Taming Risk

Risk takes many forms in the scrap industry, from safety and environmental hazards to price volatility and bad debts. Indeed, if Scottish poet Alexander Smith was right when he said “Everything is sweetened by risk,” scrap recyclers must sometimes feel as if they’re drowning in saccharin.
   Still, though risk is often an unavoidable aspect of buying, processing, and selling scrap commodities, that doesn’t mean it must be an unmanageable fact of business life.
   State and federal laws, for instance, require companies to manage some risks by establishing safety programs and paying into workers’ compensation plans.
   Likewise, a variety of voluntary risk-management techniques can help scrap recyclers control or reduce the level of other risks they face. These techniques range from financial tools to insurance products and even basic strategies for buying and selling material.
   But keep in mind that “managing risk doesn’t always mean reducing risk,” notes Don Chance, First Union professor of financial risk management at Virginia Polytechnic Institute and State University (Blacksburg, Va.). “It means getting your risk at the level you want it to be.”
   After all, risk is often linked to reward, at least on the financial side. So a scrap professional trying to “manage” risk might decide to assume more risk—for instance, by taking riskier positions in the market, accepting a higher deductible for lower insurance premiums, or forgoing certain types of voluntary insurance.
   In such cases, the key question is how much money are you willing to lose if you make the wrong decision? Or, as insurers like to ask: What’s your risk appetite?
   To satisfy such appetites and help you avoid being consumed by risk, a good risk-management menu will include at least one or more of the following: hedging, credit insurance, and environmental insurance.

Hedging Your Future
In some ways, the decision to buy or sell scrap is always a bit of a gamble. But at least there’s a way for scrap recyclers to hedge the bets they make on the markets.
   Hedging is the term used to describe the risk-management technique of buying or selling futures contracts to offset the possibility of a significant change in a commodity’s price. Basically, the hedge locks in a price one or more months in advance for a predetermined quantity of a given commodity. The actual futures contract is for a primary commodity, such as copper cathode, traded on exchanges such as Nymex’s Comex division or the LME. The system works for scrap because consumers base their prices for many scrap commodities on Comex and LME primary prices, with the scrap price usually discounted.
   Scrap paper can also be hedged through so-called “market makers”—such as Houston-based Enron Corp.—that use derivatives contracts. And while scrap recyclers have expressed interest in hedging ferrous grades, there’s reportedly no system available to do that.
   It’s also possible to hedge with financial tools called options, but even experienced hedgers find these more complex and potentially riskier than futures, so they advise recyclers to steer clear.
The futures hedge, when correctly done, is only half of an overall transaction, as explained in this example from Nymex’s brochure, A Guide to Metals Hedging. 
   A transaction begins, for instance, when a scrap recycler buys a load of copper scrap in January at 86 cents a pound—which represents the then-current discount from Comex copper. But the recycler doesn’t have a customer for this scrap yet and worries that the price of scrap might fall before he finds a buyer. To offset that risk, he decides to lock in an acceptable price today with a hedge by selling a number of Comex copper futures contracts for March at the going price of $1.07 a pound. Ironically, the recycler doesn’t have any of the primary copper he just agreed to sell nor can he actually deliver the copper scrap in its place when the March contracts come due. But that doesn’t matter, as we’ll see.
   When the recycler finds a buyer for his scrap in February, he sells the material at 83 cents and hedges that transaction by buying copper futures at the then-current price of $1.02. Thus, while he loses 3 cents a pound on the actual scrap (called the “cash” or “physical” market in hedging jargon), he ends up 5 cents a pound ahead ($1.07 versus $1.02) on his futures deal, making an overall 2-cent-a-pound profit on the combined transactions. And while he bought and sold primary copper, he never actually possessed an ounce of it.
   While Nymex’s example sounds straightforward enough, scrap recyclers who hedge caution novices against thinking that the futures market is simple or easy. For instance, had Comex copper and scrap copper risen in value over this period instead of falling, the scrap recycler would have made money on the scrap deal but his profit would have been offset by losses on the futures transaction. In the Nymex example, the recycler makes 2 cents a pound on the overall deal, but that’s not as much as he would have made without the hedge.
   That’s why it’s important to understand that hedging is a tool for managing risk, not for maximizing profit. “A very thin, somewhat murky line exists between hedging and speculating,” notes Virginia Tech’s Chance, who warns: “This is not a game for amateurs.”
   Speaking of hedging in general, Chance observes, “You start off trading as a hedger and find yourself making a little money—and you get sucked in. You start thinking, ‘I’m good—I’m a good trader,’ and the next thing you know you’re starting to speculate. You’re taking risk rather than managing risk. You’re creating new risk beyond where you really need to be.”
Think Hamanaka and copper.
   So it’s important to closely monitor the person who conducts your trades, experienced hedgers advise. Also, consider hiring a professional, either in-house or at a brokerage firm. After all, the beginner’s classes on hedging offered by the exchanges can take two days just to cover the basics, notes Matt Levine, vice president of Leonard Levine Metals Corp. (Highland Park, Ill.) and a member of the Chicago Mercantile Exchange.
   Moreover, he adds, it takes great discipline to hedge properly even under the best conditions. For one thing, you can’t exactly hedge your scrap shipment since the typical truckload of scrap involves roughly 40,000 pounds of metal while the Comex copper contracts are sold in 25,000-pound increments. As a result, you must usually over-hedge or under-hedge, which can quickly lead to using your hedge positions for trading rather than risk management, Levine notes.
   Also keep in mind that futures contracts require a cash settlement at the end of each day. So if the markets move against your position—say, copper falls 1 cent a pound—then $250 will be taken from your account that same day for each 25,000-pound contract you purchased. And if the markets fall dramatically, you could pay several thousand dollars out-of-pocket just to maintain your position. Of course, if you hedged properly you’ll get all that money back at the end of the transaction when you sell the futures, but that won’t be for another 30 days or more, Levine explains.
   So start out slowly if you haven’t hedged before, suggests Sheldon Tauben, president of Metalsco Inc. (St. Louis), and make sure you know which scrap metals correspond to and move with the exchanges’ primary contracts. Most scrap recyclers use Comex for copper and the LME for aluminum and zinc, but not all grades of these metals can be readily hedged. Low-grade aluminum and brass rod borings, for example, are described as very difficult to hedge.
   In addition, understand that there are various strategies for hedging. The LME and Comex operate on different timeframes, for instance, with Comex offering contracts for standard months (say, March copper or May copper) while the LME works on rolling three-month contracts. OmniSource Corp. (Fort Wayne, Ind.) hedges some metals on a transaction-by-transaction basis and others at a more macroeconomic level based on its total net price position for a given commodity, explains Rick Rifkin, president of the nonferrous operating group. Meanwhile, Kripke Enterprises Inc. (Toledo, Ohio) bases its hedges on the dollar-value of its exposure in a given transaction rather than the pounds of physical metal involved, though the hedge itself, of course, involves buying a pounds-based contract, explains Larry Kripke, president.
   In the end, it’s crucial to remember that a hedge works primarily to reduce, rather than eliminate, risk. As Rick Rifkin notes, “A hedge isn’t going to make a bad sale good or a good sale bad.”

Avoiding Credit Catastrophes
Credit insurance is designed to protect scrap companies against losses if a customer that owes them money goes bankrupt—a common occurrence these days. Credit insurance works like other insurance programs in that customers pay premiums, deductibles, and copayments for policies that, in this case, cover the credit they extend to customers. Scrap recyclers can choose various coverage levels, including protection for all their accounts, specific accounts, or just losses above a certain level.
   Though commonplace in Europe, credit insurance has been viewed negatively by many U.S. scrap recyclers because of two misconceptions—that the policies are too expensive and that they don’t cover the accounts scrap recyclers truly need to cover, says Victor Sandy, vice president of Global Commercial Credit L.L.C. (GCC) (Bingham Farms, Mich.), an insurance broker.
   On the coverage question, Sandy states that “there are some people you shouldn’t extend credit to anyway.” Still, he adds, today’s policies are better-structured for the scrap industry than in the past. Recyclers will be “surprised at what underwriters can do now,” he asserts.
   Likewise, the costs associated with such policies have fallen by about 15 percent in recent years, Sandy says. Today, the typical premium runs from one-tenth to three-tenths of one percent of covered annual sales—for example, $10,000 to $30,000 a year for a company with $10 million in covered sales, he explains.
   Interest in credit insurance seems to be growing as the economy continues to sour. Currently, at least a dozen insurers, both domestic and international, offer such 
policies.
   OmniSource hadn’t used credit insurance in years, relying instead on its internal credit department to help manage customer-related risks, notes Gary Rohrs, CFO. But last year, “due to higher credit considerations and value-oriented premium pricing,” the company decided credit insurance would be a useful tool, Rohrs says. With the assistance and guidance of GCC, OmniSource shopped around, taking quotes from three insurers before choosing a policy that best matched its needs.
   “Even though we didn’t buy the policy with the expectation of losses or based on a short-term outlook, the timing of our decision was a wise one,” Rohrs explains. “The policy has already proven to be a valuable tool in hedging risk and helping the company reduce the impact of unexpected 
losses.”
Credit insurance offers policyholders four potential benefits, says GCC’s Sandy.
   • Protection Against Catastrophic Loss—especially if one of your largest accounts goes bankrupt. In fact, Sandy argues that scrap recyclers should be insuring their largest and therefore “safest” accounts rather than just their marginal accounts because a sudden bankruptcy by a large customer could force their company out of business.
   • Freedom to Expand Sales Safely. Covering new accounts or expanding coverage on growing accounts lets you extend more credit at less risk and, thus, safely grow your business, Sandy says. The incremental business from one or two such accounts will likely recoup the cost of the credit-insurance premiums, he adds.
   • Greater Borrowing Power. Credit insurance can help you borrow more money from a bank, Sandy says. That’s because many companies pledge their receivables as collateral. If such receivables are insured, chances are you’ll be able to borrow more money at a lower interest rate. Moreover, many banks exclude exports—even to Canada—from a company’s borrowing base, Sandy notes. Credit insurance, however, can return covered exports to that pool.
   • Expert Credit Advice. Credit insurance can help companies decide how much credit to offer their customers, Sandy says. The especially appealing part, he adds, is that it’s the underwriters who’ll pay if they let you extend, say, $50,000 credit to a covered account that then defaults. [If, however, a credit insurance program is not a good match with your company’s goals, you can always “fall back on ProfitGuard, the only credit advisory service exclusively for the scrap recycling industry,” Sandy adds. Through an annual subscription, companies can secure credit-limit recommendations and put key accounts on an alert service for ongoing monitoring, he explains.]
   Larry Kripke is a true believer in credit insurance. When he was starting his brokerage firm in 1993, he found that credit insurance made both banks and scrap suppliers more comfortable about doing business with him. Plus, as a two-person operation, he can’t afford to have a credit department or even purchase expensive credit rating reports, so he lets GCC handle those tasks for him.
   Metalsco’s Sheldon Tauben also touts the benefits of credit insurance for “those accounts that we consider less-than-gold-plated.” And while he’s filed only two claims over the past 25 years, Tauben considers his credit-insurance premiums an investment in his peace of mind. “Credit insurance lets you sleep at night,” he concludes.

Green Peace of Mind
Peace of mind through premiums can also describe another specialized type of insurance useful in managing risk: environmental insurance. Though Business Insurance magazine recently reported that there are only a “relatively small number” of environmental insurance underwriters, at least one of those underwriters focuses specifically on the scrap recycling industry.
   ECS Underwriting Inc. (Exton, Pa.) teamed up with ReMA last year to begin offering a specialized pollution liability program for scrap recyclers. The program offers recyclers one to five modules of coverage, with essentially a $1-million cap per occurrence, for liabilities involving:
   • third-party loss and remediation (for bodily injury, property damage, and remediation costs caused by pollution “emanating” from your location);
   • first-party loss and remediation expense (from pollution conditions on, at, or under your location);
   • products pollution liability (including issues involving radioactively contaminated scrap shipped to consumers);
   • non-owned disposal sites (primarily for waste sent to landfills); and
   • contingent transportation (for pollution liabilities arising from the transportation of scrap or waste by a third-party carrier).
   While various scrap recyclers have purchased such policies, no claims have been filed in the roughly one-year life of the program, which isn’t surprising, says Joe Catanese, ECS’s assistant vice president, since the nature of environmental incidents is, fortunately, infrequent. He adds that these policies don’t distinguish between sudden contaminations, such as a ruptured aboveground storage tank, and gradual contaminations from an undetected leak, nor between onsite or offsite incidents.
   So far, many of the companies buying such policies have been larger scrap operations with multiple locations, notes Joe Madigan, an ECS underwriter. In many cases, he adds, these policies have helped satisfy requirements from local governments that the scrap processor put money in escrow in case of an environmental accident.
   Premiums are averaging $10,000 to $30,000 annually, though ECS also offers a special minimum premium of $5,000 for ReMA members that, in most cases, offers principally the third-party loss and remediation coverage.
   In addition to helping scrap recyclers manage their environmental risk through insurance, the program encourages proactive risk control by usually offering lower premiums to companies that have good radiation detection equipment and providing assistance in the form of a risk consultant who can tour scrap facilities and make recommendations on ways to reduce risk. These consultants can look into how well the recycler stores and handles raw materials, how he maintains aboveground or underground storage tanks, and what kind of inspection programs, storm water management plans, and other programs the recycler has in place, says Beth Gaughan from ECS’s risk control division.
   Moreover, ECS can help with due diligence for the Superfund Recycling Equity Act, provide a training module on radiation issues specifically for scrap recyclers, and offer assistance in more general areas such as emergency response plans. The company can also put recyclers in touch with legal expertise or even an emergency- response team in case of an environmental accident, Gaughan notes. Such services can be provided either on a fee-basis or as part of the insurance policy, depending on what premiums the recycler pays.

Managing By Other Means
Beyond the three risk-management tools discussed above, scrap recyclers can purchase other insurance policies or follow various strategies to satisfy their risk appetite. Switching from company-owned trucks to contract carriers, for example, is one way of shifting certain risks, such as workers’ compensation for drivers and damage to the vehicles themselves, notes Monica McNally, senior vice president of Willis of New Hampshire Inc. (Rochester, N.H.), which handles the RecycleGuard property and casualty insurance program for ReMA members. 
   Property insurance can also be tailored to meet individual risk preferences, she says, with some companies wanting to insure everything and others opting to cover only buildings and equipment above a certain value.
   Good risk management, McNally stresses, must have a proactive nature to it—a determination to work diligently to avoid and/or control risk. “The purchase of insurance is only one of the risk management tools, and it must be managed in conjunction with controlling exposure to loss,” McNally says.
   Likewise, scrap recyclers who want to manage price risk don’t always need to expose themselves to the potential bite of the futures market. Both Matt Levine and Rick Rifkin outline strategies that essentially involve “hedging” prices by selling scrap to brokers or consumers at predetermined times—whenever you have three-fourths of a truckload, Levine says, or whenever you’re concerned that you’ve bought too much material and expect the price to drop, notes Rifkin—regardless of what the price is at that moment. 
   In the end, such buying-and-selling strategies can work as well as actual hedging, without requiring you to pay commissions or brokerage fees or delve into unfamiliar financial territory.
   Perhaps the most useful risk management tool of all, though, is self-discipline. Larry Kripke says his father used to say “the most important word you’ll ever learn in the world of business is ‘no’—to know when to say ‘no.’”
   In every business cycle, he adds, there’s a certain time when it’s more prudent not to do certain business. But on slow days, scrap recyclers often feel an overwhelming urge to make something happen, to get on the telephone and make some kind of deal.
   “Invariably,” Kripke says, “that deal turns out to be something you shouldn’t have done.” •