The first part of this two-part series essentially looked into the different effects monetary occurrences and supply and demand fundamentals can have on commodity prices. Monetary authorities around the world are implementing rampart growth in the money supply and quantitative easing in the form of negative real interest rates; meanwhile, the global economy is in free fall. The factors have opposite effects on commodity prices. We came to the logical conclusion that we wanted to give our portfolio exposure to the commodities that have significant monetary uses, aren’t cyclical, or both. Two good examples are gold and the grains. I want to be careful with my next statement.
I’m a commodity bull across the board because of my belief that triple-digit annual monetary inflation of the monetary base will trump any slack in global demand. Keeping that in mind, in order to maximize returns on capital, we want to avoid commodities that are cyclical, have limited exposure to monetary markets, or both. These include the industrial metals (copper, aluminum), silver and energy markets.
The last item I would like to note from the first part of this series is the softs (sugar, coffee, orange juice). The softs fall somewhere between the industrial complexes and the grains as far as cyclicality goes. They are a great tool to use for inter-market such as a long corn/short coffee or long soybeans/short orange juice. I’m a big fan of using inter-market spreads to give my portfolio sector exposure while reducing the risk exposure. These are all very important notions in trading commodities markets and should be kept in mind when reading the second part of this series.
Moving on, the single greatest factor that companies have control over other than their business model is price risks associated with the production of their underlying commodity. There’s nothing you can do if a mine floods, or crop yields are crushed because of an early freeze. Maybe a certain producer was counting on a credit facility that simply doesn’t exist anymore and they are simply SOL. These things are out of the producers’ control. Hedges, on the other hand, are completely controlled by management. They are used in some sort by commodity producers in almost every sector to reduce those risks. This is not to say putting a hedge on is a walk in the park; in fact it’s just the opposite as you’ll soon find out. Miners, farmers, and energy producers all use hedges to alleviate the risks associated with input costs and output values. Given the massive volatility and percent changes of commodity prices from peak to trough, using futures and cash markets to mitigate risks has never been more important than it is today and has been over the past year.
Grain hedges going nuclear
What a 12-month period to be a farmer. Seed, fertilizer, and energy products soared along with commodity prices. Energy prices such as diesel used by tractors and heating oil used for storage, obviously followed oil prices higher. Seed and fertilizer are a slightly different story. When crop prices increase, farmers are more willing to spend money on inputs that will increase yields. Essentially, the value of increasing yield is increased, or the projects on the margin now become economical. The increased value of yield growth resulted in a strong demand for things like fertilizer and seed. The increased demand lead to higher prices.
Fertilizer costs in 2008 reached approximately $850 /ton of potash, $9000 /ton of anhydrous ammonia, and $1000 /ton of diammonium phosphate (dependant on the region). Seed prices also went to the moon, reaching $90/acre for corn and $60/acre for soybeans (dependant on seed type). Just as higher crop prices lead to higher input prices, the ensuing collapse had an equal and opposite reaction. Input prices fell anywhere from 60-75%. As a result, hedges absolutely blew up. There were a number of grain elevators, for example, that secured corn at $8/bushel because they had contractual obligations. Instead of using the cash market to get by, they secured large amounts of grains at extremely high prices.
There are several things to take from this when applying these notions to the commercial farm productions and input suppliers on the stock market. The basic principal is to identify the companies that made good hedges and the companies that made bad hedges. Here are a few examples:
- Make sure the company is currently securing energy, seed, and fertilizer needs using futures contracts when available. These inputs will definitely be more expensive three, six, or nine months from now.
- Avoid, or look for a short opportunity for those who hedged costs 10 months ago and now lack sufficient capital to put to use.
- Buy companies that hedged future production with futures and options on futures when prices were peaking last spring.
- Look for seed/fertilizer producers who have significant long-term contracts set during price peaks
Cargill is one of those agricultural companies that always seems to avoid the destruction left by market volatility. For example, when they need to secure supply, they’re usually buyers of futures during low price periods and buyers of the cash market during high price periods. You don’t see Cargill buying beans futures in the teens before a market pull back.
Then you have a company like ADM. For the most part, ADM has done a reasonably good job with their business model, save one grave error. ADM has a massive exposure to the ethanol industry…really massive. A potential trade with reduced risk that still has exposure to agricultural markets could be a long Cargill/short ADM position.
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Learning from the A-bombs in metals hedges
The mining/metals production industry is no different than the agricultural business in the sense of hedging risks. The applications apply just as well here. The ultimate goal is to give yourself exposure to producers who made good hedges and avoid the ones who blew up. Let’s start our look into the metals industry with a shining example of utter failure.
Alcoa made every possible hedging and lack of hedging mistakes that a good company shouldn’t. Alcoa is the third largest producer of aluminum in the world. The production of aluminum is very energy intensive throughout most of the process. It also happens to be a very cyclical industry. Alcoa managed to really make a mess of things on both the way up and the way down.
The price of aluminum peaked in July at $3380.15/metric ton. In the second quarter of 2008 ending on June 30, Alcoa received an unprecedented average of $3058 /MT of aluminum. Initially, it looked really good on paper. Unfortunately, that couldn’t have been less the case. Year-over-year income fell 24% from $715 million in Q2 2007 to $546 million in Q2 2008. In the six months starting on June 30, 2007, Alcoa’s cash from operations all but disappeared as it fell from $2.32 billion to $719 million, a decline of nearly 70%.
So what hell did Alcoa do? I mean, I think I would have to try in order to screw up so bad. Like I said, Alcoa made every wrong play possible. This was probably a combination of both human greed and utter stupidity. They didn’t hedge energy costs on the way up. Energy rose at a faster pace than aluminum prices and with aluminum production being energy intensive, their income took it on the chin. I should rephrase my prior statement. They almost didn’t hedge energy costs. The brilliant minds running the show over there figured it would be a good idea to put on an energy hedge with oil trading over $120 /barrel. While they were locking in those fantastic prices oil prices, they never figured to hedge their production risks.
Is it becoming clear what their intentions were? Alcoa decided they were going to try and maximize potential returns while doing nothing to mitigate downside risks. Think about it. With energy hedged at $120 /barrel, a rise in prices (aluminum and oil) would have allowed them to maximize profits. Instead, they were left with the exact opposite situation and nothing to do but sit with their hands in their own dumb pockets. Investing in companies like Alcoa and the situations they get themselves into need to be avoided if you intend to preserve and grow you capital base. A couple more notions to be taken here:
-All lessons from agricultural markets regarding input and production hedges apply here.
-If you want exposure to price movements on the underlying commodity, you don’t want the producer to have their production hedged. A production hedge essentially removes the affects of price action on revenues and profits.
So how about some exotic metals equities trades to close this piece out…
Say, for example, that you expect oil to outperform gold going forward. This is a very reasonable assumption given the radical action between the WTIC/Gold price ratios over the past six months. Energy is a major input cost of mining, especially with some of the more extravagant underground operations. If you think crude and gold are both increasing (crude outperforming gold), get long a company that has its energy costs hedged, with its gold production either completely un-hedged, or hedged at percentage less than the producer’s energy hedges. If you believe gold is going to continue to outperform oil look to buy a company with hedged energy costs and an empty hedge book for production.
I saved one of my favorite out of the box trades for last. Let’s say that you love everything about a company, its production prospects, location in the geo-political realm, business operations, etc.; unfortunately, you’re missing a piece of the puzzle: management. Staying in hypothetical land, everything about the management is rock solid except for their ability to put a hedge on. Maybe they have a bad track record, or maybe you just disagree with the operations at the moment. It doesn’t matter. You can put your own hedge on. As a shareholder in a company, you are part owner; therefore, you have a defined amount of exposure to input and production risks. By identifying the percentage of the risk exposure that you own, you can quantify the affects price movements will have on your specific percentage of ownership. This can be done with options, futures, or ETFs depending on your comfort level.
I’ve covered a number of things in this two-part series. It’s not enough to throw your money in the commodities sector and hope for the best. The different notions in these two articles will help you maximize returns on capital.
Disclosure: no positions