The lost art of hedging?
The pros and cons of hedging
“A hedge program is most valuable when cash flow is at its worst – when prices are low – and as long as it was entered into when prices were higher.”
Global Mining and Metals sector leader
The lost art of hedging examines why mining and metals companies decide to hedge or not to hedge.
Below are some of the indicators for consideration:
- Hedging is a risk management tool
- Greater certainty over cash flows
- Lock in profit
- Proportionate hedging
- Access debt finance
- Continuity of business
- Superior knowledge of supply
- Access to better information
Why not hedge?
- Getting it wrong
- Involve peer comparisons
- Undertake their own risk management programs
- Risk is fully priced
Why hedging hasn't worked
The most powerful argument against hedging is that historically, large amounts of shareholder value have been destroyed by poor hedging programs. Too many mining and metals companies have gotten it wrong and consequently shareholders view hedging with suspicion.
If hedging cannot be done well then it shouldn't be done at all.
Why hedging is still a worthy consideration
There are a number of important cyclical reasons why hedging should be rehabilitated.
- As metal prices are generally above historical averages, there is greater risk of downward movement in prices than sustained losses from higher prices rising above hedged prices. However, it's obviously better to hedge at the top of a cycle than on the sharp decrease. Hedging can mean putting low cost floors in place that can still have exposure to price rises.
- We are seeing early signs of the lending recovery following the global financial crisis. In the immediate aftermath, balance sheet repair for many mining and metals companies meant the total removal of debt. As mining and metals companies are now more likely to re-engage with debt providers, there will be an increased attractiveness to hedging.
- The accounting is supposed to be getting easier. Entities should take the time to familiarize themselves with the proposed changes and fully assess whether these will enable them to achieve an outcome that better reflects their risk management strategies. Reducing complexity has been the key theme associated with various financial instrument projects currently underway.
- Finally, hedging a proportion of the exposure can provide some insurance so that the mining and metals companies can continue to make profits no matter the direction of the metal price. However, such hedging needs to be well designed, properly executed and appropriately governed.