The LME and Lead Hedging

Introduction to Hedging for Lead and Battery Producers

13th Asian Battery Conference, Shanghai

Wednesday 1 September, 2009

Rick HolmesMitsui Bussan Commodities (Aust.) LtdT 61 2 9256 9599C 0411 474 800

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Agenda

Introduction

The LME and its functions

Users of the LME and Price Discovery

Mechanics of the LME metals market, Official prices

Manufacturers Price Risks

Hedging Risks in a simple form

Slightly more on Hedging with options

A Few essentials if setting up an LME Trading Department.

Conclusion and Questions

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The London Metal Exchange

Established in 1877 for the risk management of metals business

“Not for profit” organization - formalized trading in the market with: – Fixed trading times– Standard contract specifications– Providing a transparent source of price discovery

Provides 24 hour principal to principal market

Annual volume of $10.24 trillion with more than 95% of its business coming from overseas, the exchange currently has 5.13 million tonnes of metals on warrant in 516 warehouses in 38 locations globally.

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LME membership trading categories

Description Can Issue LME

Contracts

Authorized (Financial Services

Act)

Member of LCH for Metals

Member of FSA

Trading Rights

May Solicit Brokerage

Minimum # Net Worth

Requirement

1. Ring Dealing Member

Yes Yes Yes Yes Freely Yes £ 5mm

2. Associate Broker

Clearing Member

Yes Yes Yes Yes Freely Yes £ 5mm

3. Associate Trade

Clearing Member

No No Yes No May only deal with 1, 2, or 4

– not with each other

No £ 2.5mm

4. Associate Broker

Member

Yes Yes No Yes Freely Yes £ 5mm

5. Associate Trade

Member

No No No No Only 1, 2, or 4 No £ 50,000

An Introduction to the LME

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Standard Lead

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LME Volumes and facts

The LME, the worlds largest non ferrous exchange it is more than 130 years old.

In 1992 Lead volume was 1 million lots, 2 million in 1994, 6.1 mil in 2008

Annual total volume was 93 million lots in 2007, in 2008 it was 113 mil lots

Daily value of trade is between $8,000 and $10,000 million.

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Roles of the Exchange

Price DISCOVERY and provide Daily “official price”– (LME is an International Reference Price)

Price Risk HEDGING MECHANISM, by providing a futures and options market that allows prices to be locked in.

Delivery / Supply of LAST RESORT, by authorizing a warehouse system.

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The London Metal Exchange - Trading

The LME is the world’s premier non-ferrous metals market, with highly liquid contracts

The main users of the LME are:– Producers– Consumers– Merchants/Traders– LME market makers (Category 1 and 2 – see next

slide)– Funds

• CTA’s, Discretionary Funds ($10 billion)– Other speculators

LME contracts are traded in US$, but are cleared in US$, Sterling, Euro & Yen

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LME Trading Days

Today- you cant trade2 Days forward- The cash date, earliest trade dayWeek days- trade every one for 3 monthsWednesday- Trade each Wed for 3-6 mths3rd Weds.- 6 mths to 27 mths (Pb)..longer for Cu

Trading through:Open outcry in ring trading sessions and kerbLME 24 hour inter office telephone market.Electronic trading via LME Select 1am to 7pm London time

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The LME periods in each day

Periods of Liquidity (LME/OTC):– Pre-Market: 8.00 – 11.50 (all London times)– AM Rings/Kerb: 11.45 – 13.05– Lunchtime Kerb: 13.15 – 14.45– PM Rings/Kerb: 14.55 – 17.00– Lates: 17.00 – 18.00 (COMEX close)– Late NY: 18.00 – 22.00– Overnight/Far East Market: 22.00 – to Pre-Market

“Open”

Special times each day.– Official Price each day at close of 2nd AM ring– Evening evaluation at 5.00pm

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Large industrial companies have becomemore pro-active in managing these exposures

“Ford has a commodity hedging program that uses primarily forward contracts and options to manage the effects of changes in commodity prices on the automotive sector’s results…such contracts are executed to offset our exposure to the potential change in prices mainly for various non-ferrous metals (e.g. aluminum).” (Ford Motor Company, 10-K)

“The company operates internationally, with manufacturing and sales facilities in various locations around the world and utilizes primarily forward and option contracts to manage its…commodity exposures.” (10-Q)

“The corporation is exposed to volatility in the prices of raw materials used in some of its products and uses forward contracts…to manage some of these exposures.” (United Technologies Corp., 10-K)

“Anheuser-Busch is exposed to…commodity price risks. The company utilizes derivative financial instruments, including futures contracts, swaps and options to manage certain of these exposures.” (Anheuser Busch Cos. Inc., 10-K)

“We are subject to market risk associated with changes in…certain commodity prices. In order to manage the volatility relating to our more significant market risks, we enter into forward contracts and…commodity swaps.” (Tyco International Ltd., 10-K)

“Alcoa might be required to purchase aluminum to supplement its internal production. These purchases expose the company to the risk of higher aluminum prices. To hedge this risk, Alcoa enters into long positions, principally using futures and options. Alcoa also purchases certain other commodities, such as fuel oil, electricity and copper, for its operations and enters into futures and options contracts to eliminate volatility in the prices of such products.” (Alcoa Inc., 10-K)

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Exposures are front page headlines

China Aviation Incurs $550 million in losses in derivatives trading

Sojitz Holdings Corporation said it lost $172.8 million from commodities trading

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The Lead Forward Market

Today’s cash price 2117 +8 a contango

3month price 2125 -28 a back

15 month price 2097 -37 a back

27 month price 2060

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LME Price Differentials

Contango– If the price for delivery on an earlier date is lower

than the price for a later date

Backwardation– If the price for delivery on an earlier date is greater

than that for a more forward date

Spread– The price difference between two prompt dates is

called the spread which may be in contango or backwardation

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Lead Price & Stock Chart

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007LME stocks, mt

$250

$750

$1,250

$1,750

$2,250

$2,750

$3,250

$3,750

3M official, $/mt

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Battery Makers Non hedged position

A Simple Transaction without LME Hedge

Cost Revenue

Buy Physical Lead @3500 /mt 3500

Conversion 200

8weeeks later

Sell Batteries Pb 2700

+Conversion cost 200

Total 3700 2900

LOSS 800/mt

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What Is Hedging?

A transaction intended to protect or reduce risk from subsequent adverse price movements of a physical position already bought or sold

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Battery Makers HEDGED position

A Simple Transaction (from above) now with LME Hedge

Cost Revenue

Buy Physical Lead @3500 /mt 3500

Sell LME 2 mths Forward 3500

Conversion 200

8weeeks later

Sell Batteries Pb 2700

Buy LME at time of battery sale 2700

+Conversion cost 200

Total 6400 6400

LOSS zero/mt

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What are options….(put simply)

CALLS … set a ceiling,

The right to buy at the strike price but not the obligation

PUTS …set a floor,

The right to sell at the strike price but not the obligation

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Battery Makers HEDGED position

A Simple Transaction (from above) now with LME Hedge

Cost Revenue

Buy Physical Lead @3500 /mt 3500

BUY A PUT 100 Prem 3500

Conversion 200

8weeeks later

Sell Batteries Pb 2700

Buy LME at time of battery sale 2700

+Conversion cost 200

Total 6400 6400

LOSS 100

The PUT has the same effect as selling at 3500 but should the LME rise you sell the battery at the higher Pb price and keep the profit (net of the cost of the PUT)

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Basis 3m close on PB at 2075 here’s some ideas on FEB10 strikes. …Feb is also 2075.

Calls: STRIKE/Premium

2100: 260/280

2200: 220

2300: 190

2500: 140

2600: 115

Puts STRIKE/Premium :

2000: 220

1900: 190

1800: 140

1750: 140

1700: 110

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Effective risk management – A word of warning

Hedging frightens some companies. The anecdotes do have great deal of truth in them. History has its disasters and all could have been avoided had careful consideration been given to the trading structure and policy. Specifically:– The policy to be employed using it– The choice of instrument– The directives covering authority and

accountability, and– Adequate controls to ensure these considerations

were adhered to – this includes reports to the hedge committee on all trades compared to the trading authorization and policy

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Summary and Conclusions

Base Metals are experiencing more volatility than ever before

The London Metal Exchange is an important part of Base Metals Pricing

Don’t be afraid to identify your price risks and hedge them

Hedging goals might include– Protecting margins, covering cash costs, and preserving upside potential

Choose relevant strategy

Coordinate physicals and futures positions

Talk to your friendly Broker about your risks.

Monitor and review performance– You must report all gains and losses

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Mitsui Bussan Commodities Contacts

New York – Mo Ahmadzadeh & Abe Ulusal– +1 212 878 4192

London – Micki Waite– +44 207 489 6700

Sydney – Rick Holmes– +61 2 9256 9599