November/December 2012
With scrap commodity prices seemingly more volatile than ever, many scrap companies are hedging to reduce their price risk. Both physical hedges and derivatives-based strategies can lessen the impact of market ups and downs, but there’s always a cost.
By Ann C. Logue
There’s enough risk involved just getting up in the morning. When scrap managers think about the risks of scrap price fluctuations due to global supply and demand effects they can neither manage nor foresee, they might want to just crawl back into bed. Or, alternatively, they can hedge.
With hedging, scrap processors and traders manage their price risk to stabilize revenues and expenses. It’s like buying insurance, in a way. The company pays some money now to avoid paying a lot of money in the future if something bad happens. With car insurance, if your car is in an accident, you might be able to make the repairs or replace the car for only the cost of the deductible. With hedging, scrap companies can protect themselves against skyrocketing prices on the buy side or plummeting prices on the sell side. This helps them manage cash flow, handle large quantity orders,
and quote future prices.
Though many companies operate without hedging, doing so carries certain risks. If expenses move higher than revenue, a company could end up with a cash shortfall. Many scrap companies pay more attention to their profit margin than to their revenue, and price fluctuations can wreak havoc with margins. Hedging can reduce those risks, but it’s not a free and easy way to guarantee profits. Companies that hedge need to have the cash to lock in inventory prices or to buy derivatives contracts, and they give up the benefit of price movements in their favor. In other words, protecting against the lows also means losing out on some of the highs. Some hedgers also have faced losses from the failure of their derivatives brokers (see “What About Broker Risk?” below).
One problem is that scrap—especially ferrous scrap—comes in many varieties, which makes it tough to hedge directly. Even the one U.S. ferrous scrap contract currently trading, on Midwest No. 1 busheling, is based on a narrow specification that few yards might have in stock and few producers might use regularly. Further, most hedgers purchase contracts for specific metals, such as copper or nickel, when the material they’re buying and selling might be mixed metals or alloys of two or more—or they might not be buying metals at all. If a futures contract is not available for some or all of what’s being bought and sold, it leaves some portion of their position exposed to price fluctuations. Alasdair Gledhill, nickel product manager at stainless processor ELG Metals (McKeesport, Pa.), says he hedges what he can. With stainless, “you can’t hedge the chromium, so that leaves you with the nickel and the iron,” Gledhill says. Still, that’s better than no hedging at all, he says. “If you’re in the scrap business and you’re not hedging your nickel units, you’re leaving yourself wide open to price risk.”
There are two ways to hedge: physical hedging, which involves matching inventory to orders, and derivatives hedging. Both approaches help companies manage prices, which can lead to more stable profits, but both have costs.
Physical Hedging
The goal of physical hedging is to lock in the price through up-front purchases or contract terms. In most cases, scrap companies achieve this through back-to-back purchases and sales on the same day to lock in profit margins. Another approach is to build inventory when prices are favorable so that the price is locked in. Physical hedging is simple, involves no fees, and requires no trading expertise to keep track of the hedge. It lacks flexibility, however, especially for processors that can’t store large amounts of material on site. Physical hedging dominates in the ferrous market in particular because, for the most part, suitable derivatives contracts don’t exist. “The contracts out there are for nonferrous refined ingots,” says Edward Meir, senior commodity analyst at INTL FCStone (New York), a futures commission merchant, or FCM.
The primary cost of a physical hedge based on inventory is storage: Companies have to be able to hold inventory where it is accessible until they can find someone to buy it. Further, they might have money tied up in the inventory, depending on their financing arrangements. Successful physical hedging also requires having enough customers and suppliers to match orders quickly, allowing the company to lock in profits as soon as possible.
Derivatives Hedging
Sometimes a physical hedge is not available for a transaction. For example, a customer might place an order to buy material before a scrapyard has enough supply to fill it. In the time it takes to purchase the quantity of material needed, the price can rise beyond what the customer is paying. That leaves the yard exposed on one side of the deal. Many scrap companies rely on the derivatives market to manage the other side of these transactions.
In the metals markets, most derivatives are futures contracts sold on the London Metal Exchange, the New York Mercantile Exchange, the Commodity Exchange (Chicago), or the Chicago Mercantile Exchange. When you purchase futures, you agree to buy or sell the commodity in the future at the price that’s set now. (You also have the option of closing out the transaction—selling the futures contract before it expires—to get out of that obligation before you have to fulfill it.) Someone who buys futures in order to lock in a price to buy a commodity is said to be long; someone who sells futures to lock in the price to sell a commodity is said to be short.
Some contracts call for physical delivery: When the futures contract expires, the seller must actually provide the material to the buyer if the buyer wants it. Other contracts call for financial settlement, in which the contract holders trade money rather than goods, with the money being based on the value of the commodity so that, in theory, the contract’s buyer could buy the material on the open market.
In September, the Chicago Mercantile Exchange started trading a futures contract based on the American Metal Market Midwest No. 1 busheling ferrous scrap index. It’s part of the exchange’s Virtual Steel Mill suite of products, which currently include iron ore and hot-rolled coil, and it calls for financial settlement. “Scrap specification varies so much,” says Youngjin Chang, director of metals research and product development at CME Group (Chicago), that futures contracts based on physical settlement can be more difficult to develop.
Some metals can be hedged with options, which give holders the right, but not the obligation, to buy or sell a commodity in the future at a price set now. A put option gives holders the right to sell a commodity at a predetermined price, and a call option gives holders the right to buy it.
Commissions on futures transactions are usually $2 or less per contract, depending on the futures commission merchant. (FCMs, like stockbrokers, provide different levels of research, education, and service.) Each contract has its own specifications. For example, each contract on the American Metal Market U.S. Midwest No. 1 busheling ferrous scrap index covers 20 gross tons of material. To cover 100 tons, a buyer would need to purchase five contracts.
In addition to the commission, the buyer or seller of a futures contract also must have a specific sum of money—the initial margin—on account with the FCM. The current value of a contract determines the size of the initial margin it requires. If the contract decreases in value, the margin has to increase because the risk
of the contract being executed at a loss goes up.
For example, suppose you purchase a contract to sell steel for $330 a ton in three months. Then the price of steel goes up to $340 a ton. Your contract has declined in value; after all, a rational person would rather sell at a higher price than a lower one. You either have to have additional money in your account to cover the decline, or you have to close the position—selling a contract that you bought or buying a contract that you sold—and lose the hedge.
On the other side of the contract, the person who has the futures contract to buy steel at $330 per ton gets a credit of $10 per ton transferred into his or her margin account by the exchange clearinghouse because being able to buy steel at $330 when the market price is $340 is valuable.
“If a scrap company hedges a long physical position with a short futures position, it will be required to post additional variation margin to the futures exchange in a rising price environment,” says Lewis Hart, a vice president at Brown Brothers Harriman (New York). This starts to tie up cash, which catches many firms unawares. “When [people] get into trouble is when they get margin calls and they don’t have [the] money to put up, so they have to start liquidating” their positions on the commodity exchange, says Michael Eisner, founder of Premier Metal Services (Cleveland). That leaves their inventory exposed, as if they had never hedged in the first place. “When you’re putting in a hedging program, you must have the capital behind you so that never occurs,” he says. “You must have enough money to support your position.”
Opting Not to Hedge
Derivatives markets have long existed to help producers hedge their risk. The Chicago Board of Trade was founded in 1848 to help farmers, and the LME was founded in 1877. Agricultural contracts have a longer history, as well as multiple university agricultural economics departments to study them. That’s why the little data that exists on hedging tend to focus on its use in agricultural markets and, to some extent, on companies with foreign currency exposure. A 1990 paper in the American Journal of Agricultural Economics, for example, found that high-debt farms hedged all of their expected soybean production, medium-debt farms hedged 81.7 percent of their production, and low-debt farms hedged 39.7 percent of theirs. The implication is that farmers with high debt are more careful about their cash flow than farmers with less debt.
Sometimes it’s simply not cost-effective to hedge, the same way it’s not cost-effective to buy an extended warranty on a new MP3 player, no matter what the salesperson at the electronics store says. In other cases, firms want to keep the possibility of maximizing their gain from a run-up in prices, so they choose to leave some or all of their position unhedged. Furthermore, both physical and derivatives hedges have an opportunity cost: Money spent on a futures contract is money that can’t be spent purchasing material, and the need to purchase a specific type of scrap at a certain price on a certain day means losing out on other, potentially more lucrative purchasing opportunities. From Chang’s perspective, however, the cost to use derivatives to manage volatile scrap prices is relatively small because futures positions are executed on margin, and the benefits are clearly worth the cost. “Participants can use them to stabilize their cash flow and secure their bottom line,” Chang says.
If companies don’t hedge, they should set money aside in good years to protect against the bad years. It doesn’t take many years of scrap experience to realize prices move in both directions. Not hedging might result in greater total profits, but it also is likely to result in greater swings in profitability from year to year. Saving money to prepare for a bad year takes discipline, though, and it creates its own risk of investment loss or loss due to inflation, so most companies seem to hedge at least some of the time.
Every company that wants to stay in business needs to find a way to manage price risk, but that doesn’t necessarily have to involve derivatives. A scrap executive who wants to retain exposure to prices in the hopes of increased profits needs to manage the company’s cash flow differently than an executive who chooses to hedge all transactions to reduce volatility, but both have exposures to manage.
Certain types of transactions have more price risk to them. Matt Kripke, president of Kripke Enterprises (Toledo, Ohio), says he offers customers formula pricing on large-quantity sales, and he feels those agreements need to be hedged, especially in the aluminum market. Likewise, Hart notes that hedging is common, or even required, in export scrap sales. “Scrap consumers in Asia are typically pricing material closer to the time when they are actually consuming it, reducing their economic incentive to renegotiate contracts if prices fall,” he explains.
Because so many Brown Brothers customers are also borrowing money through the firm, the company prefers that they hedge their commodity price risk as much as possible, Hart says, especially if they’re trading nonferrous materials that are easy to hedge. “This is particularly important in light of the more pronounced volatility of recent times,” he says.
Some scrap executives see the issue in stark terms. Companies that don’t manage their price risk might do well, they say—but they also might go under. Hedging is “kind of a lifestyle choice,” Eisner says. “You either do it or you don’t. If you aren’t all-in with hedging, you’re speculating.”
Ann C. Logue is a Chicago-based freelance writer, former investment analyst, and finance lecturer at the University of Illinois at Chicago.
What About Broker Risk?
One risk associated with financial hedging many companies had not considered was suddenly a worry—or, for some, a crisis—when MF Global (New York) filed for bankruptcy on Oct. 31, 2011, after experiencing huge losses stemming from speculation in European government bonds. The company was one of the largest futures commission merchants in the world, so its bankruptcy affected people who traded derivatives in almost every industry. As the firm neared insolvency, its management allegedly authorized the use of customer funds to meet margin calls on its European bond transactions, leading to the loss of that money. On July 10, 2012, another well-known futures commission merchant, Peregrine Financial Group (also known as PFGBest), filed for bankruptcy after its founder confessed to fraud with customer money as part of a failed suicide attempt.
The Wall Street Journal has reported that trustees have returned to MF Global’s U.S. customers more than $4 billion of the up to $6 billion in segregated funds the company transferred out of their accounts shortly before its demise. The newspaper also reported in September that some Peregrine customers would soon get 30 to 40 percent of their account balances back, though those who had accounts for trading currencies and metals would not be among them. Peregrine’s customers might be helped somewhat by protections that were put in place after the MF Global collapse. These include the new CME Family Farmer and Rancher Protection Fund, which gives a payout to some agricultural contract customers when they’re affected by a brokerage collapse. The fund does not apply to those in other industries, however.
“The great irony is that the purported provider of risk management solutions became the actual source of risk,” says Lewis Hart of Brown Brothers Harriman (New York). As part of their overall risk management, many of his company’s clients are now considering the risk of their FCMs failing, he says, and they’re using several FCMs if they have enough trading volume.
One of the other ironies, though, is that FCMs are not necessarily forbidden from using customer funds as MF Global is alleged to have done, which is called rehypothecation. For example, the 2011 futures account agreement from ABN-AMRO Clearing Chicago, a major futures trading and brokerage firm, states that “Except as prohibited by Applicable Law, all Collateral now or hereafter held or carried by AACC for Customer may, from time to time, without notice to Customer, be pledged, hypothecated, loaned, or invested by AACC to or with AACC or others.” This is a standard clause, and it has led some market observers to conclude that MF Global’s use of customer funds might have been legal.
That’s one reason why Michael Eisner of Premier Metal Services (Cleveland) is advocating for changes to derivative margin account rules that place such accounts under the Security Investors Protection Corp. (Washington, D.C.), which protects holders of stock and bond funds. He also advocates allowing brokers to post Treasury bills in a customer’s name that the broker cannot use for other purposes, or redefining margin money as a receivable so it could be insured by outside parties. “I carry receivables insurance on all my customer receivables, but I can’t get receivables insurance on my brokerage receivables because they are considered depository accounts,” he explains.
Regulatory changes would not solve all of the problems that occurred with MF Global and Peregrine Financial, however. “When people are stealing your money, it doesn’t make any difference who your counterparty is,” says Edward Meir, senior commodity analyst at INTL FCStone (New York), who, coincidentally, formerly worked for MF Global. “Your money is gone.”
With scrap commodity prices seemingly more volatile than ever, many scrap companies are hedging to reduce their price risk. Both physical hedges and derivatives-based strategies can lessen the impact of market ups and downs, but there’s always a cost.