In the not-too-recent past, a manufacturing company could confidently manage nearly all of its semi-finished or finished aluminum price risk on an on-going, longer-term basis.
Not so much anymore.
We broke down the pre-2007 model for managing aluminum price risk in Part One of this article. Now consider the current model:
LME (hedge not working) + Midwest (MW) Premium (volatile and rising with AUP as only available hedge) + Conversion cost (same as in historical model) + Freight/delivery (same as in historical model) = Total landed cost per pound
The buyer takes out a hedge for the LME portion, but this no longer tracks well with the MW delivered price. Therefore, a separate hedge is required to protect against changes in the MW premium in addition to negotiating a fixed price conversion cost and freight/delivery charge with its suppliers.
The additional complexity has made it difficult for buyers to manage their volumes and protect their margins on an on-going basis.
Components of Price
Futures and forward contracts, after all, are standardized instruments that provide for a defined amount of a particular grade of material to be delivered at a specific location at a predetermined time in the future.
The issue at hand is that the current LME contract no longer relates to a Midwest-delivered location, nor does it accurately reflect the actual time when a buyer can access his or her material.
You Can’t Get It (Only) Half Right
Let’s consider a different example. If one lived in Detroit, Mich., and wanted to buy an Aston Martin in which to leave on a vacation next Monday, and two dealerships offered the exact same car for the exact same price, what additional information would one need to decide who offered the better deal?
Two important factors to determine prior to entering into a contract: location and availability of each of the vehicles. If, in the example above, one dealership could guarantee delivery in Detroit at an acceptable time and date prior to departure, and the other regularly delivers vehicles of this kind to Detroit, but could not provide specifics on vehicle delivery, the decision becomes easy.
The only risk mitigation tool available for the MW premium is the CME Group’s MW AUP contract – better than nothing, for sure, but by no means elegant because it works in conjunction with the LME contract.
More about that in our upcoming webinar:
Join us for a one-hour FREE webinar featuring an aluminum market outlook (LME price + MW premium) and the potential for the CME Group’s new physically backed ALI contract scheduled to debut May 6.