June/July 2008

Eye on Business

Copper hedging

By C. Higgins and J. Verraster

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 pure “gold play.”

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.

What are the risks?

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 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).

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.


Chuck Higgins [left] 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!

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