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What is a Spread and Why Should a Metal Manufacturer Care?

If you, a manager in an industrial metals company, are told that you have to understand how Futures Market Spreads work to do your job, you will probably think we are crazy. Not so, at least not if you are responsible for any function that is affected by metal costs and revenues. We can assure you that understanding spreads is just as important as understanding expansion coefficients, transportation rates, customer creditworthiness, or whatever else you need to know to do your job.

How so? Let’s explain. Metals which trade on the exchanges you use for price indexing of your metals costs and revenues trade mostly for forward dates. The futures contact for the Cash or Spot date on which your prices are indexed is no practical use for hedging, because, if you use it, within a couple of days you have to make or take delivery of physical metal which defeats the financial point of hedging.

Practically speaking, a hedger has to trade for forward dates to cover his risk over time, and these forward dates, while anchored to the spot date in value, always trade at a discount or premium related to the time lapse between now, the price fixing date and the date of physical delivery. This price difference is called the forward spread and, on one hand, relates to the interest and storage cost a trader has to pay to buy spot and hold – a positive yield curve known as a contango, or on the other, the premium, called backwardation, which a user is prepared to pay to get delivery now and prevent shut-down of his factory.

Simply put, if the hedge manager, wants to hedge aluminum his supply chain manager buys today at $1500, and hold this hedge open until his production manager can produce his finished product, and the sales manager can sell it, he may have to sell a simultaneous hedge contract for one to three months forward at a forward price of $1530 or $1470, a $30 gain or loss. If the company’s profit margin is $20, here are four managers who can collectively be responsible, even with a fully hedged position, for wiping out their employer’s profit if they get the spread wrong. Suppliers who are late, customers who want to price in advance or defer their shipments can wreak similar havoc on the hedge book – and consequently on the company’s bottom line.

This is the bad news for the hedger. A worse reaction would be to abandon hedging – this would just substitute a $300 risk for a $30 one. The good news is that Futures Spreads, sometimes described as the “time value of money”, can be managed in advance by managers who understand them. If the hedge manager has predictability in the volume of supplies, sales and inventory, and contractual pricing formulas, he can use his discretion to anticipate his hedges and lock in forward spreads when advantageous, and to leave them alone when not. Supply chain and sales managers can use spread knowledge to negotiate more hedge-effective price fixation terms with their counterparts, and production managers can tweak production to make product available when the market provides a spread premium for prompt delivery. As we have always said, all the managers contribute to effective price risk management, not just the hedge guy.

To achieve this within the management team is not as easy as it sounds. Market knowledge and skills need to be developed and disseminated. Accountability must be expanded to include deal by deal profitability with financial hedge outcomes, and spread results included. Systems need to be developed to enable predictability, visibility and performance monitoring. For the uninitiated, expert guidance, such as is provided by CRMA-CRCI, is a must. The really good news is that those metal companies who have adopted active spread management have used it to make significant contributions to their profitability.

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