How to Hedge Aluminum Purchases Using an All-In Futures Contract

by Raul de Frutos on

Aluminum buyers in today’s markets probably have good reason to avoid using futures contracts. That might change in a matter of days and buyers might want to reconsider these venues for future hedges.

FREE Download: The Monthly MMI® Report – covering the Aluminum market.

Many companies don’t use futures contracts at all to hedge metal purchases because they do not understand how they work, even though they remain relatively simple to use. Others may not use futures contracts because current products don’t mitigate enough price risk, rendering the hedge useless.

In the first situation, let’s say you have negotiated a long-term sales contract with a key customer and need to purchase a certain volume of aluminum by May 2015 to meet known demand. Until today, you could use the LME contracts in two ways:

  1. Futures contracts with no physical delivery:
  • The buying organization purchases X number of LME aluminum futures contracts (matching the volume one will buy from one’s supplier in May 2015) with an expiration date of May 2015.
  • In May 2015 the buyer sells the contract before it expires and the gain or loss in this contract will offset the increase or decrease in the price of the buyer’s actual physical aluminum purchase order, supposing one fixes conversion costs with the supplier.

This is how it used to work. However, the contract only represents the LME aluminum price without including the Midwest Premium. A supplier will charge a buyer the current LME price + MW Premium. Since the MW Premium has increased and become volatile, the hedge and the purchase no longer match, making this strategy completely inefficient.

2. Futures contracts with physical delivery:

  • This time, the buying organization uses a LME futures contract matching the volume it needs.
  • When the contract expires, the buyer pays the price agreed in the contract and ALSO pays the current MW Premium to receive delivery of the aluminum.

In this case, the buying organization has the same problem with the MW Premium and the buyer doesn’t know when he or she will receive the metal due to the long queues for getting metal out of LME warehouses. For these reasons, industrial buyers have long abandoned the LME.

Now, if  the new CME Group aluminum contract is able to gain popularity, buyers could take full advantage of futures contracts as a hedging instrument. Using the same example, the two venues will work this way:

  1. Futures contracts with no physical delivery:
  • Buying organization purchases X amount of CME aluminum future contracts (matching the volume bought from one’s supplier in May 2015) with an expiration date of May 2015.
  • In May 2015 the buyer sells the contract before it expires and the gain or loss in this contract totally offsets the increase or decrease in the price of the actual physical aluminum purchase order, supposing one fixes conversion costs with the supplier.

Now, since the contract represents the all-in price, a supplier will charge a buyer the CME spot price at the time the contract expires which places the value of the futures contract, itself, at its expiration date. Therefore, the buying organization will offset 100% of the risk.

2. Futures contracts with physical delivery:

  • This time the buying organization uses a CME futures contract (again, matching the volume needed).
  • When the contract expires, the buyer pays the price agreed to in the contract to receive delivery of the aluminum. There is no need to separately pay the MW Premium since it is already included in the contract.

This time, the buyer will receive delivery as expected since the CME won’t allow queue formations. The CME’s rules on warehousing restrict rent charges on undelivered metal.

The CME Group’s regulatory body has the power to force warehouse owners and managers to provide free rent should any delays occur not due to the fault of the warrant holder.

What this means for metal buying organizations

We would recommend aluminum buyers keep an eye on these developments, as they might want to embed these methods in their procurement strategies. Advantages to buying organizations include:

  • The possibility of hedging many years out. Very few suppliers will call you out 4 or 5 years after purchase.
  • No need to worry about counter-party risk.
  • Avoiding re-negotiations with suppliers when there are big price movements.



Leave a Comment

Your email address will not be published. Required fields are marked *