Hedging in theory is a relatively straightforward concept but the management and execution of a day-to-day derivatives strategy can be overwhelming for many companies at first, Mitch Robertson, a partner at commodity derivatives advisory Ferrometrics, told Fastmarkets AMM in an interview.
Robertson defined four major challenges of using futures, particularly for the ferrous industry, and explained how to overcome them:
1. Steep learning curve
“The expectations of hedging can be foreboding to people who haven’t done it before,” he said. “You can have the benefits of a liquid futures market that you can get in and out of every day but you also can have your margin called.”
While it’s understandable to be intimidated, Robertson has found that once people “dip their toe in” and start hedging with smaller tonnages - whatever amount they’re comfortable with - they start to understand and reap the benefits of hedging.
“It could be as simple as starting with 10 tons, executing a transaction and seeing it play out from start to finish for your own internal accounting procedures and to see who is best suited to execute and manage that process,” he said. “There [are] going to be some bumps - days when you print out a statement and it won’t look good for you - but you’ll learn how to work through that. It has to be a long-term mindset if you want to use it to get ahead and manage risk.”
Some market participants also fear that hedging will limit their success on the upside, Robertson noted.
“If there’s a way to eliminate downside risk, people are all about it,” he said. “It’s getting people over the hump of understanding that you might not be able to hit [the same highs] every year, but you’re going to have stable margins and limit your losses.”
2. Inventory and logistics constraints
The mindset of managing inventory levels to control price risk “has dissipated tremendously from where it used to be because a lot of people were hit so severely by the big market swings in 2015-2016,” Robertson said.
“You don’t need to hedge your entire inventory,” he said. “Hedging is a tool to enhance trading; it doesn’t eliminate trading.”
Even the best scrap processors face mill cancellations every year, Robertson said. “Hedging is a viable tool if you can identify that portion of your inventory that is exposed to market cancellations... Identify the tonnage that is unshipped and canceled throughout the duration of the year and start using that tonnage to hedge.”
That’s how hedging also can help ferrous companies secure more favorable financing rates from banks, he noted.
3. Who should manage hedging?
Typically, hedging is the responsibility of the finance team, which should regularly receive input from the sales and procurement teams, Robertson said.
“You need a point person, a single person who is in charge of managing hedging,” he said. “That person who understands the risks across all components of the company should set the guidelines - internal limits and protocols - but there has to be buy-in from all groups within the company.”
That point person should probably consult with a third-party company that understands hedging and can help build a strategy, Robertson said.
“Bring in an outside firm to partner with to get you going and help you understand where the most hedgeable price lies within your business,” he said. “Focus on that piece first and then expand from there.”
4. How to get started
Every company should begin their hedging strategy by identifying pricing risks in their business that are or are not tradable, Robertson said.
“Understand where your risk is and build a strategy,” he said.
The next step is to look at the list of brokers approved by each of the main financial exchanges: CME Group, Nasdaq and the London Metal Exchange. “The exchanges can point you in the direction of where to go,” Robertson said, noting that hedging consultants are another option.
An even easier way to get involved is to simply join the conversation. “Start attending events and networking with people who are using futures,” he said. “These tools will be around for the long haul and companies that devote resources to hedging now will be a step ahead in their business in the next two to five years,” he said.