Over the Hedge and Underground

When should companies hedge their exposure to financial and commodity risks? Is it always wrong or always right or somewhere in between? This topic arises every now and again when a goldmine is found to have made losses (and we’ll distinguish shortly between different types of “losses”) as a result of gold price increases when gold has been sold forward or they have an effective short position in gold through derivative exposures. Sasol (2) has also been in the news for making apparent losses on hedges put in place.

What is a hedge and how do companies hedge

A hedge can be constructed in several ways.

  • The commodity may be sold forward such that the price is agreed today but the goods are only transferred in future.
  • A future may be sold (or shorted) on the OTC market or on an exchange which achieves a similar overall effect.
  • A put option on the commodity may be purchased such that the company is protected from price decreases
  • Other structures may be created in conjunction with banks, hedge funds or other capital market participants

The net result is usually that disadvantageous price movements (usually price decreases for a commodity producer) result in profits on the hedging instrument that offset losses as a direct result of lower revenue from sale of commodities. When commodity prices decrease, the company doesn’t make as large losses as it would without the hedge. The catch? When commodity prices increase, the company doesn’t make as much profit as it would without the hedge. So the company ends up with lower volatility of earnings.

The problems with hedging

Hedging accurately requires exact knowledge of future volumes and dates of sales. Even the most stable goldmine has some variation in output from month to month. When predicting volumes several years into the future, the uncertainty increases in what is often described as an expanding funnel of doubt. If the hedge is put in place to offset the exposure of 100 units of gold and only 50 units of gold are available to be sold, then the hedge will overcompensate for price changes to the extent that the company will, perversely, likely make a loss when the price rises and a profit when the price drops! Similarly, if there is actually 150 units of gold available to be sold, the company will only have partial protection against commodity price movements.

Secondly, movements in the price of the hedging instrument may not exactly offset movements in the value of the underlying commodities to be sold. This is known as basis risk. An easy example to understand this is with wheat futures – the exact quality, type and transportation costs for the specified future may not be the same as the company’s own crop. Alternatively, if the hedge does not have the same maturity date as the sale date for the commodity, deviations in price for the hedging instrument on the market due to liquidity or other issues could result in differences too.

A more complicated issue reflects accounting rules for hedges and natural resources. IFRS requires derivatives to be carried on the balance sheet at market value in most instances. However, the extent to which gold deposits still in the ground are recognised as an asset depends on several other factors. The scenario can arise where the full loss on the derivative must be taken through the income statement in a particular period, but the increase in the value of the gold deposits in the ground is not recognised because the resources haven’t been proved with sufficient accuracy. This has often been the argument put forward by executives looking to explain accounting losses on hedging transactions. There is also the potential for this to be used as an excuse to hide the real economic losses.

The usual arguments against hedging

The most common argument against companies’ hedging their financial or commodity risks is that there is no need. Investors can more effectively manage their own exposures to various risk factors and adjust their exposure themselves. Many investors, wanting geared exposure to a particular commodity, will look for unhedged, marginal mines that are extremely highly exposed to changes in the price if the underlying commodity. If the gold mining company itself hedges the risk, it is no longer of interest to the investors.

The argument follows that management of a gold mine should worry about mining gold, and that maize farmers should worry about maize farming. Leave the sophisticated financial and derivative decisions up to the experts.

Can hedging be good? Aka why the previous argument is flawed.

There are three clear flaws in the usual argument against hedging.
Firstly, if investors are so adept at adjusting their risk exposures with derivatives and fancy structures, why do so many of them like marginal mines to get their geared exposure? Chat to many resources punters and investors and, while many will stick with the tried and trusted, there is significant demand for marginal gold mines too. If all investors could get the same exposure through derivatives and other hedges, this demand wouldn’t exist.

Secondly, surely the gold miner has the best information relating to the volume and timing of gold sales and can thus hedge more effectively than an outside investor? If the company is hedging 100 units of gold exposure, it is likely that each individual investor is hedging close to 1 or maybe 10 units of exposure. Economies of scale do play a role in getting the best price in hedging transactions (admittedly it can work the wrong way round too). Thus, it is not clear that investors are in a better position to be able to hedge the resources company’s exposure.

Finally, and most importantly, pulling gold of the ground and planting maize require long-term planning. Planning acreage of planting, capital investment, labour quantities and transportation contracts accurately requires solid estimates of future volumes and revenues. For a gold miner to concentrate on mining gold he or she will need to know what rate of return can be expected on sinking a new shaft or reopening an existing shaft, hiring more staff and importing machinery from Canada. This is difficult with the uncertainty of a volatile gold price. How can a farmer choose what mix of crops to plant without knowing what the final revenue from each unit of crop will be? The very argument that advises the natural resource companies to not hedge and stick to their knitting is, in my view, the strongest argument for them to hedge.

The question that needs to be asked is, “Can the company more efficiently focus on its critical success factors by hedging?” If the answer is yes, then hedging is the way forward. If the answer is no, then it might be better left to investors.

This is by no means the final word on whether hedging is appropriate or not. It’s hardly even scratching the surface. However, everytime a journalist or analyst gives a gold mine a hard time about hedging when hedging was the right thing to have done at the time then we discourage our miners from hedging. A little more insight and more carefully thought-through analysis should lead to better decisions overall.

Life insurers getting WACC’d by debt issues

Life insurers in South Africa have been stumbling over each other to issue long-term debt. The reason? Ostensibly to reduce their WACC and generate greater value for shareholders.

Common sense tells us that this is a sensible thing to do. Companies all over the world have been using debt capital to reduce their WACC by sharing the cost of financing the business with Mr Tax Collector. (The interest payments made to holders of the debt are tax-deductible expenses for the companies that issue the debt. Dividends paid to ordinary shareholders must be paid out of net-of-tax income.)

Take the example where the pre-tax cost of debt (yield to maturity on current debt or equivalently, the annualised coupon required on newly issued debt for the debt to be placed at par value) and cost of equity (a little more complicated, since the cost of equity depends on whether the equity is retained earnings or equity freshly issued through a rights offer, but will generally be based on a CAPM or APT-type model of the return required by shareholders) are equal at, say, 10%. The generic formula for the WACC is:

WACC = (1-t)*cost of debt*w + cost of equity*(1-w)

where t is the corporate tax rate and w is the percentage of total capital (measured at current market value and not book value) contributed by debt.

Thus, if w is 50%, then our WACC = (1-29%)*10%*50% + 10%*50% = 8.55%, which is lower than the 10% cost of equity. Thus, magically, but incorporating debt financing into our capital structure, we have lowered our cost of capital and increase the value of our company to our shareholders.

Or have we? Continue reading “Life insurers getting WACC’d by debt issues”

Almost Famous

Not quite rockstar material yet, but my fame is spreading, at least in The Actuary, the magazine of the UK’s actuarial profession.

Check out the mention of my involvemet in the launch of the South African version of the Actuarial Modelling course (CA2) in Pretoria during July. Overall, it went pretty smoothly – results are expected shortly. I’ll post a link when they come out if one is available.

exam results now available