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.