A lesson in commodity price hedging

A strong US dollar does not dampen raw material prices
Unfortunately there is no trace of summer in our latitudes. A pronounced cold period was followed by a pronounced rainy period. This has led to a summer edition without any real summer feeling. In any case, any cheerfulness has already been lost in all parts of the world for viral reasons. Things can and will, therefore, only get better. As far as the development of raw material prices is concerned, however, there is definitely reason for producers and traders to be happy, because after many years of a bear market there is a certain boom at present. We reported in detail about the background in the last issue.

The order books of steel producers are well filled, private and industrial consumers have a lot of catching up to do, so there are bottlenecks in finished goods and semi-finished products as well as primary and secondary raw materials for various reasons. This should, however, improve, at least in part, with an improvement in the international logistics situation. In this respect, the commodity prices are, as they say, “well supported” and there are currently few indications why this should not stay that way for a longer period of time.

The nickel price on the London Metal Exchange (LME) is currently trading at prices well above USD 18,500.00/mt and has also briefly touched the USD 19,000.00 mark. Nevertheless, also with the still rampant pandemic in mind, one must always be prepared for exogenous shocks. It is also interesting that the current rise occurred in parallel with a clear strengthening of the US dollar against the Euro (USD / EUR 1.18) and other currencies. Typically, a strong dollar has a dampening effect on commodity prices. However, experience shows that price developments are seldom one-dimensionally derived only from a single influencing factor.

China’s interventions and goals are not always in tune
Against the background of the commodity market situation with its high prices, as described above, we had written about the ambitions and also the actual interventions by the Chinese government in their fight against the price development for Chinese companies. Just recently on a government website the Chinese Prime Minister Li Keqiang once again stressed that China could continue with its dampening measures for the next 18 months. While these interventions prevent fair and free competition for non-Chinese companies, who literally cannot turn to a generous nanny state, they could also have negative consequences for the Chinese companies themselves.

There is information that the Chinese government would certainly welcome it if domestic companies would protect themselves more and more against unfavourable price fluctuations using the commodity derivatives available. The problem lies, however, in the details of the hedging logic. In order to achieve perfect hedging, it is important that the price base of the underlying transaction (e.g. the purchase of a certain amount of nickel) and the price base of the hedging transaction (e.g. the nickel futures on the Shanghai Futures Exchange) match as closely as possible.

Otherwise, it can happen that a negative result from the underlying transaction and a positive result from the hedge (or vice versa) do not offset each other as desired. It can even be more likely that if the price basis differs significantly, the result from both the underlying transaction and the hedge transaction can be negative for the company concerned. This can happen especially when prices move freely according to supply and demand on stock exchange markets, such as the SHFE, while some authorities regulate prices in defined areas, and, for example, limit their movement either up or down. We would be more than happy to explain this complex relationship to the Chinese government if necessary.

But sometimes, this can also be experienced in Europe. For example, when it’s a matter of protecting companies from unfavourable interest rate changes, with the current negative interest rates, most banks have agreed what is called a floor (lower limit) for their reference interest rate in loan agreements with companies. If this interest rate is, or becomes, negative, it is set to at least 0 percent plus an interest margin for the interest calculation. If a company has concluded a corresponding interest rate hedge, where of course, there is not usually such a floor, the same phenomenon, or problem, occurs as described in the Chinese context.

Chinese commitment to the circular economy
At the start of the month the Chinese development and reform Commission published its fourteenth five-year plan. Its focus is particularly on the promotion of the recycling economy so that carbon neutrality can be reached by the year 2060. By the way the EU has set itself the ambitious goal to reach this by 2050.

With regard to metal recycling the Commission wants to increase the use of steel scrap by 2025 to 320 million tons. Furthermore, the output of recycled non ferrous metals should grow to 20 million tons, of which: 4.0 million tons copper, 11.5 million tons aluminium and 2.9 million tons lead.

The new five-year plan should also promote new technologies to convert industrial waste into secondary raw materials. Chinese cities are advised to create new sites for the processing of municipal waste. In addition there should be a system for recycling old batteries from electric cars.

Strong increase in freight costs due to increased freight traffic
At the beginning of July, the commodity experts of Macquarie reported on the global economic developments and the effects on global freight costs.

The authors have come to the conclusion that the goods sector recovered much more quickly than the service sector due to the US economic stimulus package. As a result global trade rehabilitated rapidly, with goods exports increasing in April by 27% from the low at the end of March to the beginning April 2020. Year on year, global exports rose by 4%. If a comparison is made with the financial crisis, it is noticeable that the corona pandemic has had a significantly shorter impact on global trade.

On the one hand, this led to a bottleneck in supply chains and rising input costs as well as a rapid increase in global freight costs. However, no uniform development can be seen here either. The price index for the worldwide shipping of main cargo (coal, iron ore) the Baltic Dry Trade Index is still below the values of the commodity super cycle of 2008. In contrast, the price development of the charter market for container ships, the Harper Index, already exceeds the price level of those years after the financial crisis. According to the Macquarie commodity exports, this is because demand for consumer goods has once again increased much more significantly than that for commodities.

In most countries economies have almost reached those levels again of before the pandemic. The global economy owes this, above all, to China. The Chinese export volume is 20% above the previous year, while other countries have only seen increases of around 2%. The differences in export volumes are also reflected in freight rates. The cost of a sea container from Shanghai to New York increased by around 300% compared to the previous year, while freight rates from Rotterdam to New York only increased by 120%.

While the rise in freight costs does indeed contribute to global inflation pressures, as can be seen in the global Purchasing Managers’ Index (PMI), the actual impact on inflation has, so far, been rather weak. The increase in commodity prices has a far bigger impact on inflation than the increased freight rates.

Proposal from the EU Commission for Carbon Border Adjustment Mechanism
As numerous press outlets have reported, on the 14th July 2021, the European Commission has submitted a proposal for a Carbon Border Adjustment Mechanism (CBAM) for further discussion. This is part of a package of measures with the very meaningful name “Fit for 55”, which should ensure that the intended goal of a 55% reduction in greenhouse gas emissions in the EU, compared to levels in 1990, is reached by 2030 at the latest. The terms tax and duties have been cleverly avoided in the measures under discussion as it had previously been referred to as Carbon Border Tax or Duty, since the compatibility of such a set of rules with the free movement of goods of the World Trade Organisation WTO is already now controversially under discussion.

The CBAM of the EU should initially apply to products from the cement, iron and steel, aluminium industry, and also from the fertilizer and electricity sectors. For iron and steel, the complete double digit upper category 72 of the international customs tariffs – also called combines nomenclature – is included, with the exception of the four digit category 7202, i.e. ferroalloys, as well as 7204, steel and stainless steel scraps. That ferroalloys have been excluded from the CBAM proposal can only be due to the fact that these are often produced in emerging countries with a high energy consumption and therefore with high greenhouse gas emissions. Obviously the aim is to protect European processers who use imports of these input materials on a large scale, from an additional potential strain caused by the CBAM, as many of these companies are already weighed down by costs from the European Emissions Trading System EU ETS.

The aim of the CBAM is to prevent carbon leakage. A higher carbon price in the EU ETS could result in climate damaging production moving from the EU into non-EU countries and that in the future, products produced there, perhaps even more climate damaging, are being imported into the EU. On balance then, emission trading would go against the goal of reducing global emissions, and, at worst, even increase emissions, as the environmentally friendly production sites in the EU would be replaced by the less environmentally friendly sites of other countries.

Emissions in non-EU countries must be considered
In this respect, a consideration of emissions in other countries for goods which are imported into the EU cannot be avoided if climate goals are to be achieved. The same distortions and inconsistencies would arise if the export of climate-friendly steel and stainless steel scrap from the EU were to be hindered. This could restrict the export of climate protection and thus result in more carbon emissions in total, as the maximization of global scrap use necessary to protect the global climate would be prevented. Not to mention the lip service paid to fair and free trade within the framework of the WTO here.

In a transitional period between 2023 and 2025, importers should initially only report the emission volumes of imported goods, without any duties imposed on these imports. From 2026, the concrete measures should then come into force. Importers would then, if the rules go into effect as proposed, be required to report the quantities of greenhouse gases and energy associated with the imported goods by May of the following year, and to submit corresponding CBAM certificates for these quantities. The price represents the cost of carbon as it was in the EU ETS for the respective period. If there are comparable emissions trading systems in the exporting countries with a price for the greenhouse gases, importers can deduct these costs from the charges for the CBAM certificates,

Initially, according to the EU Commission’s proposal, CBAM measures should only apply to direct emissions from the manufacture of imported products in the third world countries. This means that the raw materials, which often account for a very significant proportion of climate-damaging emissions, will be left out. However, the EU reserves the right to expand the CBAM to include indirect emissions. If Europe is serious about carbon leakage and a genuine, universal price for harmful climate gases, then there is no way around including raw materials.

Only when their climate damage is also taken into account in the sense of internalising external costs can fair competition among raw materials be established at all. Otherwise, it would not matter whether climate friendly and sustainable secondary raw materials such as steel and stainless steel scrap or climate damaging alternatives are used as input materials in the EU. Just as a reminder, according to Fraunhofer UMSICHT, the use of one ton of stainless steel scrap in stainless steel production saves 4.5 tons of carbon compared to one ton of the corresponding primary raw materials or ferroalloys.

We wish all our readers a sunny and relaxing summer.