Risk and finance
Donald Douglas, CEO of Cambridge Risk Ltd, UK, explains the challenges of hedging.
Raising finance for new projects in the current market is difficult, and for exploration, nearly impossible. With equity markets more or less closed, project finance is usually the only source for funding the development of a mine. While price is a key driver of the viability of metal resources and how they are exploited, it is also a risk. This is exacerbated by the long period between discovery and the start of production, when metal prices can vary significantly. What started off as a marginal resource can become highly profitable or uneconomic.
Besides metal prices, currencies, interest rates and energy prices influence profitability, and financial instruments, such as forward contracts, are directly affected by market prices. Indeed, poor market price decisions by miners have had serious consequences in the past. Around the world Ashanti, Pasminco, Sons of Gwalia, Sumitomo and Metallgesellschaft, are just some of the companies that have suffered.
Ups and downs
One of the tools in a lender’s financial protection box is hedging – the outright or contingent sale of metal at a fixed price for an agreed series of forward dates matched to the production plan and as a condition precedent to the drawdown of finance. Usually banks require a mine to hedge enough of the planned production to ensure that debt can be serviced even in adverse market conditions.
Investors generally do not want their companies to hedge, preferring to benefit, or suffer, from any changes in the price of the underlying metal. Hedging can be expensive, even though it does not appear as a cost in the profit and loss account, and banks make a lot of money from it, often more than they do from the underlying credit facility.
It can also be difficult, particularly in times of high volatility or in a steeply backwardated market (where the commodity is worth more today than in the future). Other concerns include the credit risk on banks and new hedge accounting standards. Some mining companies just follow the bankers’ instructions, which is not a good policy.
It may seem obvious but it is important to match the terms of the hedge contract with those of the sale of the metal. Failure to do this can, and probably will, result in hedging losses – that is, a hedge that does not work.
Allow for delays in the start of production, avoid fixing the prices of the metal at this time, and use long put options (the right, but not the obligation, to sell at a price in the future), which do not require delivery. Some defunct companies would still be here today if they had followed this advice. However, most miners do not like paying the premiums of put options.
Keep it simple – complex products usually have high hidden costs and should only be used if necessary to match the sale terms. Also, choose banks which have good access to the market, some will simply lay off risk with the major players, thereby increasing the cost and causing you to lose access to the execution and warehousing possibilities of the bigger banks.
The size and timing of the hedge programme and the instruments to be used should be negotiated with the banks. It is helpful to understand their criteria – usually in the form of a series of ratios – and to understand what assumptions they have used in testing whether they are met. These assumptions, such as the price obtained for the metal which is not hedged, can then be questioned. There may also be room to discuss how soon the hedge should begin after the planned start of production and the instruments which are planned to be used – forwards, long puts, short calls (the right but not the obligation to sell metal) or variations of these. Long puts have no credit risk for the bank and should therefore be cheaper and approved faster. On the flip side, some banks may be unwilling to allow the mine to sell calls for credit reasons.
When structuring the hedge programme, it is worth ‘stress testing’ it. For example, what if the price goes up and production is delayed? Running several scenarios should help companies devise a robust programme. These should, of course, be closely tied to the latest version of the mine production plan.
Pricing the hedge is a key issue and it is helpful to understand how this is arrived at – although banks may be unwilling to disclose this. Credit pricing often uses complex proprietary models and may be negotiable. The price of volatility can usually be analysed, but a mine may need specialist help to do this. However, the savings can be startling – often millions of dollars. Ask for indicative prices and then for updates as time passes. Where several banks are used it may be possible to compare prices. It is worth noting that there is often tension between bankers and dealers about the value and distribution of profits – frequently bankers do not know how much the dealers make from a deal. Understanding this tension can be helpful.
Finally, ask for the documentation well in advance of the hedge’s execution. There will usually be an annexe which has the specific terms in it. Make sure that, where there are several banks, the terms are broadly consistent. It could (and will) save a lot of trouble later if there are problems with the programme.
A large hedge in a difficult market needs to be executed carefully, stealthily even. Banks watch the market, keen to take advantage of the effect of the hedge transaction on prices, so be careful about making press announcements until the hedge is completed. Note that some banks may be willing to take on the whole deal in one shot, possibly from the mine directly or from the syndicate banks, but usually at a price. If more than one bank is involved, an agreement where each takes turns to execute it is desirable. If they all go into the market simultaneously, the price will suffer. Ideally the bank with the largest capacity should go first.
Finally, make sure that the transactions are documented so that they meet hedge accounting requirements, and check that confirmations are correct.
Having completed the hedge, a report should be prepared for the company’s Board. At least quarterly, but better monthly, there should be a valuation of the hedge and a comparison with expected production. The sooner problems are known the better – it is expensive to adjust a programme, especially in a backwardated market, and rollovers to later periods can be cheaper if the need is anticipated. Credit risk should be similarly monitored and reported, as well as the hedge effectiveness, to meet accounting requirements.