Embrace modernity: try an aluminium hedge

The recent steep ascent in aluminium premiums should have put hedging of this component of the cost of the material at the top of the agendas of senior management in every company involved in buying or selling the product.

The recent steep ascent in aluminium premiums should have put hedging of this component of the cost of the material at the top of the agendas of senior management in every company involved in buying or selling the product.

For annual and multi-year contracts, buyers and sellers focus on what volumes they should lock in at fixed prices and what volumes to buy or sell on a spot or formula basis. But perhaps they pay insufficient attention to hedging premium risk.

Some companies, such as Novelis, reckon that they have solved the problem by ensuring that all the premiums they pay are passed through to their customers. Others offer fixed prices on the basis that historical prices should be a good guide to the future.

Still, duty-paid aluminium premiums in Europe have risen by more than 30% since the start of October 2013.

Or look at Japan, which imports around 2 million tpy of aluminium, and where buyers have seen premiums increase by over 20% since the start of the year.

Metal Bulletin reporters Jethro Wookey, Claire Hack and Andrea Hotter have covered the general and particular reasons for this vicious rise.

Why the rise?
First, there is the wide contango and cheap finance that have locked material up in carry trades since early 2009.

Second, there is the uptick in demand, decline in primary production and tight supply of scrap.

And, third, there is the fire lit under the price as industrial consumers of aluminium, and swaps dealers at banks and traders, covered their physical shorts.

But what does the soaring premium mean for those who have complained about its elevated levels most bitterly over the past four years and have not developed the capacity to pass through the number – and who (in Europe at least) are also subject to duties that some argue penalise a large downstream industry unfairly?

It bodes ill because remelters that did not lock in premiums from producers, at the same time as they fixed sales prices with customers, are now subject to greater costs as they must pay more for their aluminium units than the price at which they have contracted to sell them.

The sceptical might suggest that this was because they were on the wrong end of a bad bet: that they could short an aluminium premium that they still saw as being unjustifiably high. Others would say that they were simply maintaining their business as best they could in unusual times.

Be that as it may, greater buying and selling of forward premiums and better transparency around those forward premiums would serve the aluminium industry well, by providing it with better alternatives in the event that it wanted to mitigate that risk.

“Increased participation in the forward market for premiums could allow fabricators to experience less volatility in feedstock costs,” one experienced observer of the aluminium market said.

“Extreme movements in pricing can occur in any market, so it is difficult to eliminate this entirely. Nevertheless, the potential to mitigate the effect on cashflow through a more comprehensive hedging programme could create the desired stability,” he added.

Nor is it just fabricators who would benefit from the capacity to make such hedges.

At the moment last July when the London Metal Exchange announced measures to rein in the queues, premiums came off quite sharply.

Predictions ignite rally
The widespread predictions of lower prices in 2014 (there were some forecasts of duty-unpaid at $90 by January) has, as described above, played some role in igniting the latest price rally.

But in July there was a palpable unease among banks and other entities that were, in effect, long a physical premium that they had never had any ready means of hedging.

Back-to-front as it now looks, this unease was summed up in a Hotline by Metal Bulletin in September 2013.

The exposure to the premium was good for the valuation of long positions in a rising market.

But, in other circumstances, it could have come to be seen as a heedless risk in a market that, for example, lost 30% of its value.

Being able to hedge the premium, in other words, would offer risk mitigation to more than one side of the market.

Aluminium producers have called on the LME to offer contracts that enable regional premiums to be hedged.

Based on the experience of the CME Group, however, it is unclear whether at this moment the market is sufficiently liquid to support exchange-based pricing.

CME moved into this area last year, with a swap product for the US Midwest aluminium premium, in which open interest stands at only 74 lots.

Consumers, traders and producers are intrigued by the possibility of, at the very least, having clearer visibility of forward prices.

So who will step up to offer the market the capacity to bid and offer forward premiums for aluminium in a consistent and transparent fashion? 

Click here to keep up with all our coverage of aluminium premiums.

Alex Harrison
Twitter: @alexharrison_mb