Does
forward hedging make sense for miners? Many years ago, I wrote my MBA thesis on
that subject. There’s probably still a copy of it gathering dust in the City
University - now Cass - Business School library. I used Escondida as an example
of a low-cost, efficient mine to try and assess the value of a hedge. Of
course, since the mine owners were (understandably) reluctant to be too
forthcoming about their cost of production, I had to estimate that, which
probably meant that the resulting document was more interesting academically
than practically.
However,
the principle was there, and the conclusion that emerged after running an
enormous number of simulations was that a mine with a cost of production around
where I had guessed it - and in fairness I suspect that the guess was not
wildly wrong - would in the long run be better served by not making forward hedge
sales and rather relying on taking the ruling annual average price. If I’m
honest, I had hoped that I would have been able to demonstrate the opposite, so
that I could have taken my results to a raft of mining companies and persuaded
them to hedge forward. Well, I suppose one shouldn’t be surprised that the
policy mostly followed by the major miners for many years in fact turned out to
be correct; after all, they are professionals at this.
Diversified Books
It
all seems fairly clear; investors buy mining shares because they want to have
an investment in the ownership and production of metallic resources. If the
directors of the miner hedge forward, they are reducing their shareholders’ exposure
to the fluctuating price of the commodity. And yes, to get that exposure fully
it means taking the risk of falling as well as rising prices. But that’s at the
top level; Rio/Anglo/Glencore/BHP et al have the diversified book to be able to
operate such a strategy effectively, and, crucially, make it an attractive prospect
for investors.
Down the Food Chain - or up the Cost Curve
Lower
down the food chain, though, the picture may look a bit different. For those
lacking significant diversification of product, or, importantly, higher up on
the cost curve, the hedge question is slightly different. For them, the
temptation to fix forward prices may be an attractive siren-song. Although it
may tread on investors’ toes (for the reasons above) it does offer the prospect
of protecting the mine, and, crucially, protecting jobs. Additionally, there
may be pressure from debt holders (typically banks) to ensure their money is
safe - or as safe as it can be in a mine, anyway. So in that case, the use of
the terminal market can enable production to continue, even when the cost of
production is greater than the ruling spot price (of course, the corollary to
that is that there will also be times when product is sold at a price lower
than the ruling spot price - security always has a balancing cost somewhere).
Frictional Costs
In
a purely rational world, that probably wouldn’t be the case. A mine is a hole
in the ground, containing a particular sort of dirt with a commercial value. In
a completely rational environment, it would be exploited while the price was
higher than its cost, and shut whenever it dropped below that level. There are
other factors at play, like the cost of opening and closing, the cost of idled
equipment, social costs of employment, which also serve to muddy that strict
rational picture. In reality, we all know that it doesn’t work according to
that simple hypothesis, and that the overall picture is blurred by all those
extraneous considerations and frictional costs.
Why Now?
So why rehash this simplistic theory now? Well,
markets are beginning to shake off the lethargy they have shown in recent times
and, probably equally importantly, there is a fair consensus that an upward
move is indicated; the bulk of the debate now is whether it will be a weak or a
strong rally. We have already seen reported some small producer forward hedge
deals done, and more will follow. So it seems a good time to think about why
hedges are put on, and who are the likely candidates.