Fooled by Averages – Four Metals Market Misuses and Abuses
This article originally appeared on the Commodity Risk Control website.
It is a truth universally acknowledged, that a metal price in possession of a daily reference, must be in want of an average. Or so it seems in the physical metals world. In the course of our adventures through the ecosphere of commercial contracts and pricing principles we see averages employed everywhere. And why not? They’re simple, easily applied and save administrative overload. And anyone who didn’t grow up under a rock knows exactly how to use them. Or maybe not. For in the world of business affairs it is practically certain that every concept properly applied will surely attract an indiscretion. We present four opportunities.
Exhibit one, to be found in the common commercial contract with average pricing, fits squarely in the “Contracts 101” camp. In the absence of a published reference it can be as simple as not defining rounding methodology or the number of decimals to be used. Including a well spelled out averaging formula also never hurts, particularly if incorporating multiple daily reference prices as everyone forgets holiday months with shortened days that really complicate things. In one case we saw five different calculation methodologies being advanced for the same average. And you can count on contracting parties to argue for what’s most advantageous to them, regardless of last year’s position. Simple things like these waste a surprising amount of corporate time, cause payment delays and can reduce hedge effectiveness too and if it’s a problem with one of your contracts it’s surely a problem with more. And what about disrupted price publication? It’s rare but we’ve seen it happen and having a contingency spelled out will pay off. While all of the above may seem terribly obvious, our experience says don’t depend on your lawyer to catch omissions. The best advice is “definition, definition, definition”.
And then there are negotiators that, once bitten, seem to want to average every price and the kitchen sink. One favourite long-standing average agglomerated cash and forward prices across two price points across one business day, incorporating four prices a day and 80 prices a month. At least one party using this was unlikely to be a hedger as the complications with this are significant. So what is the motivation behind such a price, perhaps for two counterparties to share the pain or gain of the forward curve, or maybe for an uninformed one to give it away? If you’re going to use an average it is best to create a meaningful and manageable one.
Or…just maybe, such an average was intended to reduce price volatility, our third misuse of the concept of averaging. Common corporate CYA dictates we can’t pick highs and lows so we use monthly averages and reduce price volatility. Processing businesses hate it and you can see how the idea of condensing 260 daily into 12 could be perceived as achieving that end. But the problem is it doesn’t. It only means the jump between one price and the next is big and…lo and behold, the volatility is the same. Do the math – it tells no lies – and picture a $600/mt rise in zinc or lead, or a $10,000/mt fall in nickel or a $2000/mt fall in copper – between month averages. All have happened since 2000. The misconception also diverts attention from the question “how do we make a profit margin?” So if volatility is an issue and so is making steady financial gain, the appropriate countermeasure is a properly constructed price risk program. Introducing one will develop an understanding of your risk and when you have that you can do something about it. Those that do it well even use risk to their benefit.
But the fourth, and perhaps the single biggest abuse of the average, is a philosophical one: “We don’t worry about commodity price risk because it all averages out in the end”. We hear it a lot – a comfortable reason to do nothing that has given more managers a good night’s sleep than any drug ever did. But the reality is metal prices are driven by unpredictable events and every long-term average inescapably incorporates outliers. Some will be extreme – periods of extraordinarily low or very high prices. And the essence of the problem is that the consequences of outliers are not symmetrical. Imagine hearing this: “Thank you for flying with us today ladies and gentlemen. We’re very pleased that you are enjoying our new low fares which we’ve achieved by eliminating aircraft maintenance as, on average, we can sort through equipment problems in flight”. For an operating business that does not manage price risk it’s important to ask yourself if you have a fuel gauge that is able to predict a savage plunge or spike in your metals prices? Does your instrument panel give you an idea of their financial impact and do you have a manual of contingencies to survive it when it hits? Would your hard-won customers, your employees or your lenders care if they knew you didn’t? Unfortunately, getting to grips with price risk is not as simple as cancelling a flight on a bad airline. Fortuitously however, it is not rocket science and there are real actions you can take to secure control.
So give some pause for thought the next time the subjects of averages and metal prices converge in the context of your business. And remember the old adage (albeit slightly modified); “Businesses use averages like a drunk uses a lamppost, for support but not for illumination”. Don’t let your misuse of averages cost you time and money, lose you opportunity or worse still, put you out of business. If you’d like to bounce your ideas off people with price risk experience, we’d look forward to hearing from you.POSTED: 2017-07-09