Failure to hedge

POOR hedging has been a contributing factor to the negative effects of the Global Financial Crisis in Australia, particularly in the case of mining companies.

A common theme among mining companies that have shut down projects, or which no longer exist, is the absence of, or poor, hedging.

The GFC has initiated a lot of discussion about poor risk management, and it is accepted that the business world has been mismanaging risk for some years. One of the areas of mismanagement in Australia that has not been talked about has been the underutilisation of hedging.

Hedging involves agreeing to buy or sell something in the future at a fixed price in order to offset an exposure to a risk. It has the effect of reducing the risk of adverse price movements in exchange for a loss of possible opportunity to achieve some favourable price movements. Hedging is a risk-reduction tool, not a profit-making tool.

Why aren’t Australians good at hedging?

We are a pretty optimistic bunch, which is often an asset, but when your focus is optimistic you are inclined not to think that you need to prepare for tougher times.

Management and boards here are also often influenced by the broking community, which has historically liked companies to be fully exposed to the potential upward movement in commodities prices. Obviously this behaviour does not reduce risk.

We also don’t have a hedging culture in Australia, whereas businessmen in other countries have been actively hedging key risks in their businesses for generations.

However, what has really let us down has been the poor identification and management of risk and the poor knowledge of how hedging works when it is properly applied by boards and management.

Management are often aware of the fact that if you hedge your sales and the price goes up you have had an opportunity cost, but ignore what happens if prices were to move adversely.

Recent experience – nickel prices

Nickel has been one of Australia’s boom and bust metals. Nickel was selling for more than $US24/lb in mid 2007, went to lows of $US4/lb in November 2008 and since early October 2009 has risen back to about $US8/lb – that is an 83 per cent decrease followed by a 100 per cent increase in 27 months.

If you were a nickel producer and you were hedging forward two years at the peak, you would have had something like two extra years at good prices. That would have been quite a cushion to use while the organisation made adjustments to a lower price regime.

Hedging gives management time to adjust to substantial changes in prices; it smoothes movements in prices of key variables that are the centrepiece of many organisations.

When the Ravensthorpe nickel project was built at about double its original forecast cost, its project risk went through the roof. It needed a much longer time period to recover the substantially larger investment than originally planned. The recovery of construction costs needed “time in business”. You can’t recoup an investment if you are not in business. Therefore, at Ravensthorpe, the focus should have been de-risking to stay in business.

It is important to note that the relative need for hedging is completely different for a project that is one of the high-cost producers in an industry than a project that is one of the low-cost producers. The former has a much larger risk profile than the latter.

If you are a low-cost producer you can wait out periods of low prices. If you are a high-cost producer you can’t. Risk managers at companies are supposed to address precisely this issue.

One of hedging’s key strengths is that it gives management more time to adapt to big changes, and assists in flattening out the world of volatility, something that is sorely needed today.

There needs to be recognition that shareholders do not want their companies so exposed to the upside of commodity prices that projects fail when prices fall.