Mining is a risky business
Harry Knott considers the risks around the supply of non-ferrous metals and suggests how they could be mitigated.
These are monumental times for everyone involved in the commodity sector. Chinese demand is slowing down, cheap metals have been dumped on the market, copper and oil prices have been in free fall, UK steel mills are struggling to stay alive, and there is political risk in every direction. There have recently been positive indications of an upturn in demand from China, but many metal prices are on a long road to recovery, and not every producer will complete the journey.
All of this has made life hard for smelters. As we all know, you only stay profitable if all your plants, no matter where they are in the world, have a continuous supply of raw materials at a cost that has been factored in to the pricing equation. But if you have smelters dotted all over the globe, how can you be sure that each of these continues to receive an adequate reliable supply, when producers face so many challenges when getting their product to market?
The ability to manage the commercial activities around raw materials must give sleepless nights to smelter managers. With any physical delivery, there is always the risk that a supplier will not be able to fulfil its contractual obligations due to a range of possible logistical problems. For example, if a vessel shipment of alumina heading for an aluminium smelter is delayed, cancelled or even impounded, that smelter is consequently left short of supply. It would then have to work out the most efficient way to reroute the shipment to another smelter or source supplies of the right material elsewhere, which has a significant impact on efficiency and drives up costs.
Changes in government legislation on the trading of commodities in certain countries have also impacted the risks around metal supply. In January 2014, the Indonesian Government introduced a prohibition on the exportation of unprocessed minerals with the aim of stimulating domestic industry, creating more jobs and ultimately adding value to mineral exports by having them processed in Indonesia. However, the Government soon realised that the lead-in time for the export ban would not provide sufficient time for mining operators to build the necessary infrastructure to process and refine minerals for export. A transition period was created from 12 January 2014 until 11 January 2017.
The strict terms and conditions put in place for companies seeking to take advantage of this transition period have hampered Indonesia’s achievement of its domestic processing ambitions. One year out from the end of the transition period, there has been only a small increase in Indonesia’s mineral processing capacity. Furthermore, a combination of low commodity prices, a redirecting of foreign investment to other emerging markets, and the lack of investment in domestic processing has begun to have an adverse effect on the export of a number of key commodities.
In addition, only one bauxite refinery has been completed since the introduction of the export ban and because of this low base of existing infrastructure, coupled with the slow pace of new processing plant development, there had been production cuts at bauxite mines across Indonesia. For countries importing commodities from Indonesia, the ban has created greater uncertainty around Indonesia’s ability to meet processing requirements, especially given that its infrastructure is in the early development stages. The fact that Indonesia is having difficulty in achieving its domestic processing goals means that countries looking to import its commodities risk being undersupplied and unable to fulfil their obligations in the market.
It’s not just undersupply that can have a major impact. If one of your smelters is oversupplied in a particular location, this can also be problematic. If a vessel arrives and the smelter’s yard is full to capacity, the vessel will have to wait to discharge its cargo until the smelter has drawn down some of its stock, or the material will have to be stored elsewhere, which will incur warehousing costs. Either way, additional costs will apply.
One way smelters are mitigating these risks is through better management of inventory and logistics. It’s important for smelters to be able to track all the relevant information on the location and status of their goods – what they have and where, what is coming in and what they’re expecting to ship out. By using technology that provides these details, they can monitor the risks and, if something does happen – such as a supplier being delayed – they have all the information at their fingertips to know what steps to take next, be that sourcing alternative suppliers or rerouting a shipment.
Price volatility presents another risk. For producers, investment in their stock relies heavily on the price of the commodity in question. Take copper, for example. The price recently plummeted to levels not seen since 2008 amid fears that demand in China will fail to return. Some producers have been slashing costs, causing the global cost curve to fall steeply. With Chinese demand hanging in the balance and increasingly erratic economic figures, copper producers are having a hard time predicting when a sizeable supply response might happen.
It is this unpredictable nature of commodity prices that throws up various risks that producers can struggle to manage, especially those that are already financially vulnerable. To make things straightforward, many producers will price their stock at the average COMEX or LME price for the month. However, some customers may want to use different contractual pricing terms and that’s where various risks can come into play. If the customer has asked for a fixed price on its copper contract on an upcoming month, the risk the producer takes by agreeing to this is that they are then locked into that agreement. So if the price of copper surges by the time it gets to that month, they lose out on the rise in the underlying metal price.
This is where the importance of hedging comes in. Rather than accepting a hit on their profit and loss (P&L) statement or, worse, turning away business, producers can hedge that price risk with a futures contract or a swap contract on the underlying market. One way of seeing the risks that this poses to their P&L is to use technology that tracks hedging transactions and provides analytics that show accurate market-to-market risk figures. If producers have visibility on these risks and can hedge accurately, they are more likely to achieve their target revenue for the production delivered in a given month.
For trading companies and fabricators, the risks surrounding both logistics and price can be particularly disruptive. When it comes to buying and selling physical commodities, there is always uncertainty around what will turn up, whether it will be delivered on the right date, and if it will be of the right quality and to specification. As with smelters, risks around physical supply, such as an inbound delivery being delayed or deferred, can have a real impact on a fabricator or trader’s business, especially as a delayed shipment will, in turn, affect their exposure to price risk. For example, if a fabricator expected a delivery for the month of March but the supplier can only ship at the end of April, they are then exposed to the April price.
If a company is provided with all the information about the contract and the potential risks at play throughout the lifecycle of the transaction, they will be better prepared to tackle those obstacles when they arise. Integrating risk management into a company’s business activity is crucial for those companies facing changing markets and a volatile pricing environment. In terms of managing price risk, companies involved in the buying and selling of commodities need to deploy an effective risk management programme. Technology that provides analytics on risk figures, that monitors and manages price fluctuations can support this process and will ultimately help businesses to streamline processes, reduce transaction charges and mitigate operational risks. If companies get this right, they can better identify trading opportunities that will positively impact their bottom line and can become more effective, efficient and successful.
Harry has been with Brady plc for more than 20 years, during which time he has managed development teams, pre-sales and several product lines. Currently, he manages the Risk and Derivatives business unit and is responsible for derivative trading solutions and risk management solutions across physical and derivative trading within the commodities business.