The impact of commodity price risk management on the profits of a company

It is well recognized that for the producing companies hedging the commodity price using financial products like forwards or futures has become an important part of the company's production process. But apart from the direct impacts of hedging on the production and hedging costs the use of financial products affects the financing of the company: hedging the volatile commodity prices leads to a reduction of the risk premium the company has to pay for its debt capital, since hedging contributes to more confidence of the investors in the redemption of the debt. In this paper we therefore analyze this dependency of hedging and financing and derive optimal hedging extents for companies in different market situations based on a long-term model. By hedging the commodity price, companies can realize a surplus in profits. Thereby, the optimal hedging extent for a monopolist is often up to 100%, whereas for companies in a polypolistic market the optimum is always less than 100%. These results are illustrated by examples for a producing company.     

Oil spills on other commodities

This paper examines the effect of crude oil prices on the prices of 35 internationally traded primary commodities for the 1960–2005 period. It finds that the pass-through of crude oil price changes to the overall non-energy commodity index is 0.16. At a more disaggregated level, the fertilizer index had the highest pass-through (0.33), followed by agriculture (0.17), and metals (0.11). The prices of precious metals also exhibited a strong response to crude oil price. In terms of individual commodities, the estimates of the food group exhibited remarkable similarity while those of raw materials and metals gave a mixed picture. The implication is that if crude oil prices remain high for some time, as most analysts expect, then the recent commodity price boom is likely to last much longer than earlier booms, at least for food commodities. The other commodities, however, are likely to follow diverging paths. On the methodological side, the results show that price indices, while providing useful summary statistics, they need to be supplemented by individual commodity analysis.     

Investor demand and spot commodity prices

The on-going debate over the influence of investor demand on spot commodity prices largely attempts to assess this influence by measuring the growth in investor demand in recent years. Given the serious data problems that plague such analyses, this article pursues another approach in the hope of providing useful insights into the impact of investor demand on spot commodity prices. It focuses on the mechanisms by which investor demand affects spot prices, and in particular on two questions. First, how does an increase in investor demand on the futures markets affect the spot market and spot price? Second, when investor demand is increasing and pushing a commodity's price up, do physical stocks of the commodity also have to be rising, as economists and others widely assume?On the first question, the article concludes that a surge in investor demand raising prices on the futures markets will have a direct and comparable effect on the spot market prices when these markets are in strong contango. However, when markets are in weak contango or backwardation, price movements in the futures markets have a much looser effect on spot prices. As a result, changes in investor demand on the futures markets may have little or no influence on spot prices in the absence of a strong contango. Instead, changes in fundamentals (that is, producer supply and consumer demand) and possibly changes in investor demand taking place directly on the spot market largely determine the spot price at such times.On the second question, the article shows that investor demand can be pushing up a commodity's price even when investor stocks are falling, despite the widespread presumption to the contrary.     

Investor demand and spot commodity prices: Reply 2

This, our second reply to Östensson, supplements our earlier more technical analysis with a simple intuitive explanation of how investor demand can be driving commodity prices higher even when investor stocks are falling.     

Minerals policy in Europe: Some recent developments

The importance of a secured supply of raw materials for the European economy is evident. However, securing the supply of raw materials based on an appropriate EU minerals policy has been scarcely treated by the decision-makers in the last decades. Solely the impact of price development of international commodity markets in the last years induces a re-thinking of this field. The EU Raw Materials Initiative, which was published by the European Commission in November 2008, establishes an EU raw materials strategy including a list of actions.     

Mercury: The good, the bad, and the export ban

We analyze the bipartisan call to ban US exports of commodity mercury. An export ban can generate positive environmental benefits by increasing the scarcity of mercury in developing economies where significant toxic releases occur. We show, however, that a direct mercury purchase and retirement policy can achieve the same foreign environmental goals without adverse impacts on domestic environmental quality. We present qualitative and quantitative evidence that highlight the potential inefficiencies of a mercury export ban as a method of achieving environmental objectives.     

Theory of storage,inventory and volatility in the LME base metals

The theory of storage, as related to commodities, makes two predictions involving the quantity of the commodity held in inventory. When inventory is low (i.e. a situation of scarcity), spot prices will exceed futures prices, and spot price volatility will exceed futures price volatility. Conversely, during periods of no scarcity, both spot prices and spot price volatility will remain relatively subdued. We test these predictions for the six base metals traded on the London Metal Exchange (aluminium, copper, lead, nickel, tin and zinc), and find strong validation for the theory. Including Chinese inventories reported by the Shanghai Futures Exchange strengthens the relationship further. We also introduce the concepts of excess volatility, inventory-implied spot price and inventory-implied spot volatility and illustrate some applications.     

Optimal resource extraction contract with adverse selection

This paper studies the design of a mining concession contract as a multi-period adverse selection problem where production is the depletion of a non renewable resource. Compared with symmetric information, we show that overproduction is optimal in the terminal phase of the resource extraction program. Moreover, asymmetric information lengthens the contract duration but reduces the scarcity rent.     

An overview of global gold market and gold price forecasting

The global gold market has recently attracted a lot of attention and the price of gold is relatively higher than its historical trend. For mining companies to mitigate risk and uncertainty in gold price fluctuations, make hedging, future investment and evaluation decisions, depend on forecasting future price trends. The first section of this paper reviews the world gold market and the historical trend of gold prices from January 1968 to December 2008. This is followed by an investigation into the relationship between gold price and other key influencing variables, such as oil price and global inflation over the last 40 years. The second section applies a modified econometric version of the long-term trend reverting jump and dip diffusion model for forecasting natural-resource commodity prices. This method addresses the deficiencies of previous models, such as jumps and dips as parameters and unit root test for long-term trends. The model proposes that historical data of mineral commodities have three terms to demonstrate fluctuation of prices: a long-term trend reversion component, a diffusion component and a jump or dip component. The model calculates each term individually to estimate future prices of mineral commodities. The study validates the model and estimates the gold price for the next 10 years, based on monthly historical data of nominal gold price.     

Long-term trends in the Real real prices of primary commodities: Inflation bias and the Prebisch–Singer hypothesis

In his recent article on measuring the long-term trends in the real prices of primary commodities, Cuddington (2010) extends in several important respects our earlier efforts (Svedberg and Tilton, 2006) to correct real commodity price trends for biases in the Consumer Price Index and other deflators. First, he argues for a log-linear relationship between prices and time. Second, he proposes a simple and quick method for obtaining corrected price trends from the published but uncorrected estimates. Finally, he illustrates, for the case of copper and presumably for many other commodities as well, the difficulties of obtaining real price trends significantly different from zero when the log values of the price data contain a unit root, requiring the use of difference stationary models.We welcome these insights, which should improve and make easier efforts to estimate correctly real commodity price trends over the long run. We would stress, however, that it is still important to correct for the biases in inflation indices, notwithstanding the failure of difference stationary models to obtain long-run real price trends (both corrected and uncorrected) significantly different from zero.     

The crude oil market and the gold market: Evidence for cointegration,causality and price discovery

Given that the gold market and the crude oil market are the main representatives of the large commodity markets, it is of crucial practical significance to analyze their cointegration relationship and causality, and investigate their respective contribution, from the perspective of price discovery, to the common price trend so as to interpret the dynamics of the whole large commodity market and forecast the fluctuation of crude oil and gold prices.     

Evaluating a small deposit next to an economically viable gold mine in West Africa from the points of view of the mining company,the government and the local community

This paper addresses the question of evaluating how much the different stakeholders stand to gain from a mining project. By carefully analysing the breakdown of the cash-flows generated, we were able to estimate the amounts received by the local community and by the national community (outside the mining area), the taxes and royalties received by the government and the profits made by the mining company. A real options framework was used to take account of the inherent uncertainty on the commodity price and the reserves, and the operating flexibility (that is, the possibility for the company to stop mining if the commodity price drops and/or the reserves prove to be lower than that had been envisaged). A synthetic case-study of a gold mine in West Africa was used to illustrate how this procedure could be applied in practice. By using the real option framework we were able to envisage scenarios for developing an extension to a deposit as a function of future values of the commodity price. The procedure proposed should provide governments and NGOs with more objective data for making policy decisions.     

Informal network utilisation and water distribution in two districts in the Khorezm Province, Uzbekistan

This paper analyses informal networks and their utilisation during a period of water scarcity in an upstream and a downstream district in the Khorezm Province, Uzbekistan. The evaluation is based on an organisational theory approach on informal networks. Communication patterns between farm managers, district water departments and district governors in a year with a sufficient amount of water and in a year of water scarcity are compared with informal network structures. The analysis shows that in the year of water scarcity an informal network was utilised to receive water. The importance of the informal network increased with increasing experience and individual perception of water scarcity. The findings confirm the assumption that informal networks are utilised more frequently when formal networks fail or are not functional. The case study therefore confirms the importance of an informal network during a crisis.     

Estimating the volatility of mining projects considering price and operating cost uncertainties

In the real option pricing model of valuation and decision making, the estimation of future volatility is a key input parameter. For traded commodities or financial assets, past volatility is used as a proxy for predictions. But, for projects, this approach is not feasible because, in most cases, historical data of traded projects are not available. As an alternate solution, it is usually assumed that project volatility is equal to that of commodity price. In order to investigate this assumption, we estimate the project volatility considering that both commodity price and operating cost evolve as a geometric Brownian motion (GBM). Results of a hypothetical gold mining project indicate that project volatility is higher than that of commodity price and it only drops to price volatility under very unrealistic industry conditions, such as very high prices or very low production costs. In addition, we find that project volatility is independent of production capacity and taxation, but depends on increments in price and cost, as well as strongly on their degree of correlation.     

Informal network utilisation and water distribution in two districts in the Khorezm Province,Uzbekistan

This paper analyses informal networks and their utilisation during a period of water scarcity in an upstream and a downstream district in the Khorezm Province, Uzbekistan. The evaluation is based on an organisational theory approach on informal networks. Communication patterns between farm managers, district water departments and district governors in a year with a sufficient amount of water and in a year of water scarcity are compared with informal network structures. The analysis shows that in the year of water scarcity an informal network was utilised to receive water. The importance of the informal network increased with increasing experience and individual perception of water scarcity. The findings confirm the assumption that informal networks are utilised more frequently when formal networks fail or are not functional. The case study therefore confirms the importance of an informal network during a crisis.     

Measurement of the scarcity of soil in agriculture

The paper defines the concept of land degradation and costs and effects of soil erosion. Through the concept of optimal levels of soil erosion, a conceptual model of the social costs of soil degradation is elaborated. The discussion focuses on the measurement aspects of the economic scarcity of soil in the agriculture sector. Reliable estimates of the true impacts of soil degradation can only be made if data on marginal damage costs and marginal conservation costs are available. The different scarcity indicators are evaluated and competitive land rental prices are considered as appropriate in indicating soil scarcity in agriculture.     

The great metals boom: A retrospective

The metals boom that ran from 2003 to 2008 represented the most powerful and sustained such boom since the Second World War. As the boom gathered momentum, the notion began to emerge that commodities were at the beginning of a multi-year ‘super cycle’ driven by demand growth in the emerging economies and, in particular, China. The persistence of the boom helped sustain this belief right up to the point when metal prices collapsed in the second half of 2008. Looking back over the period, much of what occurred can be readily explained by the unusual strength of the demand shock and the lagged response of the supplying industry, with prices receiving an additional boost from the activities of commodity investors. There is, however, some evidence to suggest that the combination of downward pressure on the costs of manufactured goods and upward pressure on the costs of mineral commodities which accompanied the boom marked a shift in the terms of trade between these two product groups. This in turn seems to have brought to an end the sustained decline in real terms metal prices that occurred in the years following the boom of the 1970s. In sum, the key structural change taking place may not have been on the demand side of the industry as the super cyclists maintained, but on the supply side.     

Exploring the origins of ‘social license to operate’ in the mining sector: Perspectives from governance and sustainability theories

In the mining sector, local communities have emerged as particularly important governance actors. Conventional approaches to mineral development no longer suffice for these communities, which have demanded a greater share of benefits and increased involvement in decision making. These trends have been spurred by the growth of the sustainable development paradigm and governance shifts that have increasingly transferred governing authority towards non-state actors. Accordingly, there is now widespread recognition that mineral developers need to gain a ‘social license to operate’ (SLO) from local communities in order to avoid potentially costly conflict and exposure to social risks. A social license can be considered to exist when a mining project is seen as having the ongoing approval and broad acceptance of society to conduct its activities. Due to the concept's relatively recent emergence, however, only a limited body of scholarship has developed around SLO. Drawing on examples from northern Canada, this paper uses governance and sustainability theories to conceptualize the origins of SLO in the mining sector and describe some of the associated implications. Further research is needed to determine governance arrangements which help facilitate establishment of SLO in different mineral development contexts.     

An uncertainty based multi-criteria ranking system for open pit mining cut-off grade strategy selection

Cut-off grade strategy (COGS) is a concept that directly influences the financial, technical, economical, and environmental issues in relation to the exploitation of a mineral resource. Despite the simple definition of cut-off grade, the COGS problem is one of the complex and complicated problems in the mine planning process. From the optimization point of view, the COGS with an objective of maximizing the present value of future cash flows is a non-linear and a non-convex problem that even in its deterministic form can be solved using approximate optimization methods. This optimization problem will also be more complex and complicated under uncertainty conditions. This paper proposes an uncertainty based multi-criteria ranking system to investigate the problem of COGS selection considering metal price and geological uncertainties. The proposed system aims at selection of the best COGS among technically feasible alternative COGSs under uncertainty circumstances. Our developed system is based on integrating metal price and geological uncertainties as well as operating flexibility to close the mine early. We incorporate this operating flexibility into the proposed system using a Monte Carlo based real options (RO) valuation model. For this purpose, in addition to the expected value, other risk criteria are considered to rank the alternatives. These risk criteria include abilities of strategies in producing extra profits, minimizing losses, and achieving the predefined goals of the production. In this study, the technically possible COGSs are generated using the Lane comprehensive algorithm. To demonstrate the effectiveness of the proposed system, we utilize data of an Iranian gold mine. Results show that the proposed system outperforms conventional methods in the sense that it shows significantly lower average mis-ranking than the other methods and also selects a strategy with a higher value. The sensitivity analysis of the proposed system relative to the gold price shows that the system is highly dependent on the parameters of the stochastic process used to model the evolution of the metal price. Therefore, special consideration should be given in estimating stochastic process parameters.     

From landfill to water,land and life: The creation of the Centre for stone materials aimed at secondary processing

This paper focuses on the creation of a Centre for the recycling of stone materials. The Centre will be able to offer a range of activities amongst which is the improvement of the production chain of the Orosei Marble district in Sardinia, Italy. Several companies operate within the marble producing area, specializing in both quarrying and stone processing. They have formed a Consortium in order to rehabilitate an area of more than 17 ha. The restoration will be carried out through an environmentally sustainable procedure. The area was previously used as a landfill for waste deriving from marble quarrying and processing. At that time unshaped blocks of various sizes (which are unsuitable to block-cutter sawing), waste deriving from both block sawing and slab/strip cutting (such as broken slabs, strips, tiles) and microfine dust from filter presses of water treatment plants were representing an environmental problem. The local administration was struggling to find new areas which could be used for landfills, resulting in an additional cost for the landfill, ultimately affecting the variable production costs. The project involves the building of a venue to be used for temporary storage, treatment of wastes produced by both quarrying and primary processing, in order to make them suitable as secondary raw materials. The project also deals with the catch basin hydrology of the area involved in the project, the building of a multifunctional centre, the landscaping and other environmental features such as vehicle traffic and slopes greening.