss in the level of production and it has to completely depend on the copper ore imports. Also, not many companies are indulged in the refining and extraction of copper from its alloys and ores. India produces copper from the imported copper ore that accounts to around 6 lakh tons of production. This production level is contributes to a mere 4% share in the total copper production in the world. Indian market is divided into three parts i.e. primary and secondary. Primary segment comprises of the producers that convert copper ore into refined copper. Three companies namely Hindustan Copper ltd, Birla Copper and Sterlite Industries constitute this primary segment. Secondary segment comprises the producers that manufacture value added products made from copper like wires, foil etc. The domestic consumption demand of copper is around 5.5 lakh tons in the country. A major percentage i.e. 10% of the total consumption in India is contributed by the two major telecommunication providers namely BSNL and MTNL. The rest of the demand is contributed by the construction and automobile sector. India has always been an importer of copper ore to satisfy the domestic consumption demand. The countries from the ore is imported into India are ? ? ? ? Chile Indonesia Australia Canada
But, due to the rise in the production of the three major players in the Indian market, the country is now emerging as a net exporter. The production of copper has significantly during the last few years that has enabled India not only to satisfy it is own domestic demand but export refined copper in small quantities. The prices of copper in Indian market are highly dependent on the prices in London Metal Exchange
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Hedging Copper Price Risks
Hindustan Copper Limited
Company Profile:
Hindustan Copper Limited (HCL), a public sector undertaking under the administrative control of the Ministry of Mines, was incorporated on 9th November 1967. The GoI holds 99.59% of the paid up equity capital of the company. It has the distinction of being the nation’s only vertically integrated copper producing company as it manufactures copper right from the stage of mining to beneficiation, smelting, refining and casting of refined copper metal into downstream saleable products. The Company markets copper cathodes, copper wire bar, continuous cast copper rod and byproducts, such as anode slime (containing gold, silver, etc.), copper sulphate and sulphuric acid. More than 90% of the sales revenue is from cathode and continuous cast copper rods. HCL’s mines and plants are spread across four operating Units, one each in the States of Rajasthan, Madhya Pradesh, Jharkhand and Maharashtra as named below: ? Khetri Copper Complex (KCC) at Khetrinagar, Rajasthan ? Indian Copper Complex (ICC) at Ghatsila, Jharkhand ? Malanjkhand Copper Project (MCP) at Malanjkhand, Madhya Pradesh ? Taloja Copper Project (TCP) at Taloja, Maharashtra While Khetri and Ghatsila are fully integrated units (mining, ore beneficiation, smelting and refining), Malanjkhand has mining and ore beneficiation facilities while Taloja has wire rod manufacturing facility only. The combined capacity of HCL’s smelting and refining capacity is 51,500 MT per annum of copper cathode. The installed capacity at Taloja is 60,000 MT per annum of wire rod.
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Hedging Copper Price Risks
Risks and concerns
Main business risks faced by the Company arise out of volatility of LME price of copper and hardening of the rupee against USD. To insulate itself from the LME price risk, the Company has introduced ‘hedging’ as a risk mitigation tool. Another business risk faced by the Company is on account of delay in achieving the projected mine capacities due to socio-political factors, higher capital costs and related issues. This may restrict MIC production and put pressure on operating margins. ? LME price and TcRc for copper: The prices they pay for copper concentrate and the prices they charge for their copper products are based on the LME price for copper. Nevertheless, they are also exposed to differences in the LME price between the quotation periods for the purchase of copper concentrate and sale of the copper, and any decline will adversely affect them. They attempt to hedge against such risks, but are still exposed to timing and quantity mismatches. Treatment and refining charges, or TcRc, for some of their longterm copper concentrate supply contracts are also negotiated as a percentage of the prevailing LME price. In addition, certain of their long-term copper concentrate supply agreements provide for price participation terms which are linked to LME prices. As a result, any significant volatility in the LME price for copper could adversely affect our revenue and profitability.
The level of TcRc has a significant impact on the profitability of their copper business. These have been volatile and cyclical in the past. They purchase copper concentrates at the LME price for the relevant quotation period less TcRc. While their TcRc is negotiated between their supplier and them, their TcRc is influenced by global TcRc, which is primarily the result of factors such as the supply and demand of copper concentrates, prevailing and forecasted LME prices and mining and freight costs. Their TcRc prices are also substantially influenced by the benchmark price set by certain large Japanese smelters. The TcRc in the past has been volatile and any significant decline will adversely affect their profitability. ? Exchange rate fluctuations: They produce and sell commodities that are typically priced by reference to U.S. Dollar prices, while a majority of their costs are incurred in Indian Rupees. As a result, our financial condition and results of operations are affected, directly or indirectly, by the exchange rates of the U.S. Dollar-Indian Rupee. If the U.S. Dollar declines in value relative to the Indian Rupee, our revenues generated from and the profitability of the products we sell could be reduced. While they hedge currency exposures from time to time, as part of their risk management activities, their profitability may be significantly affected by exchange rate fluctuations between the U.S. Dollar and the Indian Rupee. Further, their hedging arrangements may, at times, limit the benefits of favourable exchange rate movements. In addition, the policies of the Reserve Bank of India may change from time to time and this may impact our ability to adequately hedge our foreign currency exposures.
Showing mettle: Processors hedge price risks involved in smelting and refining too
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Hedging Copper Price Risks
? Changes in customs duties: It may have a material adverse effect on their results of operations and financial condition. The customs duties on imported copper have been reduced over the last few years. Imports of copper metal are currently subject to a customs duty of 10%. The government of India may reduce customs duties further in the future, although the timing and extent of such reductions cannot be predicted. Since they sell a majority of their copper production in the domestic market, any reduction in these customs duties will have an adverse effect on our results of operations and financial condition. In addition, if customs duties decline further, they could incur additional competition from foreign copper producers which may force them to reduce their prices or decrease their domestic market share and adversely affect their result of operations. ? The government of India and other state governments may further increase the royalty rates/ cess they pay for their mines. ? Operations are subject to extensive regulations and may be adversely affected by present or future violations or enforcement actions including regulations relating to pollution and protection of the environment and worker health and safety. ? We incur and expect to continue to incur significant capital and operating costs to comply with environmental regulations. We could also incur significant costs, including clean up costs, fines and civil and criminal sanctions, if we fail to comply with environmental laws and regulations or the terms of consents and approvals. ? Business faces natural disasters and operation risks that may cause significant interruption of operations.
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Hedging Copper Price Risks
Hedging
Hedging is a vital risk-management tool now used by industries all over the world—primarily by metal, agricultural and energy producers, as well as processors and consumers. Hedging allows these entities to manage the price risk of their physical material by having an equal and opposite position in the futures market.
Copper Production Flow:
Copper Ore Import /mined Smelting of the copper ore Refining of the Copper
Treatment Charges & Refining charges fluctuation Exchange rate risk.
Pure Copper
Copper Price Risk Exchange Rate Risk.
Converting in to Copper Products
Working:
Hindustan copper company, which imports copper concentrate & mine it in India as well. Typically, import-pricing mechanism is on 2MAMA basis (pricing is fixed on the average cash settlement price on the exchange of the second month after the month of arrival). Copper concentrate contains pure copper, as well as traces of gold and silver. In this business, if copper prices are high, then TCRC charges (treatment and refining charges) are low and vice versa. TCRC charges are paid for by the supplier. These charges could range from $15-150 per tonne—which is eventually the actual profit margin. Therefore, the processor has to first hedge his TCRC price risk and then his finished products price risk. The typical copper percentage in copper concentrate is about 30%. Therefore, the hedge should be limited to the extent of the copper, not the entire copper concentrate. So, if the copper concentrate imported is 1,000 tonnes, the actual copper may be just about 300 tonnes.
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Hedging Copper Price Risks
Assume the shipping vessel arrives on May 1 at the Indian port, and it is ready to be discharged on May 11. As per the norms, pricing will be done for copper on the monthly average of cash settlement price of LME copper and for gold and silver at the LBMA prices for the month of July (2MAMA). The cost of smelting and refining is paid for by the supplier, as pricing is done on the actual metal price, which, in our example, has been assumed to be 30% of the concentrate. In the first stage, hedging for TC and RC takes place when the smelting process is running. If the company is importing 1,000 tonnes of concentrate and it is found on testing that 30% is actual copper, then a total of 300 tonnes will be long-hedged (since he doesn't have the copper yet) over the smelting period. In other words,if the price of copper decreases, then the decrease in price is partly made up by increased TC and RC charges. Reverse movement in price is offset by decreased TC and RC charges. This helps the processor fix his returns and eliminate uncertainty. In stage two of the hedging process, the processor now has pure copper in hand, and therefore a short hedge is required for price fixation. Since the price to be paid to the supplier for the copper will be the average of the cash settlement price using 2MAMA, the price hedge on the futures exchange will start on July 1. The quantity to be hedged on a daily basis will be the total quantity smelted divided by the number of trading days in the month. In this case, it will be around 300/22 =14 tonnes a day. By selling 14 tonnes (or 14 lots on MCX) a day over the month, the processor almost fully hedged in so far as making payment to the supplier is concerned. For commodity producers and consumers, hedging makes sense because it is beneficial in helping control, reduce and manage price risk. A hedging programme will clarify at first which risks the company is willing to bear and the ones it needs to control or convert by hedging.
Hedging Strategies
1. Futures Market: Risks associated with fluctuations in the price of the Company's products, copper are minimized by hedging on futures market. The results of metal hedging contracts / transactions are recorded at their settlement as part of raw material cost or sales as the case may be. Portion of the cash flow to the extent of underlying physical transactions having not been completed is carried forward as receivables/payables till the completion of the underlying physical transaction. 2. Forward exchange contracts and currency swaps and option to hedge its risks associated with foreign currency fluctuations. In respect of transactions covered by Forward Exchange Contracts, the difference between the forward rate and the exchange rate at inception of contract is recognized as income or expense over the life of the contract. 3. Commodity Options: A multiple Collar option strategy can be used. It is a cost free strategy to hedge against copper prices 4. Commodity Swap.
Futures
Short Hedges One of the most common commercial applications of futures is the short hedge, or seller’s hedge, which is used for the protection of inventory value. Once title to a shipment of a commodity is taken anywhere along the supply chain, from wellhead, mine, or manufacturing plant to consumer, its value is subject to price risk until it is sold or used. Because the value of a commodity in storage or transit is known, a short hedge can be used to essentially lock in the inventory value. A general decline in prices generates profits in the futures market, which are offset by depreciation in the value of the physical inventory. The opposite applies when prices rise.
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Hedging Copper Price Risks
Precious Metal Producer’s Short Hedge The producer hedge is of particular use to precious metals mining companies, especially during periods of high price volatility. In addition, the concept of price and revenue forecasting has become important to producers because of the substantial cost and lead time required of new mining ventures. Because precious metals markets are almost always in contango, gold, silver, and platinum group metals futures have removed much of the risk associated with new mine price and revenue forecasting. Precious metals producers are able to use short hedges to help secure project financing. In February, an official of a new mining venture reviews the company’s most recent copper production plans. The sales and production projections suggest that the company will have 3,000 ounces of newly mined and refined copper available for sale the following July. The executive considers the current price of the August copper futures contract at $310.20 favorable, given the company’s total production costs, including interest and depreciation, of $180 an ounce. As a result, the mining executive decides to lock in a profit by hedging his anticipated production.
Trading Strips
Strip trading is a flexible strategy that copper futures market participants can use to lock in a single price for two to 24 consecutive months forward. The strip trade is executed by simultaneously opening a futures position in each of the months to be hedged through a single Exchange transaction during the open outcry session. The price of the futures contracts for the strip is typically the average of the current market value for those months, although strips can trade above or below the average, depending upon market conditions. A seven-month strip, for example, consists of an equal number of futures contracts for each of seven consecutive contract months, bought or sold for a single account, quoted and traded at a single price. In obtaining an average price for multiple months, the hedger can average his cash flow over a period of time. The futures positions assumed in a strip trade are like any other futures position. All futures contracts are based on physical delivery. Any part of the position can be liquidated by an offsetting futures trade, an exchange of futures for physicals (EFP), or, if desired, physical delivery through the Exchange clearinghouse. Strips let a hedger retain the flexibility to change a strategy by buying or selling additional futures contracts in any month, or liquidating the position of any month of the strip, something that cannot be done easily with over-the-counter instruments. Regular margin requirements apply to strip trades.
Hedging Against a Price Decline in a Potential High Volatility Market by Purchasing Out-of-the-Money Puts
On December 23, a copper producer considers hedging against a weakening market. He knows his cost of production is 65¢ a pound, and wants to protect the most margins at the least cost. He does not want to hedge with futures, which would effectively lock in a July futures price of 94¢ per pound, nor does he want to spend 6.5¢ per pound for a July at-the-money put. He does want to protect his profitability against a significant drop in the price to 80¢, so the producer decides to purchase a put with a strike price of 80¢ for which he pays a two-cent premium. He considers this to be the optimum cost-efficient price protection, while allowing participation in any favourable upward price move. The producer has decided to hedge against the markets becoming highly volatile by purchasing an out-of-the-money put.
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Hedging Copper Price Risks
If the market price drops sharply, he will net no less than 78¢ per pound (80¢ for the copper, less the two-cent premium for the option). If prices rise, the premium of the option is the cost of the price insurance; if the market goes to $1.20, the producer will realize $1.18 ($1.20-2¢).
Using a Collar to Protect a Price Level While Mitigating the Cost of the Hedge
Sometimes the cost of buying an option can be more expensive than a company’s balance sheet requires. A collar strategy allows a hedger the opportunity to lower the cost of the hedge, while creating a beneficial revenue stream. A copper producer’s collar strategy involves the sale of a call, which is offset by the purchase of a put. The call and put both have out-of-the-money strike prices and expire in the same month. The producer would sell half as many calls as he would buy puts. That way, if copper futures prices rise, he would only be exposed on half of his tonnage; if the price drops, he can tender all of the tonnage. With July futures prices at 94¢, for example, the producer is exposed to falling prices and needs to set a floor. The cost of the 86¢-put is 3.3¢ per pound. Rather than incur this expense, the company decides to sell out-of-the-money calls to generate revenue. The effect is to cap the upside potential while reducing the cost of downside insurance. The risk manager decides to buy 100 puts with a strike price of 86¢ and sell 50 calls with a 100¢ strike price for a premium of 4.3¢ per pound. A collar of 86¢ to $1.00 is now set. The minimum he will receive for his production is 86¢, the maximum, $1.00. The financial effect is illustrated below:
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Hedging Copper Price Risks
Summary of Results: In each case, the outright cost of the collar was $1.15 per pound; a premium paid for the put of 3.3¢, and a gain on the sale of the call of 4.3¢. However, because calls were sold on only half as many puts, the net gain was 2.15¢ per pound. In Case A, the purchase of the put enabled the producer to gain 6¢ over the market price; when prices fell to 80¢, he was able to exercise his 100 puts and sell futures at 86¢, thus taking full advantage of the protection offered by the put. After subtracting the cost of the collar, the effective price of copper was 84.85¢ per pound. The 50 calls that he sold were deeply out-of-the-money, and thus were not exercised. In Case B, futures prices remained stable, but the cost of the collar — the producer’s cost of insurance — was $1.15 per pound, giving him an effective copper price of 92.85¢. In Case C, the producer’s exposure to copper prices above $1.00 through his short call position becomes apparent when futures prices rise to $1.20. He gains 6¢ a pound on the rise of prices from 94¢ to $1.00 for the 50 lots covered by the short call. There is also a gain of 26¢ a pound on the 50 lots that are not covered by the short call, totalling 32¢, which is an average market gain of 16¢ per pound on 100 lots. The $1.15 cost of the collar yields a net gain of 14.85¢ per pound, for an effective copper price of $1.0885. Thus the collar allowed the producer to participate in the rising market, although some of the potential gain was given up because of his obligation under the short call and the cost of the collar itself.
Establishing a Price “Floor” by Buying Puts
On March 16, spot copper is trading at 90¢ per pound, but a copper producer is concerned that prices will be lower in December when he will have product to ship. Since December futures are trading at 75¢ per pound, the producer considers selling futures to lock in that price to guard against a decline. However, he fears that if the current supply tightness persists, prices could rise above that level since copper is in backwardation. He decides to use options instead of selling futures, buying a December put with a strike price of 70¢ for 3.0¢. On December 1, the copper refiner sells spot copper and liquidates his options contract. The chart below illustrates the results if the spot price has decreased to 60¢ (Case A) or if it has increased to $1.10 (Case B).
Summary of Results: In Case A, the producer receives only 60¢ for his copper, but the financial offset provided by the 7¢ options profit gives him an effective selling price of 67¢ per pound (he paid 3¢ for
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Hedging Copper Price Risks
the option, but sold it for 10¢). This is eight cents less than he would have received using futures alone to hedge, but the reason he chose to purchase the put is apparent in Case B. If the price increases, the producer receives $1.10 from the spot market sale, but he would have lost 35¢ on the sale of the futures while the put option with the 70¢ strike price — the right to sell futures at 70¢ — now has no market value because futures are trading at $1.10. There is a net loss of 3¢ — the options premium paid on the position, giving the producer an effective selling price of $1.07.
Commodity Swap
There are two types of commodity swaps: fixed-floating or commodity-for-interest. Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices. General market indices in the commodities market with which many people would be familiar include the Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board Index (CRB). These two indices place different weights on the various commodities so they will be used according to the swap agent's requirements. Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate (plus or minus a spread). In Commodity swap, one counter party make a fixed periodic payments to the second at a per unit fixed price for a given quantity of some commodity. The second counterparty pays the first a per unit floating price for a given quantity of some commodity. A copper producer wants to fix the price for its copper output for next two year. To obtain the desired outcome, the copper producer enters into a swap with a commodity swap dealer but continues its transactions in actual in the cash markets. Suppose at the time of deal the copper price is $0.620 per pound. The dealer has to make fixed payments for which he charges $0.0025 per pound. Hence the copper producer receives a fixed price of $0.6175 per pound. The copper producer will pay him the average floating spot price of copper. If the copper price decreases, the copper producer pays less and receives more from the dealer. As the result the net loss from selling copper at less price is covered with the profit from the swap deal. Hence the copper producer gets a fixed price for the copper produced.
Premiums for Physicals or Discounts for Scrap
Basis usually is not a major consideration in the precious metals markets, although differences in supply and demand conditions between market centres can cause a premium in the price of the delivered physical commodity to the price of the futures. Basis can be more problematic for copper market participants. Metal which does not meet the purity specifications of a metals futures contract (scrap copper, for example) will be priced at a discount to the futures contracts. On January 20, a scrap dealer buys five truckloads of No. 2 copper scrap over the scale from a collector at the March COMEX Division futures price less 21¢ per pound, the prevailing discount for scrap. At the same time, he sells March COMEX Division futures at 90¢ a pound, the current March futures price. The scrap dealer is able to use the futures market to protect his position even though he cannot deliver scrap against the futures contract. On February 1, the scrap dealer sells the five truckloads to the ABC Copper Refining Co. at the March COMEX Division copper futures price, which is now 86¢, less 19¢, the now-prevailing scrap discount, and buys back his hedge.
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Conclusion
The report analyses the various strategies available with the copper producing companies to hedge their copper price risk. Copper price risk is one of the major risks faced in the copper industry. Depending upon the product available in their market, the companies can hedge its copper price risk and exchange rate risk. These strategies are risk management tools which work well in different situations. Some of the strategies are: 1. Forwards 2. Futures 3. Options 4. Collar option 5. Commodity Swap 6. Copper Scrap hedge Each strategy has its own cost and disadvantages. The company should look forward to the strategy which minimizes its risk and cost of hedge.
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References
1. 2. 3. 4. 5. 6. 7. Sterlite industry website Hindalco website Hindustan Copper website Financial instruments to hedge commodity price risk for developing countries – Yinqiu Lu London meta stock exchange Iberian Minerals Corp - Hedge Policy and Position Dynamic Hedging of Copper options – Rahoitus, Maisterin tutkinnon tutkielma, Riikka Tuominen 8. FACTBOX-Hedging by copper producers – Reuters 9. Copper Market-COMEX Copper Future Trading and Options Trading 10. www.metalworld.co.in
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