INTRODUCTION TO COMMODITY HEDGING
Commodity derivatives are financial instruments whose value depends on the price of the commodity. By using a derivative in the “opposite direction” to the physical commodity exposure, you can offset i.e. “hedge” the change in value of one with the other.
Commodity markets can be volatile, and a variety of market participants are exposed to price moves:
Producers Miners, oil companies and farmers benefit from high prices
Consumers Car companies, airlines and food producers benefit from low prices
Processors and intermediaries Smelters, refineries, crushers, merchants who buy, process and sell material, so benefit from contango curves
Speculators Use derivatives for direction, diversification and relative value plays
Chart 1: S&P 500 Futures - Monthly
Whilst financial speculators have been a significant presence in the metals markets since the mid-1990s, after Alan Greenspan recommended that bond investors buy commodities as a hedge against inflation, commodity hedging has been used in agriculture and metals markets since the 1500s.
This article takes a look at some price hedging strategies using LME copper for illustration, but similar strategies apply to the same class of user across the commodity markets.
1) OPERATIONAL HEDGING AND STRATEGIC HEDGING Commodity hedging can be split into two types: 1.1 “Operational Hedging” uses derivatives to offset the price risk of individual physical and customer contracts. These are frequent, small trades, using futures or forwards to hedge individual shipments and fixed price customer deals, taking the hedger back to a price neutral position.
1.2 “Strategic Hedging” is an attempt to lock in market price levels which appear favourable, by taking significant hedge positions which will have a real impact on the overall P&L of the business.
Chart 1 shows LME 3m Copper prices since April 2005 together with annualised historical volatility. With the benefit of hindsight, it suggests that hedge sales at or above $8000/Mt performed well.
Source: LME / Reuters / ADMISI
14 | ADMISI - The Ghost In The Machine | Q1 Edition
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