Beyond Hedging - How Alcoa Relies on Futures as a Management Tool
Location: Washington, DC
Author: Kevin Anton
Date: Wednesday, September 20, 2006
FuturesIndustry - Alcoa is the largest aluminum company in the world. Its global operations run all the way from bauxite mines in Australia to smelters in North America and on into fabrication, manufacturing and consumer packaging. Alcoa is also a heavy user of the aluminum futures markets, not only to hedge its price risks but also as an important reference point for pricing decisions throughout the organization. In the following article, a senior Alcoa executive explains the many ways in which the company relies on the London Metal Exchange's aluminum futures market for price discovery and risk management.
There is a saying in corporate circles: you can't manage what you can't measure. For Alcoa, the existence of a futures market in aluminum allows the company to manage its various business units in a more effective way. Each part of the value chain can be analyzed separately, and the pricing of components as they move up the value chain can be set independently, by reference to LME prices, rather than by an internal pricing scheme set by company managers. This creates price discipline within the company and allows the management to determine the profitability of each segment of the business.
Initially Alcoa was a reluctant user of the futures market. In fact, thirty years ago, when the LME first introduced an aluminum contract, the company viewed it as a threat to its pricing power. It was rumored that Krome George, Alcoa's chairman at that time, threatened to dismiss anyone who entered into an LME-based contract.
How times have changed. Alcoa now relies on LME prices in the marketing of virtually all of its commodity grade aluminum and a substantial portion of its consumer products. Alcoa also uses LME futures to manage commodity price risk, not only as a hedge for our own operations but also as part of the services that we provide to our worldwide customer base.
In 2002, the LME introduced a new contract based on the price of scrap aluminum. This contract, the North American Special Alloy Aluminum contract, was developed in response to demand from automakers, which rely heavily on scrap metal for the production of auto parts. The divergence between the prices for scrap and primary aluminum at times has been so wide and so variable that the automakers' positions in the LME primary aluminum contracts were failing to qualify as effective hedges under U.S. accounting rules. Alcoa immediately saw the benefits of such a contract and jumped into the market, providing critically important liquidity in the early stages.
More recently, Alcoa has supported the introduction of the LME plastics contracts. Alcoa itself is a major plastics user; roughly half of our consumer packaging business is based on plastic. Alcoa's involvement has encouraged other plastics companies, which like Alcoa thirty years ago have resisted the introduction of futures, to join that market.
Vertical Integration
To understand the importance of futures to Alcoa, it is necessary to understand the degree to which our company is involved in all parts of the aluminum value chain, from extracting bauxite ore from the ground to producing finished products for industrial and consumer use.
The company is divided into five main business units. The alumina segment, which in 2005 accounted for 32% of the group's after-tax operating income, covers the mining of bauxite and its transformation into alumina, the basic raw material for smelting. Roughly half of the alumina is sold to third parties, and the balance goes to Alcoa smelters to be transformed into aluminum. This is handled by the company's primary metals segment, which in 2005 accounted for 38% of after-tax operating income. Roughly half of this unit's production goes to third party clients, and the remainder goes into Alcoa facilities for further processing downstream. The company also buys significant amounts of aluminum scrap plus other forms of primary aluminum for downstream businesses.
The downstream businesses, which accounted for the remaining 30% of aftertax operating income, are divided into four groups. The flat-rolled products segment produces and sells aluminum plate, sheet and foil. The extruded and end products segment produces alloy extrusions, architectural extrusions and vinyl siding. The engineered solutions segment manufactures various castings, forgings, and fasteners as well as wheels and other products used in the aerospace, automotive, commercial transportation and power generation markets. Lastly, the packaging and consumer segment includes the Reynolds wrap and other packaging products, about half of which are based on aluminum and half on plastics.
The existence of a liquid futures market at the LME creates a very transparent price discovery method for an intermediate product— commodity grade aluminum. In effect, we rely on the LME to disaggregate the value chain. One part of the value chain runs from bauxite to aluminum, and the second part from aluminum to aircraft parts, auto frames and beverage cans.
From a practical point of view, the transparency of LME prices has two effects. First, on the internal side, it is a key source of discipline. All the transfer pricing as aluminum is passed from one part of the group to another is done at full market price. So our managers have the ability to break out measurement points along the value chain and measure the contribution of each business separately. This allows us to make better decisions on pricing and capital allocation, prevent one side of the company from subsidizing another, and decide in which parts of the business to invest.
Second, on the external side, we can incorporate a reference to LME prices in its products. Before the introduction of aluminum futures, producers sold aluminum sheet at a set price. Today substantially all of Alcoa's aluminum products are sold on an aluminum-plus-conversion price.
Risk Management
The fact that the prices for so many of Alcoa's products are referenced to the LME means that, in effect, customers are paying a floating price. This puts the onus on the customers to think about how they are going to hedge an unexpected movement in price. Some customers have the size and sophistication to go directly to the brokerage community to convert this exposure to a fixed price, but for those customers who do not want to set up a hedge program, Alcoa can provide coverage. We do not market risk management as a separate business, but it is part of the overall value proposition that we offer to our customers.
For example, suppose an aerospace company decides to launch a new airplane platform and it wants to have assured costs for the next five years. We may not want to offer a fixed price for such a long period. The existence of the exchange, where there are financial intermediaries willing to take long or short positions, provides the necessary liquidity to allow the aerospace customer to get the fixed price it wants for that five-year period, and Alcoa to hedge the risk on that long-term commitment.
For most purposes, the LME market is sufficiently deep to meet this need. The aluminum contract goes out 63 months, and over-the-counter derivatives are available for up to 15 years. Alcoa generally can find enough liquidity to conduct its business inside the exchange's 63-month window.
It is worth noting that a recent shift in the behavior of commodity investors has improved the amount of liquidity available in the back months. The so-called indexers— institutional investors and swap dealers that take positions in commodity indices—have been coming into the aluminum market in a big way for approximately the last two years. For most of this time, they concentrated their positions in the near months, but starting in the second quarter of this year, they have been moving to the back months to avoid the negative return caused by the fact that the aluminum futures market is in contango. This trend has provided more liquidity to companies like Alcoa that are looking to take large positions to hedge long-term risk.
Options vs. Futures
Futures are not the only way to hedge aluminum price risk. Options on aluminum futures and option-based structures such as collars also have an important role in a hedge program, especially when there is a fixed pricing commitment on an unknown amount of volume.
In deciding what instruments to use, the first step is to make sure that the sales and marketing strategy is aligned with the raw material acquisition strategy. If, for example, a company in the aluminum window business has sold all of its windows for next year, then it really should use futures to lock in its aluminum cost for the year to protect its profit margin. Otherwise the sales strategy has created a big short position that can blow a hole in the balance sheet.
Conversely, a company should avoid locking up all of its aluminum needs at a fixed price if it has a variable pricing strategy. Suppose an auto parts company wins a contract to provide all the wheels for a particular type of car at a fixed price for the life of that model. There is no way in advance to know how much aluminum that company will need to buy to meet that commitment. The contract could last four to six years, and the number of cars produced under that contract could range from 100,000 units a year to 200,000 units a year. By extending a price guarantee on a variable number of units, that company effectively has granted a call option to the customer.
This is where options can come into a hedge program. Options can provide coverage for the risk when a company has committed to a fixed price on a variable amount of production. Options are not cheap, however, and many customers are reluctant to use options to cover this risk because they do not like paying for the volatility. At Alcoa, the value of call options granted to customers is calculated very carefully, so that before our salespeople go out they know what that option is going to cost. We often see that other market participants do not have the discipline to put a value on the options they have granted to their customers.
Other Benefits
The existence of a futures market also helps reduce the cost of financing by allowing companies to take the price risk out of the credit decision. Banks are willing to finance inventory, so a borrower can do longer term structured financing with an LME component, or a shorter term inventory financing and consignment supported by the contango structure at the front end of the curve. Hedging, in the sense of selling production forward, can also help producers finance construction of new facilities at a lower cost, as they now have a known revenue stream.
The existence of a deep and liquid futures market also provides a springboard for centralized market intelligence analysis and dissemination. Alcoa runs its risk management function as a centralized office based in Knoxville, Tenn. This office accumulates all commercial risk from all the Alcoa business units around the world so that we know at any given time what our aluminum price risk is. The Knoxville office also runs our trading activities at the LME. Alcoa is not a member of the exchange; all of our trades are executed through brokers. Most of what Alcoa trades are either listed on the LME or look-a-like contracts available in the over-the-counter products.
The central office is supported with satellite offices in São Paulo, Perth, Shanghai and Geneva, so the company has 24-hour coverage of the global aluminum market. These offices are not only analyzing the risks for Alcoa's own operations, they are also collecting information on the risks that the company is absorbing in its marketing activities. So for example, the São Paulo and Shanghai offices have teams that are actively encouraging customers in Brazil and China to manage aluminum price risk.
Just to give an example of how global this industry is, Alcoa recently announced a joint venture that will produce aluminum brazing sheet in a city near Shanghai. This investment, our third flat-rolled products facility in China, will give Alcoa the ability to supply aluminum brazing sheet to automotive and other customers serving the Asian market.
The Asia-Pacific region accounted for 12% of our overall sales last year, and we expect that percentage to rise as countries like China and India move up the GDP per capital scale and consume more aluminum. In fact, McKinsey projects that by the year 2020, the amount of aluminum consumed in Asia will have more than doubled, far outstripping the rate of growth in Europe and North America. McKinsey also projects that aluminum consumption in Asia will account for more than half of total world consumption by 2020, versus 42% in 2005. This growth clearly will create greater exposure to aluminum price risk, and greater interest in hedging that risk.
Control Structure
An important element of a good hedging program is the control structure. Alcoa's program has direct involvement from the chief financial officer and the chairman to make sure that the hedge strategy is aligned with the company's goals. This means having the accounting infrastructure to make sure only authorized trades take place and the management infrastructure to ensure a clear line of control from the chairman through the finance organization through the metals organization down to the traders. Alcoa has encouraged and will encourage other companies to operate in these markets, but only if they have the necessary infrastructure and controls and sophistication.
The importance of having a proper control structure extends to the market itself. The LME still has open outcry, which in Alcoa's view adds to market integrity. In addition, Alcoa appreciates the oversight provided by the Financial Services Authority and the oversight infrastructure that the LME has established. Without that oversight, Alcoa would not participate in that market.
As markets continue to globalize, commodity price movements will become even more difficult to anticipate, and it seems almost inevitable that more large users like Alcoa will turn to the futures markets to mitigate that risk. In economic sectors where futures are not well established, or where they do not exist at all, there continues to be resistance to change, but our experience has shown that the price discovery and risk management benefits of futures markets are a powerful aide to effective corporate management. That said, many large users of aluminum and other traded commodities need to enhance their understanding of risk management. We welcome more participation in these markets, but we also believe that it is important that new entrants establish all the necessary controls to use these products properly.
Price ShockLME Aluminum Cas Settlement Prices--January 2003 to June 2006
Source: London Metal Exchange
Kevin Anton is the president of Alcoa Materials Management. He is responsible for materials management for all of Alcoa's upstream commercial operations; this includes primary aluminum and alumina sales, primary and scrap aluminum physical and financial trading, electricity trading and transportation. He is also the vice chairman of the Aluminum Association.
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