Nickel producers can hedge against falling nickel price by taking up a position in the nickel futures market.
Nickel producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of nickel that is only ready for sale sometime in the future.
To implement the short hedge, nickel producers sell (short) enough nickel futures contracts in the futures market to cover the quantity of nickel to be produced.
A nickel mining firm has just entered into a contract to sell 600 tonnes of nickel, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of nickel on the day of delivery. At the time of signing the agreement, spot price for nickel is USD 10,100/ton while the price of nickel futures for delivery in 3 months' time is USD 10,000/ton.
To lock in the selling price at USD 10,000/ton, the nickel mining firm can enter a short position in an appropriate number of LME Nickel futures contracts. With each LME Nickel futures contract covering 6 tonnes of nickel, the nickel mining firm will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the nickel mining firm will be able to sell the 600 tonnes of nickel at USD 10,000/ton for a total amount of USD 6,000,000. Let's see how this is achieved by looking at scenarios in which the price of nickel makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the nickel mining firm will have to sell the nickel at only USD 9,090/ton, resulting in a net sales proceeds of USD 5,454,000.
By delivery date, the nickel futures price will have converged with the nickel spot price and will be equal to USD 9,090/ton. As the short futures position was entered at USD 10,000/ton, it will have gained USD 10,000 - USD 9,090 = USD 910.00 per tonne. With 100 contracts covering a total of 600 tonnes, the total gain from the short futures position is USD 546,000
Together, the gain in the nickel futures market and the amount realised from the sales contract will total USD 546,000 + USD 5,454,000 = USD 6,000,000. This amount is equivalent to selling 600 tonnes of nickel at USD 10,000/ton.
With the increase in nickel price to USD 11,110/ton, the nickel producer will be able to sell the 600 tonnes of nickel for a higher net sales proceeds of USD 6,666,000.
However, as the short futures position was entered at a lower price of USD 10,000/ton, it will have lost USD 11,110 - USD 10,000 = USD 1,110 per tonne. With 100 contracts covering a total of 600 tonnes of nickel, the total loss from the short futures position is USD 666,000.
In the end, the higher sales proceeds is offset by the loss in the nickel futures market, resulting in a net proceeds of USD 6,666,000 - USD 666,000 = USD 6,000,000. Again, this is the same amount that would be received by selling 600 tonnes of nickel at USD 10,000/ton.
As can be seen from the above examples, the downside of the short hedge is that the nickel seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling nickel prices while still be able to benefit from a rise in nickel price is to buy nickel put options.
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