Risk, Uncertainty and Managing Commodity PricesSME, Current Trends in Mining Finance - April 29th to 30th, 2013

Paul Shellman – PrincipalWainscott Commoditiesemail: paulshellman@cs.com

www.wainscottcommodities.com

The Mining and Metal Industries Encounter Market Forces

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Today’s Discussion Topic:

• Should mining and metal companies incorporate an active price risk management program into their company strategy?

• Role that price volatility has on corporate earnings

• The arguments “for and against” an active price risk management policy.• Does this activity contribute to shareholder value• Academic studies, empirical evidence and market returns• Distinction between passive and active price risk management

• What steps or actions should firms consider when seeking to add value by using an active risk management program.

• Need for paradigm shift in corporate and stakeholder culture• The toolbox includes: physical contracts, financing structures and derivatives• Adapt proper skill sets: quantitative and qualitative expertise is imperative for managing risk• Innovation: Markets are dynamic and are always changing, need to be pro-active and responsive

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Price Volatility, Quarter to Quarter Variance

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Price Volatility, Daily Variance

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Source: BREE

Forecast Prices

Forecast Prices

Commodity prices are volatile and will remain volatile, hence the need for mining and metal companies to understand the best means to manage price risks.

On balance, the key to commodity price movements are marginal costs and inventories.

• Inventories will fluctuate with the economic cycle and short-term supply and demand shocks.

• Marginal costs are driven by technology, geology and politics, all of which are extremely uncertain when looking forward, making it virtually impossible to define a long-term equilibrium oil price.

Source: BREE

Price Volatility, How Accurate and Precise are Long Term Forecasts?

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Withstanding the Cyclical TurbulenceA holistic and coherent strategy of managing exposure throughout price cycle is required; integrated approach across operations, assets, commercial interests and balance sheet exposure

Asset Management

Strategy

Commercial Strategy

Balance Sheet Management

Operational Strategy

Commodity Price Cycle

Price Risk

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The Hedging Dilemma - Does Modern Finance Theory Support Hedging?The Modigliani–Miller Irrelevance Hypothesis Regarding Hedging of Corporate Risk

• The original MM theorems states value is determined by the discounted future cash flow stream generated by its assets. • Short term transactional hedging will not directly improve the productive value of the firm’s operations or investments in shareholders’

valuation models since these are tied to expected future years.

• The MM theorem goes against hedging • Hedging does not directly increase the value of the firm.

• Risk is lowered, but so is return expectations. On net value terms, this is seen as a wash for shareholders.

• Investors seek risk transparency, and the company should show and price risks in the way that investors do.• In some sectors, investors are risk takers to market prices, e.g., gold mining shares or oil & gas producers.• Also many investors have a negative attitude toward derivative hedges due to historical problems that have occurred in markets.

• Contemporary attitudes towards hedging say it can increase shareholder value in the presence of market imperfections. • Indirect value of hedging far outweigh the short-term transactional gains/losses of a dynamic hedging program. The

hedge is meant to deal with cash flow planning issues – reduce cost of working capital.

• Risk aversion activities will yield benefits. A firm that can execute more cheaply, capture arbitrage opportunities and out-compete its peers will generate higher shareholder value.

• Value can be achieved when a company’s shareholders do not represent a well diversified group of investors.

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Global Commodity Merchants have Extracted Large Profits from Markets in Past DecadeMiners and metal firms should ask, how these firms make money and if the same strategies and activities are open for them?

• Top ten merchants reported annual revenues in 2012 of $1.2 trillion (equivalent to Spain's GDP).

• Merchants have extracted nearly $250 billion (top 20) in net earnings over past 10 years.

• The 5 leading independent energy trading houses together handled more than 15m barrels of oil a day during 2012.

• Trafigura registered a profit of just $24.2m in 2000. It record $1.1bn in 2011. 40% of world’s copper traded by Trafigura.

• Vitol, the world’s largest oil trader broke even in the late 1990s. In 2000 it made $296m. By 2009 its profits had surged to $2.28bn.

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Financial Market’s Expansion into Commodity Derivative TradingWhile commodities are a relative small percentage of overall trading, profitability from this activity is considerable

Source: U.S. Comptroller of the Currency

• Global OTC derivatives trading has expanded significantly in past decade.

• This activity is dominated by a handful of Banks.

• Commodity related trading income for US Bank Holding Co.s peaked in 2007 at $15 billion.

• Other financial participants active in the paper/physical commodity markets, include:

• Hedge funds• Commodity trading advisors• Pension Plans• Sovereign wealth funds• Passive commodity index funds• Commodity ETFs and ETPs

• These other financial participants have invested over $400 billion into the commodity markets.

U.S. Bank Holding Co.'s OTC Notional Derivative Positions

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Price Risk Mitigation versus Position Optimization StrategiesManagement’s objective is to lower probability of negative returns

Profit and Loss Distribution Curve

Loss Profit

Profit and Loss Distribution Curve

Loss Profit

Risk Mitigation Reduces Loss Potential Risk Management Shifts Entire Profit/Loss Curve

0 0Unhedged

• Firms should seek to raise risk appetite in areas of core knowledge and close down risk in those areas that are not to its own advantage.

• Risk management is about trading price for value. Knowing when and where to shift risk and what value this risk is worth for you and to others.

• Value-adds include targeting/executing alternative operating strategies, commercial contract designs and terms of business

• “Knowledge-based” trading allow firms to price risk more accurately and precisely recognizing the risk granularities of their different activities.

• Result: minimize the risk-adjusted cost of delivering the same services, hence become more profitable.

Hedged

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Exploiting the Market Opportunities within the Value ChainEnd-to-end flexibility in sourcing, operating and selling provides enterprise value

Rigid System

Raw-material sourcing flexibility

Finished product pricing flexibility

End-to-end flexibility

Risk leveraging

Raw materials Concentrate or liquid phase Semi-finished phase Finished end products

System works when raw materials act as utility function for processing and manufacturing sectors. Not viable during supply deficiencies, leads to misallocation of capital. Globalization accentuates competitive pressures for scarce resources.

Flexible sourcing with market based pricing terms and spot contracts. Allows the use of inventory tools to buffer short term cyclicality. Commodity merchanting increases number of supply sources and market opportunities.

Flexible product pricing required to adjust to changes in demand. Allows processors to manage revenues via contractual terms. Mill’s gain capability to support customer volume and pricing demands.

Dynamic pricing on both inputs and outputs support asset optimization programs. Provides additional leverage for mill/processor to control operating margins. Requires greater internal risk controls, robust data and management skills,

Decomposition of the value chain into components to optimize discrete operational performance at each sector. Market based pricing within internal supply chain establishes asset-based trading capability to go beyond own needs – become a buyer and seller of market risk.

High market liquidity Low market liquidity Medium market liquidity

Increasing Capabilities

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Source: BCG AnalysisKnowledge Based Skill Level

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Learning to Live and Prosper with Price VolatilityEvolving from passive price risk exposure to an active risk leveraging firm

• Increased price volatility throughout the metal value chain substantially impacts terms of business • Prolong exposure to volatile prices creates earnings uncertainty and leads to lower stakeholder valuations.

• Firms across all sectors need to adapt with new proactive means to cope with the pricing uncertainty.

• The pace and acceptance of these changes will not be uniform across the global mining and metal industries.

• Embrace an active approach to managing pricing, this provides greater flexibility within the procurement and sales processes. Companies can differentiate themselves

• Price volatility should not be only viewed as a negative, but it offers upside opportunities in managing costs and revenue streams.

• Innovative approaches to handling price exposures are required to maintain or increase profitability.

• Management of these risks and opportunities will require additional skills and knowledge within the company.

• Flexible raw material sourcing and finished product procurement programs offer valuable avenues for managing price exposures.

• Apply an integrated strategy across operations, commercial, assets and balance sheet linked to commodity price cycles to maintain value

• These strategies support asset-backed optimization to dial down/up operations when markets change.

• Allow company to ride out negative points of the down cycle.

• Commodity linked finance structures offer balance sheet protection.

• Derivatives are one of the available tools for managing this risk.

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References:

• Aretz, K., and Bartram, S., 2009 “Corporate Hedging and Shareholder Value,” Lancaster University

• Govindarajan, D., 2011 “Corporate Risk Appetite: Ensuring Board and Senior Management Accountability for Risk,” ICMA Centre, Henley Business School, University of Reading

• Dey, S., 2012 “Unlocking value in cyclical commodities”

• Woertler, M., 2012 “Living with volatility, how steel companies can improve their adaptability to volatile market conditions”