How to Make Volatility Your Friend

We're living in an age of commodities volatility.

The last ten years have seen a number of big price swings for many natural resources. Uranium ran from $10 to $140, and then back to $40. Oil hit $145 then plummeted back to $35. Copper went from $4 to $1.25 and then back to $3.50 (and now back below $3).

As the saying goes, if you don't like the price, wait five minutes.

These swings don't go unnoticed. Especially by end users of these commodities.

Companies that use copper, oil, natural gas, nickel, phosphate, aluminum and a host of other commodities as inputs are faced with a challenge. How do you plan your project economics when costs keep pin wheeling?

One way is hedging. Lock in an acceptable price through the use of swaps, collars, futures, options and other derivatives. We are seeing more of this (particularly on the petroleum side).

But hedging requires a certain degree of sophistication, a staff dedicated to managing the hedge programs, and often comes with financial costs for executing these trades.
There is another solution. Integrate.

If you're a steel-maker worried about iron ore prices, buy an iron ore mine. Now if iron ore prices rise, you pay the increase to yourself. Keeping profits high. And if prices plummet, the loses on the mining business can be made up by increased margins on steel.

This "hedging by ownership" is becoming a more common strategy as users recognize that commodities volatility is here to stay. This weekend, India's Reliance Power announced it will merge with natural gas producer Reliance Natural Resources. Reliance Power is largely an end user of gas, managing a portfolio of gas-fired power plants across India. Buying Reliance Natural Resources gives the company assured access to (and guaranteed revenue from) natural gas supplies.

Of course, this deal is a little cozy as billionaire Anil Ambani owns both companies. And there are some other benefits to both companies in terms of streamlining government permitting. But the synergies in being both supplier and end user of a commodity certainly played into the deal.

We've also seen of late fertilizer companies getting into the natural gas exploration business in places like Canada and Chile. Many big oil companies are already integrated by owning producing wells and refineries. Steelmakers in Asia are buying coking coal and iron ore mines. Copper smelters are looking at funding porphyry exploration.

It's interesting to think what might be next. How about aluminum companies investing in geothermal power? Nuclear power operators buying into uranium mines? (They got burned on this last cycle, so it might take awhile.) Housing developers getting into copper development?

By. Dave Forest of Notela Resources