Strategic Hedging in Metals: Practical Lessons from Past Disasters

“Get your things and report to the mailroom!” In parts of the metals industry the mere mention of strategic hedging can have career limiting effects. Yet price risks that require a discretionary approach to hedging are so common and impactful. Almost every major class of metals business is shaken by the financial volatility they cause, whether it be producers with price risk on sales of future production, processors with risk on permanent inventory and sales of metal gains or consumers with risks on future raw material purchase prices. Yet for strategic hedging, the specter of legendary past disasters looms above like some radioactive miasma, prompting many managers to adopt the ostrich position. Ignored are the successes that exist and with enough frequency that they are no accident, particularly among consumers. Our ostriches could in fact be looking at disasters upside down. Far from portending certain doom, past calamities hold valuable lessons on must-avoid practices for good hedge process design.

A former boss used to say “the best is the enemy of the good. It’s a phrase that applies to strategic hedging, as failure often starts with impossible management-imposed expectations. Strategic hedging requires making multi-dimensional decisions in a dynamic environment and, because markets are unpredictable, every decision cannot possibly be optimal. Hedging programs geared exclusively to the capture of absolute extremes, high or low almost always get it wrong and miss opportunity along the way. They also risk fostering a blinkered view that results in performance paralysis when action is needed, all of which leads to loss and disillusionment. Correctly designed and articulated goals must target what is possible, but still aim to yield significantly better overall value over time than doing nothing.

A realistic approach also excludes long-term passivity. One-off drag-and-drop hedging, popular with producers especially for sizable longer tenor hedges, has been a common contributor to catastrophe. It is realistic to amend strategic hedges to meet evolving market conditions and changing business needs. That means being on top of position and exposure mark-to-markets and option values at all times, having an assessment of hedge strategy alternatives at hand and having the capability to generate scenarios for all of the above. For most businesses, it is fantasy to believe that this can be done on a pad of paper, with a calculator and a sharp pencil or even on a spreadsheet. Capital and time invested in system tools is a must.

“In-flight” hedge position amendment does not mean wandering aimlessly, however. Hedges must always fit business goals so hedging activity needs a planning framework with controls and review cycles that are well-defined and involve a range of management resources to stay on track. The process should make use of relevant talent across the business. It also serves a second purpose, to educate decision makers and keep them involved and aligned, reducing the direction-deforming and momentum-sapping consequences of executive armchair quarterbacks. And to make it clear to everybody, process and participation must be delineated in policy and management guidance documents.

Trouble is also known to cascade from the top itself at times, with impulsive hedge executions ordered by impetuous CEOs or business owners with a penchant for speculating. Freewheeling C-suite power people, who are generally not best placed to make good market calls, have more than once been known to cause predicaments by ordering trades that colour outside of lines set in strategic plans. Conversely, the imposition of strict requirements for their personal pre-execution approval has led to many a missed opportunity as their crowded schedules and frequent distance from the office can be serious process impediments. Better long-term results can be achieved with regulated execution rights for knowledgeable and on-top-of-the-market front-desks who are monitored by an independent middle office, a risk management committee and systems. The framework described above must also define appropriate authority for trade execution, that allows rapid capture of fleeting opportunities, while remaining within the confines of executive comfort and the plan.

None of the above works if people from front line through C-suite and the Board cannot know the current state, see results to date and understand future possibilities. Access to the present picture is critical to achieving management understanding and identifying problems if they develop and eliminating the possibility of hidden errors and fraud. And reporting is as much about visibility of the hedge program and its performance as it is about seeing the exposures they are meant to be covering. To do the job effectively, report design must be relevant for each type of user. Today’s systems have come a long way allowing data to be personalized and presented in a form that is easier to absorb as well.

Management guru Eliyahu Goldratt once said “good luck is when opportunity meets preparation while bad luck is when lack of preparation meets reality”. For effective strategic hedging, arriving at the intersection of opportunity and preparation means spending upfront time and resources to build solid foundations. No substitute exits for a well-crafted commodity risk policy, robust planning, review and control processes, proper delegation of authority and the support of a system with well thought out reporting. And like any journey into unknown lands, the addition of education and guidance from those with experience can make getting there a whole lot easier.

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