…that is the question.
Over the last few years many firms in Australia, and in particular the mining firms, have taken conscious decisions not to hedge. Note here I am not talking about hedge accounting, but economic hedging.
For the last few years this has been a very profitable strategy. Commodity prices have largely, and sometimes spectacularly, gone up. The Aussie dollar has been largely stable in the 70 to 75 cent (to the USD) range, and so anyone that did hedge has normally been losing money on the strategy.
The temptation, then, has been to decide not to hedge.
The problem is that the future is, as always, uncertain. If you know anyone who can be certain what will happen in the markets even 5 minutes from now then I suspect they are one of:
- A fool
- A liar
- Simply wrong or
- Misinformed.
The thing that is not generally understood about a no-hedging strategy is that this is taking a particular view on the future. Provided this is known to your shareholders this is not a problem – it is their money that management is risking. Equally, making a decision to hedge is also making a call on the future. Of course, a firm can also decide to increase its exposure to a particular risk (and some do it by mistake) but I will ignore naked speculation of this nature in the rest of this piece.
Given the current very high commodity prices, though, for those not currently hedging it may be prudent to consider whether locking in some prices now may be prudent.
The problems with a conventional hedging strategy, though, are well known. During the 1980s and 1990s it was common to take out forward contracts to lock in a price for production. The problems came when your production fell short – with a forward you still need to deliver into the contract. The result is that you need to buy whatever it is you produce to deliver – leaving you exposed if the prices of your commodity have risen. The perverse result was that if producers had a prodution shortfall they would be praying for low prices.
My preferred path on hedging, though, is to use options. These have several advantages – but one, notable, disadvantage.
The disadvantage is clear – you (normally) have to fork out money up front. Most Boards, if asked to hedge, are used to forwards or similar derivatives, where there is no up-front cost – it is all buried in the margin, but you do not see that.
The advantages, though, are clear. With a bought option strategy the downside is known; it is the amount you have already paid out to get the option. The upside, though is unlimited. If your production does not come up to where you expect you can still make some money if the option is in the money – there is no further downside risk for you.
There are various ways to try to reduce the amount paid out to buy the options – simple caps and collars, “smart” or participating forwards (these are actually various options with knock-in, knock-outs) etc,. but the more complex the option play the less transparent the pricing gets and the more (typically) the bank will make from selling you the options. Additionally I would add that, if you cannot understand the position you are being sold in all its complications, you should not buy it. If you are not sure on this point, just google “Gibson Greetings” and “Bankers Trust”.
I have seen what I consider to be just about an optimal position. This strategy takes advantage of the currently (historically) very high prices for commodities – and the current high profitability of mining firms. It is to buy deep out of the money options, with the strike price set slightly above break-even for the mines concerned for every gram or tonne of forecast production.
As they are deep out of the money their cost is negligible (for example, the gold price is currently USD667 per oz. and these were at USD200 or so). The firm will, therefore, participate in (almost) all of the upside and all of the downside – with one, crucial, difference – it will not lose money due to the cost of gold being too low to mine profitably.
You will probably not get hedge accounting on this – but this is not really important. If you look at appropriate strategies now you have a really good chance to ensure your profitability for years to come. Think of it as an insurance premium and it may even get past the Board.
Posted on ozrisk.net
5 comments
20 July, 2007 at 01:03
bruce
Great article Andrew.
I’d taken hedging to be the elimination of risk by covering the negative risks to your business such that profitibiliy is dependable and consistent, and less boom/bust. I assumed some form of optioning was usually the method but I now appreciate the cost would be very high to eliminate risk but acceptable where the goal is to limit risk to a manageable level.
very well explained.
20 July, 2007 at 12:20
Andrew
Bruce – well put. Eliminating risk is expensive. Managing risk to a level you are comfortable with need not be.
20 July, 2007 at 23:52
Ralph
Today’s Board’s are driven by shareholder requirements – with large fund managers preaching the non-hedge philosophy. A relevant question is why then do fund managers then take out hedging to protect downside risk in an investment with exposures to interest rate, foreign currency movements or commodity prices? A classic example would be a large fund manager with exposure to a gold mining company’s share price taking out gold swaps in the background to hedge their exposure to the gold price inherent in the share price. Does this make sense? Of course not as fund managers do not live by the rules they preach. In reality if commodity prices dropped sharply and the currency rose sharply over coming years who is responsible should a mining company fail? The shareholder or the Board? I know the answer – the Board. Thus direct hedging by any company is important from an economic perspective to ensure a sustained future for the organisation – albeit hedging a relative percentage versus 100%. Comments welcomed.
21 July, 2007 at 00:58
Andrew
Ralph,
Thanks for welcoming comments :).
The funds managers tend to prefer no-hedge strategies as it makes a company easier to price and therefore more valuable. Additionally, in the long term hedging does cost no matter what way you do it. So, in the long term, the strategy that pays the best is not to hedge. In the long term, though, we are all dead.
As fund managers normally have a broad spread of firms in their portfolio, the failure of any one firm will not greatly affect the value of the portfolio. For those of us invested in funds (and that includes all Australians in employment through our superannuation) this is a good thing.
For boards, though, it is a problem. They owe a fiduciary duty to the firm – and several legal duties. Their first duty is to act bona fide in the interests of the firm – and that means there has to be a firm to keep running.
For the last decade or so the unhedged strategy has paid well – just ask BHP. What I am saying here is that it may be time to re-appraise it. Fund managers do not (and should not) run the firm, but, as part owners, they have a right to be heard. It is the board, though, that must make the decisions.
I would agree that hedging a relative percentage is a good precautionary measure – given where commodity prices are now I feel that the strategy outlined here is a good precautionary one.
As for the fund managers – they have a right to be heard, as stated, and they have a right to know what the strategy is. Beyond that they only have the right to receive dividends.
21 July, 2009 at 10:46
Fan Poh Lin
Generally the decision to hedge is based on exposures and risk tolerence. However, even if exposures are well within tolerence, we should still consider hedging if we can lock in at desired spreads. We can then put aside the lock-in profit and focus on new business. With the lock-in profit, the exposure is also reduced and gives room to take on new positions. So, it may not always be an opportunity cost when hedging. Locking in spreads and doing new business is giving additional gain.