Hedging activity among Chinese miners on the rise, even after LME debacle
China Baowu Steel Group employees work at its steel plant in Maanshan, China’s Anhui province. Baowu is the parent company of Baoshan Iron & Steel Co. Ltd., which has hedging plans for 2022 including up to 8 million tons of iron ore and 2.2 Mt of hot rolled steel.
A growing number of Chinese metals and mining companies have started using derivatives to hedge against unprecedented volatility in commodity prices, despite risks that could turn out to be catastrophic.
Global commodity prices have fluctuated in recent years amid the COVID-19 pandemic, Russia’s war in Ukraine and the global energy crisis. Metal and mining companies in China reacted by hedging their bets in the financial markets. Typically, companies trade futures and options to lock in the prices of their commodities and products. They hope to secure their income and reduce potential losses and gains.
Fifty-five Chinese metals, steel and coal companies launched hedging programs in 2021, up 29% year-on-year and hitting a record high, according to S&P calculation Global Commodity Insights based on voluntary company announcements in the Shanghai market. Stock Exchange and Shenzhen Stock Exchange. In 2022, 31 Chinese metals and mining companies released hedging plans as of April 13, up 14.8 percent from the same period of 2021.
But hedging is a double-edged sword, as nickel traders learned on March 8, after nickel and stainless steel giant Tsingshan Holding Group Co. Ltd. attempted to cover a short position that drove nickel prices up so rapidly that the London Metal Exchange halted trading and unwound all trades made on the day.
“Hedging should help companies reduce the impact of price fluctuation on their core business,” Kenny Ng, securities strategist at Hong Kong-based China Everbright Securities International, told Commodity Insights in an interview on Tuesday. April 11.
Hedging against volatility
Commodity prices have increased over the past two years. The S&P GSCI index, which tracks 24 commodities, jumped more than 260% from a low of 228.24 on April 21, 2020 to 822.3 on March 8, the highest level since 2008, and is since in full mutation.
As the prices of some metals hit all-time highs, miners worried that metal prices could fall sharply this year could take a short position to avoid a potential shock to their earnings, Ng said.
However, if they’ve built a large hedge position and those forecasts are wrong, the losses will hurt their profits, Ng said.
“For most Chinese miners, the main purpose of hedging is to prevent raw ore prices from falling. [to cause losses]“Xia Yingying, metals analyst at Nanhua Futures Co., told Commodity Insights on April 14.
In practice, these companies typically sell futures contracts covering the same amount of ore for sale in the spot market, with a futures market delivery date that is the same or close to the spot market trading date. Then miners can close out the futures contract position when they actually sell the ore in the spot market and lock in trading prices, the Hangzhou-based analyst said. Some miners use options, which have more complex structures and provide more flexibility, Xia added.
Integrated metal producers are also looking to hedge against rising commodity prices.
“[The smelting segment] must use derivatives to lock in processing profits and reduce the volatility of the operation,” said Wu Honghui, financial controller of Zijin Mining Group Co. Ltd. to investors on a March 21 call.
Zijin mainly conducts its foundry business in the domestic market, but it depends on foreign raw materials and sells the majority of its products in the overseas market, Wu said.
Meanwhile, companies with overseas operations have started to hedge against foreign currencies. For example, major steelmaker Baoshan Iron & Steel Co. Ltd. plans to use currency swaps, iinterest rate swaps and structured products for its foreign currency hedging program in 2022, covering a total of no more than $15.99 billion.
China’s largest lithium company, Ganfeng Lithium Co. Ltd., plans to invest a maximum of 10 billion yuan in currency hedging in 2022, up from 5 billion yuan in 2021. Ganfeng uses forward settlements, currency swaps and currency options for its currency hedging, Yang Manying, chief financial officer and vice president of Ganfeng, told investors on April 8. “In order to hedge the impact of interest rate and exchange rate fluctuations on the operation, currency hedging activities are conducted opportunistically based on market fluctuations,” Yang said.
These companies are preparing for greater exchange rate fluctuation, said China Everbright’s Ng. The US Federal Reserve has entered a cycle of interest rate hikes in 2022, but China is expected to ease monetary policies further to counter downward economic pressure from a resurgence of COVID-19, which could prompt foreign investors to withdraw money from China, the securities strategist added.
Double edged sword
Although hedging strategies are designed to reduce risk and volatility, risks are inherent in the use of derivatives.
The biggest risk Chinese miners face is that they might not find commodities on futures markets that perfectly match what they produce, Xia said.
Tsingshan Holding Group Co.Ltd. faced paper losses of $8 billion after nickel prices more than doubled to a record high over $100,000/tonne on March 8 after Russia invaded Ukraine.
Tsingshan had built a short position of 150,000 tonnes of nickel on the LME through regular hedging over the years, Bloomberg News reported. According to the report, the world’s largest nickel producer thought prices would fall after expanding battery-grade nickel production capacity in Indonesia.
Ideally, short sellers such as Tsingshan borrow goods and sell them immediately, then buy them back when prices fall. And they can return those products to lenders and take advantage of price differentials. However, the unprecedented rise in nickel prices has forced Tsingshan provide more liquidity to meet minimum margin requirements, which also continued to rise with nickel prices.
Tsingshan could return the nickel to lenders. But the company mainly produces lower-grade nickel pig iron, compared to the high-grade nickel metal it trades on the LME.
“Mismatch of Assets and Maturities Backfires Tsingshan turns to speculation,” Gu Fengda, director of the research and advisory department of Guosen Futures, said during a webinar on April 12.
Department derived from Tsighshan did not issue early warnings and did not adjust hedge positions when nickel prices rose about 20% over about 20 days in January, Gu added.
Cover against cover
Other Chinese miners are more cautious. Zijin “has always been cautious in his hedging” and hired a professional team to handle his complicated bets, Zijin’s Wu said. There is strict control over the extent of coverage and clear stop-loss limit regulations, and smelters also have exposure limits, Wu added.
Zijin covers no more than 4% of current year production for mining products.
“We have been very cautious this year, with a gold position of just over 300 kilograms, a copper position of only 500 tonnes of watch positions, a zinc position of around 12,000 tonnes and a iron ore position of 40,000 tons. So the whole position is very small,” Wu said.
As of April 19, US$1 was equivalent to 6.39 Chinese yuan.
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