The LME and Lead Hedging
Introduction to Hedging for Lead and Battery Producers
13th Asian Battery Conference, Shanghai
Wednesday 1 September, 2009
Rick HolmesMitsui Bussan Commodities (Aust.) LtdT 61 2 9256 9599C 0411 474 800
2
Agenda
Introduction
The LME and its functions
Users of the LME and Price Discovery
Mechanics of the LME metals market, Official prices
Manufacturers Price Risks
Hedging Risks in a simple form
Slightly more on Hedging with options
A Few essentials if setting up an LME Trading Department.
Conclusion and Questions
3
The London Metal Exchange
Established in 1877 for the risk management of metals business
“Not for profit” organization - formalized trading in the market with: – Fixed trading times– Standard contract specifications– Providing a transparent source of price discovery
Provides 24 hour principal to principal market
Annual volume of $10.24 trillion with more than 95% of its business coming from overseas, the exchange currently has 5.13 million tonnes of metals on warrant in 516 warehouses in 38 locations globally.
4
LME membership trading categories
Description Can Issue LME
Contracts
Authorized (Financial Services
Act)
Member of LCH for Metals
Member of FSA
Trading Rights
May Solicit Brokerage
Minimum # Net Worth
Requirement
1. Ring Dealing Member
Yes Yes Yes Yes Freely Yes £ 5mm
2. Associate Broker
Clearing Member
Yes Yes Yes Yes Freely Yes £ 5mm
3. Associate Trade
Clearing Member
No No Yes No May only deal with 1, 2, or 4
– not with each other
No £ 2.5mm
4. Associate Broker
Member
Yes Yes No Yes Freely Yes £ 5mm
5. Associate Trade
Member
No No No No Only 1, 2, or 4 No £ 50,000
An Introduction to the LME
6
Standard Lead
7
LME Volumes and facts
The LME, the worlds largest non ferrous exchange it is more than 130 years old.
In 1992 Lead volume was 1 million lots, 2 million in 1994, 6.1 mil in 2008
Annual total volume was 93 million lots in 2007, in 2008 it was 113 mil lots
Daily value of trade is between $8,000 and $10,000 million.
8
Roles of the Exchange
Price DISCOVERY and provide Daily “official price”– (LME is an International Reference Price)
Price Risk HEDGING MECHANISM, by providing a futures and options market that allows prices to be locked in.
Delivery / Supply of LAST RESORT, by authorizing a warehouse system.
9
The London Metal Exchange - Trading
The LME is the world’s premier non-ferrous metals market, with highly liquid contracts
The main users of the LME are:– Producers– Consumers– Merchants/Traders– LME market makers (Category 1 and 2 – see next
slide)– Funds
• CTA’s, Discretionary Funds ($10 billion)– Other speculators
LME contracts are traded in US$, but are cleared in US$, Sterling, Euro & Yen
10
LME Trading Days
Today- you cant trade2 Days forward- The cash date, earliest trade dayWeek days- trade every one for 3 monthsWednesday- Trade each Wed for 3-6 mths3rd Weds.- 6 mths to 27 mths (Pb)..longer for Cu
Trading through:Open outcry in ring trading sessions and kerbLME 24 hour inter office telephone market.Electronic trading via LME Select 1am to 7pm London time
11
The LME periods in each day
Periods of Liquidity (LME/OTC):– Pre-Market: 8.00 – 11.50 (all London times)– AM Rings/Kerb: 11.45 – 13.05– Lunchtime Kerb: 13.15 – 14.45– PM Rings/Kerb: 14.55 – 17.00– Lates: 17.00 – 18.00 (COMEX close)– Late NY: 18.00 – 22.00– Overnight/Far East Market: 22.00 – to Pre-Market
“Open”
Special times each day.– Official Price each day at close of 2nd AM ring– Evening evaluation at 5.00pm
12
Large industrial companies have becomemore pro-active in managing these exposures
“Ford has a commodity hedging program that uses primarily forward contracts and options to manage the effects of changes in commodity prices on the automotive sector’s results…such contracts are executed to offset our exposure to the potential change in prices mainly for various non-ferrous metals (e.g. aluminum).” (Ford Motor Company, 10-K)
“The company operates internationally, with manufacturing and sales facilities in various locations around the world and utilizes primarily forward and option contracts to manage its…commodity exposures.” (10-Q)
“The corporation is exposed to volatility in the prices of raw materials used in some of its products and uses forward contracts…to manage some of these exposures.” (United Technologies Corp., 10-K)
“Anheuser-Busch is exposed to…commodity price risks. The company utilizes derivative financial instruments, including futures contracts, swaps and options to manage certain of these exposures.” (Anheuser Busch Cos. Inc., 10-K)
“We are subject to market risk associated with changes in…certain commodity prices. In order to manage the volatility relating to our more significant market risks, we enter into forward contracts and…commodity swaps.” (Tyco International Ltd., 10-K)
“Alcoa might be required to purchase aluminum to supplement its internal production. These purchases expose the company to the risk of higher aluminum prices. To hedge this risk, Alcoa enters into long positions, principally using futures and options. Alcoa also purchases certain other commodities, such as fuel oil, electricity and copper, for its operations and enters into futures and options contracts to eliminate volatility in the prices of such products.” (Alcoa Inc., 10-K)
13
Exposures are front page headlines
China Aviation Incurs $550 million in losses in derivatives trading
Sojitz Holdings Corporation said it lost $172.8 million from commodities trading
14
The Lead Forward Market
Today’s cash price 2117 +8 a contango
3month price 2125 -28 a back
15 month price 2097 -37 a back
27 month price 2060
15
LME Price Differentials
Contango– If the price for delivery on an earlier date is lower
than the price for a later date
Backwardation– If the price for delivery on an earlier date is greater
than that for a more forward date
Spread– The price difference between two prompt dates is
called the spread which may be in contango or backwardation
16
Lead Price & Stock Chart
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007LME stocks, mt
$250
$750
$1,250
$1,750
$2,250
$2,750
$3,250
$3,750
3M official, $/mt
17
Battery Makers Non hedged position
A Simple Transaction without LME Hedge
Cost Revenue
Buy Physical Lead @3500 /mt 3500
Conversion 200
8weeeks later
Sell Batteries Pb 2700
+Conversion cost 200
Total 3700 2900
LOSS 800/mt
18
What Is Hedging?
A transaction intended to protect or reduce risk from subsequent adverse price movements of a physical position already bought or sold
19
Battery Makers HEDGED position
A Simple Transaction (from above) now with LME Hedge
Cost Revenue
Buy Physical Lead @3500 /mt 3500
Sell LME 2 mths Forward 3500
Conversion 200
8weeeks later
Sell Batteries Pb 2700
Buy LME at time of battery sale 2700
+Conversion cost 200
Total 6400 6400
LOSS zero/mt
20
What are options….(put simply)
CALLS … set a ceiling,
The right to buy at the strike price but not the obligation
PUTS …set a floor,
The right to sell at the strike price but not the obligation
21
Battery Makers HEDGED position
A Simple Transaction (from above) now with LME Hedge
Cost Revenue
Buy Physical Lead @3500 /mt 3500
BUY A PUT 100 Prem 3500
Conversion 200
8weeeks later
Sell Batteries Pb 2700
Buy LME at time of battery sale 2700
+Conversion cost 200
Total 6400 6400
LOSS 100
The PUT has the same effect as selling at 3500 but should the LME rise you sell the battery at the higher Pb price and keep the profit (net of the cost of the PUT)
22
Basis 3m close on PB at 2075 here’s some ideas on FEB10 strikes. …Feb is also 2075.
Calls: STRIKE/Premium
2100: 260/280
2200: 220
2300: 190
2500: 140
2600: 115
Puts STRIKE/Premium :
2000: 220
1900: 190
1800: 140
1750: 140
1700: 110
23
Effective risk management – A word of warning
Hedging frightens some companies. The anecdotes do have great deal of truth in them. History has its disasters and all could have been avoided had careful consideration been given to the trading structure and policy. Specifically:– The policy to be employed using it– The choice of instrument– The directives covering authority and
accountability, and– Adequate controls to ensure these considerations
were adhered to – this includes reports to the hedge committee on all trades compared to the trading authorization and policy
24
Summary and Conclusions
Base Metals are experiencing more volatility than ever before
The London Metal Exchange is an important part of Base Metals Pricing
Don’t be afraid to identify your price risks and hedge them
Hedging goals might include– Protecting margins, covering cash costs, and preserving upside potential
Choose relevant strategy
Coordinate physicals and futures positions
Talk to your friendly Broker about your risks.
Monitor and review performance– You must report all gains and losses
25
Mitsui Bussan Commodities Contacts
New York – Mo Ahmadzadeh & Abe Ulusal– +1 212 878 4192
London – Micki Waite– +44 207 489 6700
Sydney – Rick Holmes– +61 2 9256 9599