The management of commodity prices is important when it comes to resource extraction. The hedging technique is a way of managing the risk of losing asset value in case of any possible change in prices, particularly in the case of commodities. Some of the major hedging techniques include forward sales, which involve selling a certain amount of the commodity at a certain price in the future, and options.
Mine economics depends on stable income flows to counterbalance large investments required for such operations. Being unstable, global commodity markets can suddenly experience a sharp decrease in prices, which will make mining ventures economically unfeasible. Financial risk management helps to guarantee stability in future income flows and meet financial obligations (covenants) (Ghoddusi et al., 2022). This is why a customized hedge becomes crucial insurance.
The forward sale ensures that mining income streams are safeguarded through setting an agreement for selling at a predetermined price in the future. In case of a copper mine anticipating a price drop in the future, they could enter into a forward sale contract for selling the output at the current advantageous price levels. This ensures certainty in planning, even though it forces the miner to deliver the output irrespective of future conditions (Halkos & Tsirivis, 2019).
The use of options will be a perfect way to deal with price risks associated with mining firms. The mining firm may choose to buy put options for the commodity, whereby the minimum price is determined, although there is no upper bound to the price. If prices fall, the option will cater to the price risk, but if prices increase, then the firm will sell its products using the current price. The expenses that will be incurred through buying the option may affect the bottom line (Ghoddusi et al., 2022).
However, hedging excessively exposes firms to financial risks. Excessive hedging arises from situations where the firm hedges too many future quantities of production. In case of a rally in spot prices above the level of the hedged price, the firm experiences huge opportunity costs of missed gains. Moreover, derivative contracts have collateral, and huge mark-to-market losses on forwards give rise to margin calls, causing liquidity problems and limiting investment (Rampini et al., 2014).
To sum up, the application of commodity price hedging techniques is essential to protect mining economics from volatility. The forward selling technique guarantees definite prices, whereas option technique provides protection against the downslide but gives upside flexibility. But mining firms have to be cautious in setting their hedging ratio since too much hedging leads to liquidity problems and opportunity costs.
References
Ghoddusi, H., Titman, S., & Tompaidis, S. (2022). Hedging Commodity Price Risk. Journal of Financial and Quantitative Analysis, 58, 1202–1229. https://doi.org/10.1017/s0022109022001478
Halkos, G. E., & Tsirivis, A. S. (2019). Energy Commodities: A Review of Optimal Hedging Strategies. Energies, 12, 3979. https://doi.org/10.3390/en12203979
Rampini, A. A., Sufi, A., & Viswanathan, S. (2014). Dynamic risk management. Journal of Financial Economics, 111, 271–296. https://doi.org/10.1016/j.jfineco.2013.10.003
