Commodities volatile, but producers shy of hedging

By Pratima Desai and Barbara Lewis - Analysis

LONDON (Reuters) - Wild swings on metals markets have created cash flow uncertainty for producers, but high costs are expected to deter them from using hedging, or selling forward, to protect their revenues.

An exception could be the biggest commodity market oil, where the downside price risk is limited by OPEC's willingness to intervene, which has moderated the slide.

In other markets, declines have been tempered as firms have shut loss-making output, but few are ruling out further falls.

A $600 billion stimulus plan in China, the world's top copper consumer and second biggest oil consumer, has not changed expectations for weak demand growth for at least the next year.

"You've got clear drivers in opposite directions," said Stephen Briggs, commodities analyst at RBS Global Banking & Markets, referring to weak demand versus output cuts.

"Volatility will continue into next year ... Volatility makes hedging a less attractive alternative."

One way of hedging is with options -- which give holders the right to buy or sell at a specified price in the future -- that can be bought for a premium calculated using implied volatility.

Implied volatility -- a measure of the range in which prices could move -- on copper options in London last week rose to above 90 percent.

The higher the implied volatility the higher the premium hedgers have to pay. It is now less than 80 percent compared with levels nearer 30 percent in early September.

PATHOLOGICAL

Illustrating the problem facing producers, the benchmark LME copper futures contract hit a record high of $8,940 a tonne on July 2 and is now around $3,800. Since late October, it has fluctuated between $3,600 and $4,800 a tonne.

"It would be unrealistic to expect a normalization in commodity markets until we see broader financial markets becoming less pathological," said Sean Corrigan, chief investment strategist at Diapason Commodities Management.

Following the credit crunch that stoked volatility across financial markets, central bank action has helped to thaw the lending freeze between banks.

But progress has been slow and economic data points to recession in the United States and Europe, as well as a significant slowdown in emerging countries such as China.

"It doesn't make sense to hedge at these low levels. Some metals prices are below the marginal cost (highest cost) of producers," said Eugen Weinberg, analyst at Commerzbank.