Strategic Hedging Part 3 – Your Choice of Weapons

In our previous blogs on strategic hedging we talked about the key goals of long term optimization of outcomes, through trade-offs, which brings out the value-for-money of options as risk management tools for end-consumers and producers, rather than the sheer precision of futures and forwards which is more prized by offset hedgers of pass-through commodity processing businesses. The choice of weapons in the options armory, an ongoing process of changing choices, is more complex than simple offsets, and harder to explain to colleagues and shareholders. We offer here a few guidelines for success – and survival – to those strategic hedge practitioners who are in the front lines of, in this example, an end-consumer of aluminium.

We’ve stated before that the goal has to be that over the long term, say five years, the hedger does better than if he had done nothing. In a year of rapidly collapsing bear markets no strategy will be better for a commodity end-consumer than standing aside, but that strategy will not help in the next four years of price recovery. The first trick for ongoing success, in this case, is to limit the hedge settlement losses in Year One and have them more than offset by gains in Years Two-Five. This is achievable by intelligent price risk management techniques, whereas positive hedge settlement outcomes year after year is not. The second target is to make sure the people who matter understand this.

One enemy of long-term management goal is standard accounting rules. The annual P&L has to reflect actual hedge settlement cash flow and year-end mark-to-market revaluation – these cannot be amortized like other five-year investments. One sensible approach is to present the strategic hedge program as a five-year investment and provide for both senior management and shareholders, as a footnote to the accounts, a rolling five-year study of the program with the costs and outcomes amortized over the period.

Once visibility of the program’s long-term outcomes is achieved, the optimization of those outcomes can clearly be seen to depend on the aggregate amounts by which hedged pricings are better than actual commercial pricings, combined with the overall cost of achieving that. The management factors necessary for achieving positive long-term results are the ability to recognize:

1. When long-term value points are available in the market – do we start to look for buying 5-year value in aluminium at $1700 or $1500?
2. The points on the forward 5-year price curve where currently achievable values will look the most valuable – when do we expect markets to peak and trough in the next five years
3. The company should craft different strategies for when it believes it is facing a bull or bear market. How much restraint do we put on ourselves in locking forward hedge outcomes – perhaps 50% for two years out, against 10% for five years out? How much do we limit hedged quantities at any time, even for one month forward?
4. What are the relative values vs costs for achievable hedge protection? Option premiums are a function of expiration time, out-of-the-moneyness and volatility, and long-term options will always look (and probably be) expensive
5. What are favourable hedge outcomes that we are prepared to forego in return for premium credits – say by granting $1900 calls in aluminium
6. When we need to recognize that any of the above judgements have changed enough to merit repair and enhancement tactics – buying back or rolling strikes forward or upward/downward.

Exploring the comparisons, outcomes and enhancements described above imposes the need to map the landscape using calculations that require many moving parts. Scenarios incorporating shifting layers of options-based insurance, varying volatility and multiple periods across a range of possible outcomes is simply more than a pencil and paper can cope with. And computations must be repeated as markets move, making it inescapable that a system is a must. Those that combine scenario mapping with the ability to manage the administration for actual positions and even the underlying physical metal commitments are especially efficient tools for this work.

This kind of strategic approach is complex and difficult to explain to the un-initiated. It also requires considerable hands-on market expertise and attention, a defined policy and a sophisticated control and budgeting system. For the reason the new strategic hedger is not likely to get much help from his friendly competitors – outside independent expert help will certainly be needed. Nonetheless this approach to strategic hedging satisfies the requirement of being manageable and capable of being evaluated – and can also be a considerable contributor to profitability.

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