…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:

  1. A fool
  2. A liar
  3. Simply wrong or
  4. 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.

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