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Adapting to the ‘new normal’ of slower growth
Mining companies largely shunned derivatives in recent years following memories of the active hedge books in the gold industry during the late-1990s, with companies locking in prices for most of their production and for many years into the future, only to face sizeable losses on those hedges upon the onset of the subsequent decade-long bull run in gold prices during the 2000s. Surging demand growth for major commodities during the last decade – primarily from China - drove most prices a lot higher as supply was unable to keep pace with demand. During that environment, with many markets experiencing supply deficits and price risk often skewed to the upside, appetite for derivatives dissipated and the benefits of hedging were largely forgotten.

That environment has clearly changed in recent years. Supply growth has accelerated as previously-approved projects came to fruition, while demand growth on the other hand has been moderating. In this ‘new normal’ of slowing demand growth and relatively abundant supply, many commodity markets have either been balanced or oversupplied. Meanwhile, low-cost supply growth and deflationary pressures have led to flattening and lowering of industry cost curves in many cases.  Most mining companies have focused relentlessly on cutting costs to remain competitive, to some success, though only to ignore the management of price risk (which has caused comparatively greater damage to equity valuations).      

Short-term vs long-term hedging
In the consideration of hedging and over what timeframe, it is worth noting some of the clear and significant differences between short-term and long-term hedging. Short-term hedging (e.g. up to several months forward) is not about making a call on long-term price trends, nor does it lock in future prices very far forward. Essentially, it is about mitigating the shorter-term price risks (which are comparatively harder to anticipate), enabling managements to focus on managing margins rather than merely costs alone. Some of the benefits of short-term hedging include: (i) reduced short-term earnings/margin volatility; (ii) easier budgeting/forecasting and planning of capex spending; (iii) improved access to capital; and also (iv) a well-designed hedging programme may also enhance a company’s equity value.

Learning from others
Interestingly, some of the gold industry has been turning back towards derivatives once again. Over the past year for example a number of gold companies have begun hedging with Polyus Gold, Fresnillo, Petropavlovsk and Hochschild among others seeking to hedge production. In 2014, the volume of gold sold forward by mining companies experienced its biggest annual increase since 1999.

Polyus Gold, which announced a hedging programme in July 2014, has been implementing a zero-cost collar options strategy; an options structure which maintains exposure to price fluctuations within a certain range, at zero cost. Petropavlovsk also last year highlighted some of the benefits of short-term hedging, particularly when prices are volatile: “Once you have built your hedge book, it is really not that different than selling spot…it does mean that you have a degree of certainty over the next financial year that makes running the company easier,” commented Petropavlovsk CEO Peter Hambro.  Hochschild also decided to implement a short-term hedging strategy on about 20% of its production.

Many of the world’s largest mining companies are heavily exposed to iron ore and/or coal in particular. Furthermore, with the recent transition away from longer-term fixed-price contracts towards shorter-term spot and index-linked pricing, miners’ earnings are increasingly impacted by volatile spot price movements. To date this year, the iron ore spot price has on average more than five times more volatile than the Thomson Reuters/Jefferies CRB commodity price index. Furthermore, the very same principles that apply to gold companies hedging similarly apply to the bulk commodity markets.  In light of the global mining sector’s significant exposure to bulk commodities such as iron ore and coal, and the increasing impact of shorter-tem pricing on earnings volatility, the benefits of hedging in mining are now arguably more relevant than ever.