When hedging goes bad: how a spike in nickel prices upended a risk management strategy?
Nickel generally trades at a pretty level price. But when a combination of growing demand and geopolitics caused that price to spike dramatically, it exposed the dangers of inadequate risk management.
Nickel is everywhere. Most of it is used in combination with iron to create the widely used alloy stainless steel, but it’s also in batteries, including those inside electric vehicles. That creates steady demand for the metal – so in early 2022, for example, it was trading at a steady level of about US$20,000 per metric tonne. Then, in early March, everything changed: the price started to rise quickly, and then exponentially. Between March 3 and 8, it leapt from about US$27,000 per metric tonne to about $101,000 – a 270% rise over just three trading days.
As attendees discovered at a recent CUHK EMBA Master Class ‘Risk Management Strategies in Financial Derivatives: Hedging vs Speculation?’ given by Dr Anson Au Yeung, Senior Lecturer in Finance and the Assistant Dean for Undergraduate Studies at The Chinese University of Hong Kong (CUHK) Business School, there were several reasons for that.
Many people took a bullish view on nickel prices as a result of anticipated growing demand for the EV market, which coincided with the world’s economies starting to fire up again as Covid restrictions were lifted. But the short-term trigger was a supply-related one: the surge came just after Russia’s invasion of Ukraine on February 24, raising the prospect of sanctions against Russian companies – and Russia is responsible for about 17% of global nickel supply, mainly through a single company, Norilsk Nickel.
The shortcomings of shorting
Making good investment decisions and having a good financing strategy, said Professor Au Yeung, are not enough. If a company’s risk management isn’t up to scratch, it doesn’t matter how much money it makes – it could just as easily lose that money the next day.
He illustrated his point with the case of private nickel company Tsingshan, which is headquartered in China and accounts for about 22% of global production. Like most companies in its position, it hedged its position, using derivatives as a risk management strategy to protect it against fluctuating commodity prices. In early 2022, it held a major short position of an estimated 300,000 tonnes on nickel futures – a financial instrument whereby a buyer and seller agree on the price of a future transaction. That would mean that even if the price on the metal had fallen, Tsingshan could still sell it at the same profit. However, it also means that if the price of nickel rose, the company, obliged to sell at a lower price, would suffer accordingly. That, of course, was precisely what happened – locking it into losses of about $8 billion.
There were several reasons why it happened, said Professor Au Yeung: the London Metal Exchange (LME) demands that all nickel traded is of at least 99.8% purity and meets the stringent specifications of a standard known as B39-79; and the exchange requires physical delivery of that nickel to the buyer. Tsingshan’s main products, ferronickel (mixed with iron) and nickel matte (used to make nickel sulphate, used in batteries), are intermediate forms of the metal that don’t conform to these requirements, and so aren’t eligible for trading on the exchange.
That left Tsingshan with three options to deal with the short squeeze: maintain its short position and cross its fingers that the price dropped; surrender the position and cut its losses; or hold the contract till maturity and physically deliver nickel bought from the market. However, none of them was possible in reality: the first would force it to deposit more than $6.4 billion, based on the rising price; the second would mean losses of $18 billion at $80,000 a tonne, meaning it needed to find another $11.6 billion-plus; and the third had become physically impossible, given the challenges of purchasing nickel after the outbreak of the Ukraine war.
Mistakes made, lessons learned
The incident yields several managerial insights, said Professor Au Yeung. The size of Tsinghan’s position was in excess of its production of high-purity nickel, indicating a strategy that counts more as speculation than hedging. Moreover, using LME nickel to hedge the Class 2 nickel the company produces represents inaccurate risk management, given that the prices of the two aren’t highly correlated during volatile periods. It also suggests weak liquidity management: LME nickel inventory stands at 76,800 tonnes, whereas average open interest in nickel contracts is about 1.15 million tonnes – making it obvious to the counterparty in the futures contract that Tsinghsan would be unable to acquire the physical nickel for delivery. Furthermore, nickel exhibits higher volatility than other metals, something Tsingshan’s management failed to account for.
There are two key lessons of the incident, concluded the professor: hedging through futures is not easy, as it involves meeting margin calls, with a potential adverse impact on cashflow; and it’s critical to accurately estimate and not overlook worst-case scenarios.