Can ETF Commodity Backed Funds be Used for Hedging?

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Commodities, Sourcing Strategies

Faced with an advantageous or even acceptable price today, many metal consuming companies struggle to find a mechanism to fix their raw material metal cost forward for any significant period of time. Depending on the size and sophistication of their suppliers they may be able to access fixed price contracts for a period of time, typically 3 months or occasionally 6 months. They may have the liquidity and storage facilities to pre-buy enough raw material for the year ahead and sit on it. But few CFO’s would allow that much cash to be tied up in such a way and the firm is then locked into the cost of that material with no “get out of jail option if the market turns bad, as it did 12 months ago. Anyone with a large stock position was stuck this time last year as they saw the markets relentlessly slide but had no way to get out of resting orders or sell pre-purchased stocks.

We have been asked several times lately of our opinion regarding the use of ETF’s or Electronic Traded Funds to hedge against price movements. ETF’s come in various forms as eloquently outlined by my colleague Lisa in an earlier post today. In theory, all forms of ETF’s track the underlying metals markets and as such should offer a form of hedge against price movements. And, unlike trading directly on futures markets like New York’s Comex, London’s   LME or Shanghai’s SHFE, a party does not need large volumes to participate. Typically brokers require clients to generate some $20k in annual fees to justify opening metals exchange trading accounts. Depending on the brokers’ fee, that could easily equate to $8-10m of hedging activity a year. If cheaper options exist, then please get in contact with us at MetalMiner. We know there is a demand for hedging services among firms with smaller metals spend than this but have to date not been able to provide an exchange based solution.

So back to ETF’s, can they fill the gap? As Lisa explained there are broadly two kinds of Metal ETF’s, index based which rely upon a rolling month futures contract, and physical metals backed. In addition, most metal ETF’s to date have been multi-metal, that is they are either precious metal based, or specifically gold or silver, or loosely commodities based, meaning they could be a mix of metal, energy and agricultural commodities. In some cases, as Lisa’s article points out, they contain “only base metals” but still, a mix to be sure. Clearly to accurately reflect the underlying market for a specific metal none of these would be suitable. Only single metal funds could hope to realistically match movements in say gold, copper or aluminum. So far, only two funds have been announced handling base metals and only one of those has started trading. ScotiaMocatta’s Copper Fund started in July and Glencore Credit Suisse will unlikely start before January as it has yet to pass regulatory approval and licensing. Judging by the level of interest in ETF’s over the last few years and the movement by the US government to control the perceived risks of certain ETF’s the likelihood is that more base metals backed ETF’s will be forthcoming shortly. Interest in physically backed commodity products is widely expected to grow as tougher U.S. regulation on futures contracts threatens to shift investment flows toward exchange-listed physical ETFs.

Physically backed ETF’s by their very nature, allow a party to buy for spot delivery. In that respect, they are much less sophisticated than futures ETF’s which allow a party to buy and sell not just for spot delivery but anytime up to 27 months into the future. So at best an ETF could allow a party to purchase a number of fund units today equivalent to the value of metal the party needed over the coming 12-18 months. Then depending on how the party purchased product on the open market, they could sell an equivalent volume of ETF units at the same time. If the underlying metal price rose between purchase and sale, the firm would pay more for their raw material but would make a profit on the ETF. Likewise if the price fell over time they would gain on the physical metal purchase but lose on the ETF, essentially locking in the price at the start of the process. One of several caveats here is the interest cost of holding the ETF units for the period and the fund managers fee, typically 0.75%, need to be taken into account. To test the closeness of the correlation between the commodity backed ETF unit price and the underlying metal price on the exchange we will be tracking the ScotiaMocatta Copper price against the Comex Copper quotation and will report the findings in due course. Meanwhile we would cautiously say it looks as if ETF’s  backed by physical metal may offer a mechanism to limit cost fluctuations but we want to further evaluate the degree of correlation because even ScotiaMocatta’s fund has only been operating for a few months.

–Stuart Burns

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