eye on business
Copper hedging
Generally speaking, a “hedge” or a “hedge contract” is a
legally binding obligation to deliver or purchase specified
quantity of a product at a specified price at a future date.
There are a number of factors that could influence a company in its decision to hedge future output. First, where
there is a “contango” (future price is higher than current
spot price) as opposed to a “backwardation” (future price
is lower than current spot price) in the market, hedging
may be attractive.
Primary copper producers may want to hedge a portion
of future production to ensure at least break-even revenues
and to avoid the risk of having to place a mine on care and
maintenance if and when prices decline again. In addition,
hedging of byproducts (e.g. the copper byproduct output
of a gold-copper mine) may reduce the copper price risk
and improve equity valuations, as the
company would be considered more of a
by Chuck Higgins and
pure “gold play.”
James Verraster
Perhaps one of the more frequent uses
of hedging is where price protection is required in debt
financing. It would be common in some forms of bank
financing (i.e. non-recourse project finance) for the borrower to be required to enter into a hedging program sufficient to secure cash flows to cover operating costs and debt
service during the repayment period of the loan.
Types of hedging arrangements
There are two main types of hedging transactions —
public and private. Public transactions take the form of
futures contracts traded on certain commodities
exchanges. The main exchanges are the London Metal
Exchange for base metals and the New York Mercantile
Exchange for precious metals. Contracts between private
parties are usually governed by a standard form agreement
prepared by the International Swaps and Derivatives
Association, Inc. The agreement, which is updated from
time to time (the current version is the ISDA Master
Agreement, 2002), has a checklist of alternatives and additional provisions that may be incorporated.
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Obviously, there are price and production risks. The
price risk involves the forgone revenue if the future price
of copper turns out to be higher than the price at which the
forward contract was set. For example, some primary copper producers sold forward portions of 2006 and 2007 production, after which copper prices rose substantially,
resulting in a substantial forgone profit and a significant
unrealized “mark-to-market” accounting charge.
Gold producers Ashanti and Cambior were unable to
cover substantial long-term forward gold sales (and other
gold derivative sales) with current production when the
price of gold increased significantly following the highly
publicized Central Bank Gold Agreement in 1999. The
companies could not meet the sudden and significant cash
margin calls, and they were also unable to afford going into
the spot market to purchase sufficient quantities of gold to
satisfy their future delivery obligations. This resulted in the
substantial restructuring of both companies.
There are also less obvious risks such as credit worthiness of the contract parties. Each hedging program
will have credit risks, both of the producer and the
hedge counterparty. Further, as hedge contracts in some
cases can be complex and expose a producer to hidden
risks, an adequate evaluation of internal controls is
required to ensure that the hedging program and contractual arrangements are clearly documented and the
risks and rewards are fully understood, before the
arrangements become binding. It is worth noting that
there are products readily available in the market that a
producer can purchase/employ that will limit the risks
eye on business
of non-delivery and eliminate or limit the risk of exposure to cash margin calls (see reference to Yamana’s program below).
Accounting issues
Although it is beyond the scope of this article, there are
substantial accounting issues with hedge programs, centring on the question of whether a hedge program is eligible for “hedge accounting” treatment. For example, if the
program is eligible for hedge accounting, then any
increase or decrease in the market price of copper following execution of the program (when compared to the
actual hedge program price) will be reflected in the financial statements as a balance sheet entry. If the program is
not eligible for hedge accounting, then any increase or
decrease will be reflected as unrealized gains or losses on
the income statement. The test is whether the hedge will
be highly effective over its duration. International
Financial Reporting Standards 39 and Financial
Accounting Standards 133 in the United States address
this issue in great detail.
Copper market
Over the course of the last 10 years, the copper market
bottomed out at US$.58 per pound in November of 2001
— a level that rendered many copper mines uneconomic.
The copper world changed dramatically towards the end
of 2003 when copper started its rather meteoric rise,
eventually reaching US$4.00 per pound in May of 2006.
While copper was traditionally in a contango in the
nearby (six to twelve) months, hedging of medium or
longer term (12 to 36 months) copper was extremely difficult, due to the presence of the steep forward backwardation caused by a lack of liquidity to hedge longer dated
contracts. After 2003, the copper market got a real boost
from two main factors: 1) a significant increase in global
demand for physical copper for infrastructure, and 2) the
growth of hedge funds, which are keen to invest in physical and forward copper, providing new liquidity for
hedgers. Therefore, despite the presence of the steep
backwardation, producers have started to hedge given the
hugely attractive current prices (in other words, they
would be willing to suffer some forward discounts
because for the first time in history they could start with
a current copper price in the US$3 to $4 range).
About the authors
Chuck Higgins works for the Global
Mining Group at Fasken Martineau
DuMoulin LLP. His interest in mining
comes from his grandfather, Larratt
Higgins, Sr., who was a mining
engineer at the El Teniente copper
mine in Chile, which is still the biggest
underground mine in the world.
James Verraster and his partners
opened the doors at Auramet in 2004
right around the time that metal and
other commodity prices started to
recover, helping clients in the mining
sector achieve their financial goals.
Those who know Jim well can
confirm how busy Auramet has kept
him because they know he hasn't
been spending enough time trying to
improve his golf game!
Examples
Recent public company examples of copper hedging
programs that were mentioned in press releases include
Baja Mining Corporation, Fronterra Copper Corporation
and Equinox Minerals Limited. Alternately, Mercator
Minerals Limited, a copper-molybdenum producer, completed a public debt financing without a hedge program.
An example of a gold company that hedged a portion of its
copper byproduct is Yamana Gold Corporation. CIM
June/July 2008 | 45