Actually, prior to the wave of pension fund buying which engulfed commodities from 2004 onwards, LME copper prices had an expected price range of $1300-$3300/Mt, which explains why some experienced copper longs hedge sold as the rally pushed above $3000.

Speculative investors cited Chinese economic growth as justification for the copper rally, but didn’t prevent heavy short selling of copper by China’s Strategic Reserve Board in 2005, incurring heavy losses.

The commodity price volatility of the past 15 years made strategic hedging a risky occupation. Corporate hedgers had little upside if the hedge book went well, with their jobs at risk if the hedge book lost money.

Additionally, equity investors in resource companies at the bottom of the price cycle were vocal anti-hedgers because it curbed their upside price exposure. However, many of these same investors would exit their equity position at the top of the cycle, leaving resource companies un-hedged before a price fall.

Nowadays, strategic hedging is much more structured, with hedging miners operating a scale up hedge program approved by the board.

Histograms are sometimes used to plan hedge programs, with the percentage of production and tenure to be hedged increasing with price level. The copper chart 2 below shows days spent in each $500 range (left scale) with % of days at or below a particular price range on the right scale.

Tighter capital adequacy rules, smaller bank hedging lines, preference for vanilla strategies, higher initial margins, stricter regulation and memorable trading losses mean that strategic hedging books are much smaller and far simpler than in previous decades.

Chart 2

2. HEDGING INSTRUMENTS AND “DELTA” 2.1 “Futures” are the most common hedging instrument, allowing hedgers to “lock-in” prices.

Futures are exchange traded and either cash settled (basis the difference between the contract Fixed Price and the prevailing Market Price) or physically settled for the future date.

“Forwards” are Fixed Price contracts to buy or sell with similar economics to futures, but tend to be traded over the counter (OTC). The London Metal Exchange offers exchange traded forward contracts that result in physical delivery unless the position is closed out.

The payoff diagram 1 shows the impact of market prices (x-axis) on the value of a long position (red line) and a short position (dashed line) in LME Copper at $5700/Mt, comparable to the unhedged position of a producer and a consumer respectively.

“Delta” is the change in the value of the derivative as the underlying market price increases, and understanding delta is key to hedging. Looking at the long position, its value increases by $100 for each $100 increase in market price, i.e. a delta of +100%. Conversely, the short position has a delta of -100%.

The simplest way for a physical long (i.e. producer) to hedge is to sell a future. The sum of the two deltas is zero, thereby negating the effect of market price moves on the hedged position. Conversely, the simplest way for a physical short (consumer) to hedge is to buy a future.

Hedging with futures gives a known, fixed price outcome whatever the market price, but “options” allow hedgers to tailor a strategy to their market price view.

Diagram 1

Source: LME / Reuters / ADMISI

Source: LME / Reuters / ADMISI

15 | ADMISI - The Ghost In The Machine | Q1 Edition

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