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30 November 2016

Hedge Sales - Who and Why?



Does forward hedging make sense for miners? Many years ago, I wrote my MBA thesis on that subject. There’s probably still a copy of it gathering dust in the City University - now Cass - Business School library. I used Escondida as an example of a low-cost, efficient mine to try and assess the value of a hedge. Of course, since the mine owners were (understandably) reluctant to be too forthcoming about their cost of production, I had to estimate that, which probably meant that the resulting document was more interesting academically than practically.

However, the principle was there, and the conclusion that emerged after running an enormous number of simulations was that a mine with a cost of production around where I had guessed it - and in fairness I suspect that the guess was not wildly wrong - would in the long run be better served by not making forward hedge sales and rather relying on taking the ruling annual average price. If I’m honest, I had hoped that I would have been able to demonstrate the opposite, so that I could have taken my results to a raft of mining companies and persuaded them to hedge forward. Well, I suppose one shouldn’t be surprised that the policy mostly followed by the major miners for many years in fact turned out to be correct; after all, they are professionals at this.

Diversified Books

It all seems fairly clear; investors buy mining shares because they want to have an investment in the ownership and production of metallic resources. If the directors of the miner hedge forward, they are reducing their shareholders’ exposure to the fluctuating price of the commodity. And yes, to get that exposure fully it means taking the risk of falling as well as rising prices. But that’s at the top level; Rio/Anglo/Glencore/BHP et al have the diversified book to be able to operate such a strategy effectively, and, crucially, make it an attractive prospect for investors.

Down the Food Chain - or up the Cost Curve

Lower down the food chain, though, the picture may look a bit different. For those lacking significant diversification of product, or, importantly, higher up on the cost curve, the hedge question is slightly different. For them, the temptation to fix forward prices may be an attractive siren-song. Although it may tread on investors’ toes (for the reasons above) it does offer the prospect of protecting the mine, and, crucially, protecting jobs. Additionally, there may be pressure from debt holders (typically banks) to ensure their money is safe - or as safe as it can be in a mine, anyway. So in that case, the use of the terminal market can enable production to continue, even when the cost of production is greater than the ruling spot price (of course, the corollary to that is that there will also be times when product is sold at a price lower than the ruling spot price - security always has a balancing cost somewhere).

Frictional Costs

In a purely rational world, that probably wouldn’t be the case. A mine is a hole in the ground, containing a particular sort of dirt with a commercial value. In a completely rational environment, it would be exploited while the price was higher than its cost, and shut whenever it dropped below that level. There are other factors at play, like the cost of opening and closing, the cost of idled equipment, social costs of employment, which also serve to muddy that strict rational picture. In reality, we all know that it doesn’t work according to that simple hypothesis, and that the overall picture is blurred by all those extraneous considerations and frictional costs.

Why Now?

So why rehash this simplistic theory now? Well, markets are beginning to shake off the lethargy they have shown in recent times and, probably equally importantly, there is a fair consensus that an upward move is indicated; the bulk of the debate now is whether it will be a weak or a strong rally. We have already seen reported some small producer forward hedge deals done, and more will follow. So it seems a good time to think about why hedges are put on, and who are the likely candidates.

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