The underlying price of a commodity in the marketplace can have a massive impact on a mining company’s performance, going straight to revenues yet typically resulting in minor impact to the cost side bar the cost of fuelling mines. When costs are deemed significant they are usually mitigated through hedging, to limit the cash cost per unit key performance indicator in the sector. As a result, profits are almost as well correlated to commodity prices as the revenue line, an outcome that many investors seek from their investment.
Most shareholders in this sector actually want exposure to a particular commodity, or basket of commodities, and expect mining companies to provide it. For these reasons one would expect treasurers would avoid hedging, since it limits the volatility that shareholders typically seek.
There is often a conflict in play here however, with the bank(s) that financed the operation to begin with. As much as shareholders seek volatility, banks abhor it. When the banks finance new mining projects they insist on securing, where possible, enough profit margin to ensure that revenue received will be sufficient to cover the principal and interest payments required by the lenders providing the capital. As a result, treasurers must hedge to lock in commodity prices and, in turn, profit margin. Although in the pre-production phase, treasurers often do seek protection from a downwards movement in the commodity’s price, the compulsion of the lenders may see the company hedging at levels much higher than their shareholders would prefer. Even using options to participate on upwards trends, the premium cost is usually high given the volatility in most commodity markets.
Treasurers rely on stress testing and scenario analyses to illustrate the impact of hedging strategies. The approach is to stress exposures and hedges separately and then combine the results rather than stressing the presumed net position, particularly when modelling option-based strategies. Treasurers consider a number of pricing scenarios for the stressed analysis and it is often more meaningful to build in target price levels. Figure 1 below illustrates a copper producer, who is considering hedging 40% of production using over-the-counter (OTC) swaps or OTC collar options and wants to assess the impact on profit and loss (P&L) for the upcoming financial year.
Figure 1: The Impact of Hedging on Copper Production
Analysing different hedging strategies against each other supports the treasurer in managing the conflicting requirements of shareholders and financiers. In the example given, the option collar scenario allows more participation in increasing commodity prices and taking more risk on decreasing prices; thus it is a scenario better suited to shareholders. If the purchased floor component, which is the worst case outcome, is at levels that the company’s lenders are satisfied with then both parties´ needs are satisfied and this strategy is preferable to the straight swap scenario.
The Importance of Liquidity Planning
Beyond commodity price volatility, cash flow outcomes are another key priority for treasurers. This focus is particularly important in the pre-production phase of a new mine. This phase is characterised by uncertainty as to the start date for production and negotiation on sales contracts, so scenario-based cash flow forecasting is very important. For example, in Figure 2 a treasurer is analysing three scenarios by forecasting quarterly cash flows and cumulative cash flows over a three-year period with production planned to begin in Q114.
Figure 2: Three Potential Scenarios for Three-year Cash Forecasting
The profile in Scenario 1 illustrates that the mine has negative cash flows in the first four quarters during construction. Once production starts, the mine realises positive quarterly cash flows and the cumulative cash flow turns positive after a certain time as well.
Scenario 2 shows how a lower commodity price can impact quarterly cash flows and the cumulative cash flow referencing to the mining sector’s price sensitivity.
Miguel de Cervantes, the author of the novel Don Quijote, wrote “Delay always breeds danger”. In Scenario 3 we can see why: cumulative cash flows can be severely impacted over a given timeframe when production doesn’t commence as planned.
Being able to model the impact of production delays and commodity prices can make it much easier to align the management team’s goals with those of the banks. Treasurers, who have the capability to stress prices and timelines within an automated tool, are well placed to assess the implications on cash flows for the uncertainties inherent in their business, particularly in this crucial pre-production phase when all risks are accentuated.
Market Data for Pricing OTC Derivatives
In the mining sector, OTC derivatives are preferred to exchange-traded instruments when hedging commodity price risk, as treasurers seek to match cash flow streams as closely as possible. OTC instruments avoid the strains placed on working capital that futures-based hedging requires through its upfront and ongoing margin calls.
Realising the benefits of OTC derivatives in risk programmes does not come without work. It requires constant monitoring, measurement and evaluation of the hedging programme. To achieve this, the treasurer needs ongoing access to market data. Market data for OTC instruments is often not available, particularly in the long term. If market data is available, the quality varies significantly and can be quite expensive. In case of OTC options, commonly only exchange trade option prices are publicly available, but not the volatilities themselves. It is only through reverse engineering to determine those prices to imply the volatilities that they can be used for valuing OTC options. In general, scarce treasury resources are not devoted to such a time-consuming task.
Despite the challenges of acquiring market data, it is not impossible. Treasurers looking to achieve best results in their commodities hedging programmes in terms of minimised risk and positive revenues know that the benefits of OTC derivatives far outweigh the challenges.
FX Risk and Correlation Factors
Nearly all commodity prices are denominated in US dollars (USD). As such, even if you are domiciled outside of the US, many mining companies have a functional currency of USD rather than their local currency. This makes particular sense if the majority of your cost base is USD-centric as well.
However, there are mining companies with other free-floating functional currencies and currency risk represents a secondary significant risk to their profitability. In this instance the interests of shareholders and financiers are aligned, as neither wants profitability to be adversely impacted due to a strengthening of the local currency.
The first consideration for treasurers in this situation is whether to measure and manage commodity price and currency risk separately or together. There are a small number of hybrid products, which will effectively mitigate risks simultaneously, but force the treasurer to hedge commodity price and currency risk at the same level.
When currency is hedged separately, the treasurer must keep a very close watch on drivers of that risk; specifically forecast production levels and, particularly, the volatile commodity price. A downward movement in the commodity price of 10% reduces the currency risk by the same proportion. Treasurers and policy setters recognise the risk, and tend to set conservative levels of hedging this type of currency risk to avoid over-hedging.
Treasurers analyse the correlations between all commodities involved in production and currency risk. By taking correlations into account, they can effectively limit the total exposure needed to be hedged externally by allowing for the natural hedge components of the currency component. A common mistake is to assess correlation components as a one-off exercise. In today’s volatile market this is not sufficient, as correlations can change over time or be broken completely.
Modern Technology for Risk Management
Elaborating the challenges treasurers face in the mining industry, modern solutions for integrated treasury and risk management (TRM) provide professional tools for:
- Stress testing and scenario analyses.
- Liquidity forecasting and cash flow analyses.
- Commodity and currency pricing analyses.
- Calculation of cash flow-at-risk (CFaR).
Integrated market data, calculated volatilities and correlation factors across all asset classes.
Technology cannot stop speculators driving prices down or a port strike delaying a sale, but it supports treasurers in identifying the market risks inherent in the mining industry and arms them with the tools to manage those risks.
In this article, we have reviewed the unique concerns of treasurers working in mining companies such as the conflicting view of shareholders and financiers on volatility, the large impact of commodity and currency prices on profitability, and the challenge of capturing market data for risk management. Finally, we have seen that modern technology can support treasurers to measure and mitigate exposure.
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