Commodities volatile, but producers shy of hedging

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.

"Hedging does stabilize the cash flow and makes it more predictable ... But it is very difficult to sell to shareholders because many are buying exposure to the commodity."

OIL CALMED FOR NOW

Hedging can make sense when prices for future delivery are higher, a market condition known as contango.

Contango has deepened in the oil market as it fell from a record of $147.27 in July to less than $60 a barrel this week.

In theory, contango is an incentive to build stocks, but the lack of available credit, combined with aggressive OPEC cuts, is expected to drive inventories down.

That could further fuel volatility once demand kicks in.

"Keeping low inventories will definitely make the market very reactive in the case of demand reappearing, but we are not in that mood yet," said a senior trader at a major oil company.

Implied volatility on U.S. oil climbed to a peak above 95 percent on October 24, the day the Organization of the Petroleum Exporting Countries said it would cut output. It has since eased to below 90.

One element of volatility earlier this year was extensive use of options, which have lost some of their appeal.

Given the now limited downside risk on oil markets, traders said anyone who decided they would hedge oil was more likely to use relatively cheap futures, rather than options.

Data from the U.S. Commodity Futures Trading Commission showed a big increase last month in outstanding positions on U.S. crude for delivery between 2011 and 2013.

Olivier Jakob of Petromatrix interpreted that as "a first warning sign that some hedging activity might be starting to re-enter the futures market."

(Additional reporting by Jane Merriman; editing by James Jukwey)