Nickel
We talked on Tuesday about a hedging problem for nickel producers. If you make nickel and the price of nickel goes up, you will make more money, one day at a time, as you sell your now-more-valuable nickel. Meanwhile if you have hedged your nickel production by selling nickel futures on a commodities exchange, and the price of nickel goes up, you will get a margin call from your broker demanding that you put up a lot more money right now. Your stock of nickel in the ground and in warehouses has become more valuable, but it is not easy to turn that all into ready money; your short position in nickel futures has moved against you, and that does require ready money. In the worst case, you run out of money and lose your business even as it is becoming more valuable.
There is a variation on this problem.
Commodities futures are standardized contracts for the future delivery of some commodity. The word “commodity” suggests that the commodity itself is standardized, and that every instance of it — every bushel of wheat or barrel of oil or ton of nickel or pork belly — is the same. But of course this isn’t true. 1 The oil industry produces oil of different compositions and purity. Typically for each commodity there will be one or two sorts of futures that are heavily traded and that people use as a benchmark, “the” price of the commodity. And these futures will specify exactly what sort and grade of the commodity can be delivered where to satisfy the futures. London Metal Exchange nickel futures, for instance, are contracts for the delivery of Class 1 nickel, meaning nickel that is at least 99.8% pure; the contract specifies what shapes and brands of 99.8% pure nickel are permitted. Lots of nickel, in the real world, meets that specification. Lots of nickel doesn’t.If you produce Class 1 nickel, and you are worried about price risk, you can hedge by selling futures. If you do this, you will probably close out your hedge by (1) buying back the futures for cash before they expire and (2) delivering nickel to some steelmaker or battery maker or other industrial user who is a customer of your regular business. But you could, perhaps with a certain amount of shipping costs and administrative annoyance, instead deliver your nickel to an LME warehouse to physically settle the futures.
If you produce other sorts of nickel, and you are worried about price risk, you can also hedge by selling futures. The futures you can sell — the liquid standardized ones with lots of buyers — are pretty much LME futures on Class 1 nickel. That is not the kind of nickel you make, and you cannot deliver your nickel to satisfy the futures contract. But it is still basically a good hedge. If demand for nickel goes up, (1) the price of your nickel will go up and (2) the price of LME futures will go up; if demand for nickel goes down, the prices of your nickel and LME nickel will both go down. The futures are correlated enough with your product that this is a sensible trade.
On the other hand you have basis risk, the risk that the correlation will break down and LME nickel will be worth a lot more than your nickel. And you can’t arbitrage this away, because your nickel and LME nickel are not fungible. You’re short a lot of nickel futures, meaning essentially that you owe a lot of nickel to the LME; meanwhile you own a lot of nickel, but it’s not the sort that you can deliver to the LME.
Also if everyone on the LME knows that (1) you are a huge nickel producer, (2) you are short a lot of nickel futures, and (3) you make the wrong kind of nickel, then they can bet on the basis blowing out. If the price of LME nickel goes up high enough then you will get margin calls, you won’t be able to deliver nickel, you’ll have to buy back your LME contracts at a loss, the LME price will go up even more, and the people betting on this breaking down will make money.
This may be part of what happened to nickel this week, as Chinese nickel tycoon Xiang Guangda and his Tsingshan Holding Group Co. got short squeezed:
The tycoon long believed that because he was the world’s biggest player and had ultra-low costs, he could wield unprecedented influence over the nickel market, people familiar with the matter said. When prices rose above $20,000 he would consider shorting nickel, the people said, because his production costs in Indonesia were as low as $10,000 a ton.
Xiang was aware of flaws in his strategy, people familiar with the matter said. Tsingshan’s nickel doesn’t match the grade used in settlement on the LME, so the contracts aren’t a perfect hedge. However, Xiang believed the risks to be manageable, the people said, even as an unidentified nickel stockpiler controlled at least half of the inventories on the exchange.
And:
A record-breaking rally in nickel prices that led the London Metal Exchange to halt trading on Tuesday is putting increased pressure on the Chinese stainless steel producer Tsingshan and its billionaire co-founder.
Tsingshan, the world’s largest stainless steel producer, is rumoured to have built a big short position in nickel before a 250% rally in the price of the metal this week, which saw prices top $100,000 a tonne.
That could put the company in a difficult position, as it is not approved to deliver nickel metal into the London Metal Exchange to close out its position. It also raises questions about the LME’s trading structure, especially as more nickel production is geared towards use in electric vehicle batteries.
“It can’t deliver against the LME because of the confines of the exchange structure which is not geared for the EV revolution,” Caspar Rawles, head of data at Benchmark, said. “Tsingshan’s recent investments have been in battery nickel projects but the exchange is rigid in requiring high purity Class 1 metal.” …
The LME requires nickel that is 99.80% purity and in the form of cathodes, pellets, briquettes and rounds. Tsingshan’s nickel matte, however, has a 70% to 75% nickel purity.
One simple form of this story is “the price of nickel shot up, and Tsingshan was long real-world nickel but short nickel futures, which created a cash crunch that led to margin calls and the closing of the LME.” Another simple form is “the price of LME nickel shot up, and Tsingshan was short nickel futures and long non-deliverable nickel, so it lost a ton of money on the basis.” 2 The first form suggests that Tsingshan had a liquidity problem but not a fundamental economic problem: It was hedged but needed cash. The second form suggests that Tsingshan had an actual loss: Its hedge stopped working. 3
Anyway the liquidity problem is fixed-ish:
The Chinese nickel company at the center of a historic short squeeze has secured a package of loans from local and international banks to help it meet a wave of margin calls, according to people familiar with the matter.
Tsingshan Holding Group Co., which faces billions of dollars in potential losses on short positions in nickel futures, won credit promises from banks including JPMorgan Chase & Co. and China Construction Bank Corp. in meetings that ran into the pre-dawn hours of Wednesday morning, the people said, asking not to be named since the matter is private. Some of the terms, such as how much extra collateral Tsingshan needs to pledge, are still under discussion, the people said. …
The bank loans are expected to help Tsingshan address its immediate liquidity squeeze. With large nickel production facilities in Indonesia and China, coupled with surging prices and strong demand, the firm’s owner, Xiang Guangda, told bankers at the meetings that he’s confident his company can meet its obligations, according to the people. He’s also reviewing his hedging strategy and is considering exiting the bets against nickel, one of the people said.
Yeah no when your hedges blow up, the exchange shuts down, and you have to go to banks to beg for loans, you probably have to tell them that you are reviewing your hedging strategy. It has not quite worked, has it?
Also! On Tuesday I made a joke about melting down nickels (the coins, I mean) and like six people told me that it is illegal in the U.S. to melt nickels. So don’t do that then. As I am constantly saying, nothing here is ever legal advice. Imagine melting down a nickel for $0.037 of metals-arbitrage profit and then realizing (1) you have to pay for, like, a smelter or whatever and (2) you have to hire a criminal defense lawyer. Imagine being prosecuted for it. The little blob of metal, Exhibit A for the prosecution.
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