In our initial article we discussed the basic idea behind hedging, that is, using the futures market to protect the value of inventory you may have on the ground. Conversely, hedging may also be appropriate when you want to provide protection against an unwanted increase in prices.
By Daniel Uslander
(Industrial Metals Specialist High Ridge Futures LLC and ScrapMonster Contributor)
In our initial article we discussed the basic idea behind hedging, that is, using the futures market to protect the value of inventory you may have on the ground. Conversely, hedging may also be appropriate when you want to provide protection against an unwanted increase in prices. For example, in those cases after you obligate yourself to filling an order, but before you have collected enough material to fill the order. We discussed that second scenario in my last post, so let’s take a moment to cover the first case, a more traditional inventory hedge commonly known as a short hedge.
Say you have about 1000 tons of material on the ground. Perhaps you just bought it or maybe it’s been sitting for some time. Based on your reading of the market, you believe that more likely than not, the next $30 move in the market will be lower. You are not a guru or a fortune teller, and you have made your share of good market calls and some not-so-good. You just don’t want to look out your window in a month or two at material that is worth $30,000 less than it is worth today. You want your inventory’s value to reflect current price levels for some period into the foreseeable future. Let’s assume for our purposes that at the moment shredded prices are about $230 per gross ton.
You check the quotes with your futures broker and determine that you can sell futures contracts that expire in approximately 90 days at an acceptable level; about $228 per gross ton. Each scrap steel futures contract prices to the value of an index. For example, if we use the NASDAQ Shredded contract for the hedge, our expectation is that the value of our scrap will more or less track with a shredded index calculated and maintained by the TSI (“The Steel Index”) division of Platts. The index is calculated by tabulating a volume weighted average price for shredded for the first ten days of the month, with the final settlement value released on the 11th day of the month. It is designed to be a benchmark price for shredded material delivered to US Midwest mills. It is meant to be particularly adept at tracking “buy week” transactions, the transactions that normally set the tone for month over month changes in scrap prices. Will the relationship between the prices in your local market and this index be perfect, with the up and down moves in each market matched dollar for dollar? Probably not. The question to ask yourself is whether the index can provide a general level of price protection.
Since each contract represents 20 tons, in order to place the hedge, we sell a total of 50 contracts at $228 per ton. Once the sales are completed the material in the yard is considered hedged. Now fast forward 45 days. Let’s say that you made one of those good market calls and at the 45-day mark prices are in fact lower. As a matter of fact, the best offer received for your scrap is $208. Futures prices fell in a similar manner. Futures buyers have retreated to $208 and futures sellers are at $212. Since you hedged by selling contracts, as prices go down the short futures position in your hedge account will show a profit. The short position can be closed out by buying contracts, which is what you decide to do; you cover (buy back) the 50 contracts at $212. At the same time as you sell the 1000 tons in the yard at $208. The sale price of $208 was $22 less than our $230 target. However, the profit in the futures account was $16 ($228 less $212). So on a combined basis, we sold the scrap for $224 ($208 + $16). No, that’s not $230, but certainly better than taking the full blow of getting rid of the material at $208. Note that the positive balance in the hedge account is reduced by the commissions on the futures transaction. Placing the hedge and then closing it out will cost about 75 cents a ton each way, or based on these 20 ton contracts, $30 per contract to sell them and then buy them back (called a “round turn”).
Now let’s flip the script. Let’s assume the same market conditions (shredded at about $230 per ton); also like before, let’s say that the 50 futures contracts were sold as a hedge for $228 per gross ton. This time, your market call of lower prices is not so prescient: the scrap market keeps going up. 45 days later there are shredded buyers at $248. Our contracts were sold at $228; futures buyers now stand at $246 and futures sellers are at $250. Similarly, at the 45-day mark the physical scrap is sold for $248 and the short position of 50 futures contracts is covered (bought back) at $250.
Remember the original goal was to try and protect the value of the material by doing our best to preserve a price of $230 per ton. After covering the short futures position, the hedge account shows a loss of $22 per ton on 50 contracts (sell at $228 and buy back at $250). In the hedge account there is a realized loss of $22,000 ($22 on 1000 tons, or $22,000). On the other hand, the physical sale at $248 took place a full $18 over our objective ($248 - $230). Therefore, the net impact of hedging was that our sale of material yielded $4 per ton less ($22 - $18) than our intended target. That net impact should include the additional cost of futures commissions, which is about 75 cents per ton each way or (based on the 20-ton contract size) $30 per contract for each round turn.
Should you be kicking yourself for hedging since there’s a loss in the hedge account? No, not at all. Hedging is meant to try to preserve your bottom line based on the simple premise that you don’t know what the future holds. If the available price is an acceptable price, hedging may be in order. Also consider that by using futures it may be possible to smooth out the cash flow bumps caused by price volatility. That is to say, when prices and revenues are relatively high you are more likely to be in a stronger operating position; when scrap prices are low and flows into the yard (and orders from mills) slow down, decreased cash flows may make it more challenging to get by with available cash. Since hedging provides an opportunity to preserve at least some of the benefits of receiving higher prices for material, even after the market has moved lower, we can state that when done properly, hedging may be able to smooth out the natural “ups and downs” in cash flow. Smoother and more predictable cash flows may yield benefits in various aspects of your business, including your long range planning, business budgeting and acquisition of competitively priced lines of credit.
So that’s the short hedge. Hope you enjoyed it. In the next post we will drill a little deeper into tactics you can use as you put hedges on and take them off. In the meantime, contact me with any questions or comments.
BE ADVISED THAT TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS OR PRODUCERS.