Hedging Example for an Auto Salvage Operation

A Hedging Example for an Auto Salvage Operation

By Daniel Uslander (Industrial Metals Specialist, High Ridge Futures LLC)

(Dan can be reached at 212-859-0295 or at duslander@highridgefutures.com)

If you are in the auto salvage or car crushing business, it may not be apparent that the same hedging tools used by the integrated steel mills and global steel traders can also be used in support of your business. Maybe you’ve already accepted that beyond shopping your cars around to different shredders, there’s not much more you can do to help your bottom line…except wait for higher prices if you happen to not like today’s price. Do you really believe that shredders are always moving their prices to fully reflect changes in the underlying scrap markets? I didn’t think so. There is another approach that deserves a look, and that’s the prudent use of the futures market to hedge.

We can illustrate the basic concepts of hedging through the use of hypothetical examples. The prices used in these illustrations may not reflect current market conditions, but the concepts described will apply regardless of price levels. For example, here's a depiction of how hedging might work: Let's say you have about 600 stripped car bodies in your yard; each represents about 1900 pounds of metal, so there is (1900 x 600), or 1,114,000 pounds of metal. That works out to (1,114,000 / 2240) 509 gross tons of scrap. To keep it simple, let’s round that off to 500 gross tons. Each futures contract is for 20 gross tons, so there's about 25 contracts worth of scrap in the yard. Your shredders indicate they are paying $5/cwt. for cars, or about $110 per gross ton (22.4 x 5=112).   The 500 gross tons x $112 comes out to total revenue to you of about $56,000--if you are selling the car bodies today. However, you won’t be ready to truck the car bodies to a shredder for about 45 days. Your objective is to sell the cars in 45 days at today’s prevailing price—and realize gross revenues as close to $56,000 as possible.

In order to preserve today’s price into the future, you will hedge. Your hedge consists of selling short 25 futures contracts at a prevailing market price of $220 per gross ton.

Key points:

• Contracts expire and are settled monthly. For example, the shredded contract settles on the 11th of each month. The settlement price is based on the volume weighted average price of deals done during the first 10 days of the month, in other words, during “bid week”. The price itself is the delivered price for shredded ferrous scrap to a mill, Midwest location.
• Contracts are listed usually 6 months out. That way if you wanted to place a hedge today for two or three months into the future, the contracts are set up in a way to allow that.
• The contracts are strictly a financial transaction. There is no physical delivery of scrap material associated with these contracts. You continue to seek the best buyer for your car bodies and make your sales as you normally do.
• The markets are designed so that there is a ready market each day in the event participants want to buy or sell contracts. If you want to hold until expiration, you can do that too.

Our hypothetical transaction is called a short hedge. When selling short, the futures positions appreciate in value when shredded prices go down. Let’s fast forward 45 days or so to a point in time when you are ready to call the shredders and entertain offers. Let's also keep it simple by assuming that your "call around" to survey local shredders occurs on the 10th of the month, the day before your contracts are set to expire. One of the usual shredders you deal with offers you $4.00/cwt. for your cars. That's $89.60 per gross ton which is about $22 per ton less than you were planning (hoping) for. On 500 gross tons of metal, that $22 difference is worth $11,000. The $56,000 you were expecting to make just became $45,000. Ouch.

The lower offers made by shredders reflected the weak demand for scrap at the mill level. Futures prices had been trending lower, and the next day your contracts settle at $200, meaning that in your futures account your short futures positions have a profit (before commissions) of $20 per ton, which offsets all but $2 of the price drop that you were tagged with by the shredders. Notice that the futures contract showed about a 10% drop in price. The offers from the shredders, in going from $5 to $4, showed a 20% drop. In the real world, the percentage changes in the offers made for car bodies by shredders probably won’t match up perfectly with the percentage changes in market prices for shredded scrap delivered to steel mills in the US Midwest. It is this Midwest delivered price for shredded that is the basis of the futures contract.   What is most important is that there is a high degree of price correlation between the two markets. That is, the market for car bodies as represented by what you receive from shredders will tend to move with prices paid by mills for shredded scrap steel. As long as those prices tend to move together, the gains or losses in your hedge (futures) account will offset to some extent the price increases or decreases imposed on you by shredders. Be aware that the gain (or loss) in the hedge account will rarely if ever be a perfect offset with the gain (or loss) on your physical sales compared with your revenue target.

Now let's flip the script and say that prices went up: instead of $5 per cwt. the shredder pays you $6. The mills pay more to the shredders, so the shredders pay more to the crushers. These higher prices are reflected in the futures market. This time, the futures contract settles up $20 at $240, resulting in a loss in the hedge account of $10,000 (that is $20 per ton x 20 tons per contract x 25 contracts; it is the same dollar amount as in the falling prices example, except with the sign reversed). The net effect on revenue is the same as in the falling price scenario since the additional $1 per cwt. paid by the shredder is worth approximately $22 per gross ton. The loss in the futures account and the additional revenue realized on the sales to the shredder at least partially cancel each other out, resulting in a net selling price of about $5 per cwt., the same as before. One crucial difference in this example--in order to hold onto the hedge, as prices rise you will need to meet margin calls to adequately secure the positions. The exact amount of those calls and how we calculate the calls is a conversation for another day, but the basic idea of hedging is valid regardless of market direction. The gains (or losses) in the physical market are offset by a loss (gain) in the hedge account.

Whether the hedge account shows a profit or a loss, the commission expense of putting the hedge on and then removing the hedge would be the same. A representative figure would be $30 per “round turn” (meaning to put the futures position on and then take the futures position off). In our example, commission costs would be $30 x 25 contracts, or $750.

To sum up, don’t lose sight of the fact that we entered into the hedge with a clear mission--receive a net price of $5 per cwt. for our car bodies. By the time we can deliver the car bodies, prices could be higher or lower, but since we are not fortune tellers, we only care that our objective of $5 per cwt. provides an adequate overall return. During the next month or next quarter, we can crank it up and start all over again, with the implementation of a new hedge designed to provide some measure of protection as we begin to accumulate a new inventory of car bodies to sell to the shredder.

BE ADVISED THAT TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS OR PRODUCERS.