Hedging Against Falling Aluminum Prices using Aluminum Futures

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Using Futures to Hedge Against Shifts in Commodity Prices

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Producers and consumers of commodities use futures markets to protect against adverse price moves that could result in large financial losses. A producer of a commodity is at risk of prices moving lower while a consumer of a commodity is at risk of prices moving higher.

Hedging is an important tool when it comes to running a business from either of those perspectives. A hedge will guaranty a consumer a supply of a required commodity at a set price. A hedge will guaranty a producer a known price for their commodity output.

Advantages of Futures

Futures exchanges offer contracts on commodities. These futures contracts provide producers and consumers alike a mechanism with which to hedge their positions in commodities. Futures contracts trade for different time periods, allowing producers and consumers to choose hedges that closely reflect their risks. Additionally, futures contracts are liquid instruments, meaning there’s a lot of trading activity in them and they’re generally easy to buy and sell.

Aside from producers and consumers, speculators, traders, investors, and other market participants utilize these markets. The exchange requires those who hold long and short positions to post margin, which is a performance bond to cover potential losses.

Producers and consumers often receive special treatment on commodity exchanges. As hedgers, their margin rates are often lower than other market participants, who are trying to make money on trading, not protect against losses.

Reducing Risks

To hedge, it is necessary to take a futures position of approximately the same size—but opposite in price direction—from one’s own position. Therefore, a producer who is naturally long a commodity hedges by selling futures contracts. The sale of futures contracts amounts to a substitute sale for the producer, who is acting as a short hedger.

A consumer who is naturally short a commodity hedges by buying futures contracts. The purchase of futures contracts amounts to a substitute purchase for the consumer, who is acting as a long hedger.

While supply and demand for commodities fluctuate, so does price. A producer or consumer who does not hedge assumes price risk. Producers and consumers who use futures markets to hedge transfer their price risk.

If someone holds the physical commodity, they assume the price risk for it as well as the costs associated with holding that commodity, including insurance and storage costs. The price of a commodity for future delivery reflects these costs, so in a normal market, the price of deferred futures is higher than nearby futures prices.

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When a producer or consumer uses a futures exchange to hedge a future physical sale or purchase of a commodity, they exchange price risk for basis risk, which is the risk that the difference in the cash price of the commodity and the futures price will diverge against them.

Futures exchanges have associations that act as clearing houses, which means they become the transaction partner of a trade. They match up buyer and seller, check their creditworthiness, and ensure each one is paid what they’re owed. Therefore the clearing houses help remove credit risk from the system.

A Drawback of Hedging With Futures

Hedging in the futures market isn’t perfect. For one thing, futures markets depend upon standardization. Commodity futures contracts require certain quantities to be delivered on set dates. For example, a futures contract for corn might entail a delivery of 5,000 bushels in December 2020. And sometimes quality—for example, the purity of precious metals—comes into play.

Hedgers sometimes produce or consume commodities that do not conform to the specifications of future contracts. In these cases, hedgers will assume additional risks by using standardized futures.

Alternatives to Futures Markets

Futures markets are not the only choice for hedgers. They can also use forwards and swaps to hedge. These markets entail principal-to-principal transactions—meaning no exchange is involved—with each party assuming the risks of the other. However, these tailor-made transactions may meet the specific needs of commodity consumers or producers better than standardized futures contracts can.

Aluminium Price is Falling due to trade war. Which stock to buy?

On one side aluminium price is falling globally. On the other side the cost of Alumina (raw material) is rising. But this increase in raw material cost is not visible in aluminium’s market price.

Why Aluminium price is falling? Because of the import duties imposed by USA. Donald Trump has been in sorts of trade war with China and few other countries.

Talking about Aluminium specifically, USA has imposed a tariff of 10% on Aluminium coming from Europe and China. Moreover, it has also put sanctions on RUSAL (second largest producer of Aluminium).

What does it mean for the world? Lower demand of Aluminium across the world. Why? Because USA is one of the biggest consumer of Aluminium in the world. Low demand is causing the price fall.

Current Price trend of Aluminium…

In last 12 months, the global price of aluminium has fallen by more than 17%. In Feb’18, its price was $2,255 per tonne. Today in Feb’19, its price is $1,839 per tonne.

In fact, if we will compare April’18 price of $2,597 per tonne, global aluminium price has fallen by 20%+ in just 10 months.

As a rule of thumb, when aluminium price trades at $2,000+ per tonne, price of alumina should trade at $370+ per tonne levels. But the price of Alumina as on today remains as high as $620 per tonne levels.

What does it means for the Aluminium companies? Lower profitability (margins). In this scenario, almost all Aluminium producers are facing huge problems.

The condition is not different for the two Indian Aluminium producers as well.

Name of Stocks Market Cap (Rs.Cr.) Current Price (Rs.) 52W High Price (Rs.) Current Price below 52W High (%)
Hindalco 43,316.17 192.9 267.35 27.85%
NALCO 8,768.40 47 90.1 47.84%

Within last 12 months, Hindalco is trading at 27.85% below is 52 Week high, and NALCO at 47.84% below is 52 week high price.

Though comparison between 52W high is no way to judge price valuation of stocks, but it certainly gives a strong hint for further price analysis.

Which Indian Stock to Buy?

In the Aluminium sector, we have two heavyweight stocks, Hindalco and NALCO. The price of both these stocks have take a good beating in last 12 months.

Out of the two, I have picked NALCO as a better bet. Why? Because NALCO has the lowest cost of production of finished aluminium in the world.

This cost advantage is also reflected in its margins. As reported in moneycontrol, RoCE of these two stocks are as below:

  • Hindalco: RoCE – 2.05%.
  • NALCO: RoCE – 11.02%.

Profitability of NALCO far exceeds Hindalco. We will discuss about the business fundamentals of NALCO in more detail later. But for the moment, let’s concentrate on the price trend.

There are two scenarios here which makes NALCO as a good stock to watch-out for in next few months:

  1. In Aluminimum sector, NALCO has the most profitable business.
  2. Its price has corrected by more than 35% in last 12 months.

Business fundamentals of NALCO is rock solid. But still its price is falling. I am sure it is only a mid-term phenomenon (triggered more by USA-China trade war).

Hence I thought to do a more detailed fundamental analysis of NALCO. Here are my results:

Stock Analysis of NALCO…

#1. Aluminium Demand…

In year 2020, it was estimated that the global demand for Aluminium was 63.2 Million Tonnes.

In 2020, the demand took a massive beating due to trade war between USA and China, also involving EU and RUSAL. This has resulted in the price fall of global Aluminium prices.

Experts say that Aluminium demand will ‘not’ continue to dip in year 2020. Demand growth will be slow at rate of 4-5% in 2020. But for stock prices, it will be enough motivation to turn bullish.

Moreover, Aluminium demand cannot remain low only because of USA’s inflicted trade war. Why? Because of the uncompromisable utility of Aluminium in the world market. Presently there is virtually no economical alternative to Aluminium in the world. Major use of Aluminium are as follows:

  • Packaging.
  • Construction.
  • Electrical equipments.
  • Automobiles and Aviation industry etc.

Now we are ready for the detailed stock analysis of NALCO. I use my stock analysis worksheet to analyse my stocks.

#2. Debt & Cash position…

In last 10 years, NALCO has remained virtually debt free. For a company operating in Metal space, this is quite an exceptional achievement. Why? Because metal companies are very capital intensive. Hence companies has to resort to debt to fund its working capital, capital expenditure etc.

Also in last FY, NALCO reported a cash & bank balance of Rs.2,700 odd crores. In last FY (Mar’18), NALCO reported a net profit of Rs.1,300+ Crores. Comparing the cash position with PAT, NALCO has close to 2+ years profit sitting in its bank balance. This is quite an asset.

With so much liquid cash available at its disposal, NALCO can easily pay dividends to its shareholders, and can also plan more share buybacks in next months.

Why share buyback? Because it looks like NALCO may be trading at undervalued price levels. In Nov’18, NALCO has already offered one share buyback proposal at Rs.75 per share.

In FY ending Mar’18, NALCO has paid Rs.900+ crores as dividends to its shareholders.

At current price level of Rs.48 per share, NALCO’s dividend yield is @10% p.a. This is again a reliable signal of undervaluation.

#3. Growth Rates…

I personally feel that NALCO is not a kind of company which can trigger price rise with its ‘growth’ numbers. Why I say so?

Because of its below average growth rate numbers shown in last 10 years. These are numbers computed by my stock analysis worksheet for NALCO:

If this is so, why I am interested in this stock?

Because of its price valuation. I believe that, at current price levels, NALCO can be a good buy. When shares are bought at such undervalued price levels, future price rise is almost inevitable.

#4. Price valuation…

I used my stock analysis worksheet to estimate the intrinsic value of NALCO. It comes out to be greatly undervalued. Look at the results here.

  • Current Market Price: Rs.47.3
  • Estimated Intrinsic Value: Rs.87.6

Having said that, I’m also aware that even such undervaluation will not help the ‘stock to grow’ till the global Aluminium market recovers. It is important for global Aluminium price to start rising back to $2,200/tonne levels to render profits for NALCO’s investors.

But I believe that in next 12-16 months, Aluminium prices will reach newer heights.

Final Words…

[You can access final report of my stock analysis worksheet here in PDF.]

Currently the aluminium price is falling. But this price fall is not likely to continue in year 2020-20. The price rise is almost imminent. Why?

Because experts say that the current Aluminium prices are already so low that, few companies are operating at break-even levels. So it will not be wrong to assume that $1,840 per tonne is already a rock-bottom price.

This is about the price.

The overall business fundamentals of NALCO is also decent. Why I say decent and not good? Because NALCO being a public sector enterprise, has its own share of disadvantages.

There is too much intervention of Indian Government in these “Navratna” companies. This is the reason why most experts refrain themselves from suggesting these PSU stocks.

But at such price levels, even these stocks becomes a mouth watering proposal.

The overall rating of NALCO as suggested by my stock analysis worksheet is looking like this:

I am targeting NALCO for myself based on following parameters:

  • Buy Price: Rs.48 or below.
  • Target Price: Rs.60 or above.
  • Holding Period: 12 to 16 months.

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