Managing Price Risk Apr. 1, 2009 John Gross | Electrical Wholesaling
Hedging can help protect buyers of copper and other metals from wild swings in prices.
We have all seen unprecedented price volatility for commodities over the past few years, with copper in particular subject to violent swings. In just the past nine months, copper soared to record highs, only to fall precipitously to multi-year lows.
Any number of factors may contribute to these sudden reversals, including fundamental considerations, changes in foreign exchange rates and speculative influences, as well as our overall perception of future economic conditions. Thus, it comes as no surprise that many organizations feel they are at the mercy of the markets, with little or no control over metal prices or the damaging impact upon their business.
While it's true that no one can control the price of copper, many tools exist that can help you manage price risk and enable your organization to prosper during turbulent times. The first step is to clearly define the risk your company faces by asking yourself the following questions:
Is it the difference between the price you pay for metal and your selling price, or do you make the sale first and then buy the metal necessary to fill the order?
Do you have to quote on a long-term project with firm metal prices and wait some period of time before learning that you were awarded the business, or is it the valuation of inventories that poses the risk?
Each of these scenarios raises a different element of risk, but each one also has a solution for managing and controlling that risk. In the world of commodities, there are two words of paramount importance that are all too often either confused, or misunderstood: hedging and speculating. The dictionary defines hedging as protecting oneself from losses in market fluctuations with a counterbalancing transaction. Speculating on the other hand is defined as buying or selling in the expectation of profiting from market fluctuations. Clearly, these are two very different approaches to the market and should be treated as such. For our purposes here, the focus is on how hedging can work for you.
The most basic form of hedging is to buy and sell a physical commodity like copper on a “back to back” basis. For example, a wire and cable manufacturing company may agree with their customer that the base price of copper contained in a product will be the market price on a specific day. Correspondingly, the manufacturer will buy copper from their supplier on that same basis. This means there is neither a gain nor loss on the price of copper, and the margin built into the selling price is protected. However, in the normal course of business, there are many other variables that may prevent a “back to back” transaction from occurring, and require a different approach.
Within North America, the vast majority of copper-related transactions are based upon trading on the New York Commodity Exchange, or Comex, with the official daily closing, or settlement price recognized as a benchmark for the industry. Futures markets such as Comex serve many purposes. First and foremost, it's the arena of price discovery, as buyers and sellers transact their business, with the resultant prices communicated to the market at large. The futures market is also the vehicle that enables one to offset or hedge price risk exposure.
For example, assume that a manufacturing company had the opportunity today to sell their product at a firm price with delivery six months into the future, but had not yet purchased the copper necessary to make the product. To avoid the risk of paying a potentially higher price when they purchase the physical copper, they could instead place an order to buy copper in the futures market as an offset to the sale. When the time comes to buy the physical metal, they would correspondingly sell the futures position. Thus, regardless of whether prices rose or fell, the profit on their product was protected.
From another point of view, let's take a look at a utility doing its planning and budgeting for the upcoming year. For planning purposes, the utility can look at prices for 2010 today, and see that for the full year, the average price of copper is about $1.75 per pound. The utility has a good estimate of their wire and cable requirements for 2010, as well as transformer and hardware needs. What they don't know, however, is who they will be buying from, or precisely when they will be taking delivery. The one thing they do know, however, is that they want to stay within budget, and therefore must control future costs.
To achieve this objective, the utility can buy, or lock in copper prices on the futures market today for 2010 and be assured that their budget requirements will be met. When the time comes to place the orders for delivery and agree with their suppliers on metal pricing, the futures market position will be sold at the then current market price. Thus, the combination of the futures transaction coupled with the physical purchase price will comprise a total cost of copper that will be in line with expectations, regardless of where the price is in 2010.
For example, assume a wire & cable manufacturing company sells copper in cable with the ‘copper price in effectÃ‚Â on date of shipment’ and they ship consistently throughout the month. The company is generally receiving the average price over the course of the month and therefore should be buying copper at the average price in that month. Thus, they are inherently hedging their risk.
As another example, companies typically must maintain some level of inventory to support their business. During the first half of 2008, copper averaged $3.67 on Comex. Thus, many companies were holding inventories with historically high valuations. If management was concerned about a decline in prices, they had the opportunity to sell copper in the futures market, and thereby offset or negate the potential of losses from falling prices.
Although any number of situations exist that can expose a company to price risk, there are just as many solutions and tools available to mitigate the exposure. When properly employed, hedging can protect your profitability and enable you to focus more time on running your business — and less time worrying about the market.