Futures Daily: Futures-Spot Synergy Adds Luster to Business Operation of Tongling Nonferrous Metals Group

Updated on: August 10, 2017

Professional Division of Labor and Well-established System Lay a Foundation for Effective Hedging

Aluminum Substitution Affects Domestic Copper Consumption

Tongling Nonferrous Metals Group is currently engaged in main business line of mineral processing and sale, in which self-producing ore business accounts for less than 5%, while more than 95% of ore production are dependent on external resources. However, regardless of self-producing ore or outsourcing ore, in order to prevent fluctuations in copper prices from affecting corporate profits, Tongling Nonferrous Metals Group conducts hedging on the futures market. At present, the futures market is not only the main pricing basis for Tongling Nonferrous Metals Group to carry out raw material procurement and product sale, but also direct transaction site to buy raw materials and sell products.

According to announcement of Tongling Nonferrous Metals Group, in the first quarter of 2017, it totally invested RMB153.64 million into funds to be engaged in hedging business of SHFE and London Metal Exchange (LME), accounting for 9.39% of net asset ratio at the end of the reporting period. Tongling Nonferrous Metals Group also realized investment income of RMB9.4508 million. Also in the first quarter of 2017, Tongling Nonferrous Metals Group realized satisfying investment income of RMB6.6968 million, RMB2.3687 million and RMB3.8668 million from hedging business of Gold, Silver and Zinc Futures at SHFE, respectively.

In recent years, under further faster pace of China’s industrialization, gradually-increasing governmental supports are provided for urban and rural construction. Urban and rural power distribution programs for “the Thirteenth Five-year Plan”, related power distribution upgrading programs and rural power grid renovation programs are introduced one after another. Driven by these situations, the rapid expansion takes place in China’s power industry scale, which further pushes up China’s copper consumption. However, with the gradual popularization of the concept of “aluminum substitution for copper”, domestic copper consumption is affected, while copper processing industry, led by cable businesses, witnesses decline in profits.　

It is reported that concept of “aluminum substitution for copper” has long been mentioned in China. In the 1950s and the 1960s, China ever proposed to implement policy of “aluminum substitution for copper” in the cable industry. In 2007, Alcan (Tianjin) Alloy Products Co., Ltd imported aluminum alloy cables from Alcan US aluminum for domestic sale, and introduced foreign mature aluminum alloy cable formulations, technologies and products for the first time. Since then, aluminum alloy cable continued to sweep domestic cable market at low price, thereby affecting the copper consumption. Until 2017, the market share of domestic copper cable fell to about 90%, while aggregate domestic copper consumption was affected. In addition to a direct blow to domestic copper consumption, the popularity of aluminum alloy in power industry not only reduces profit rate of copper enterprises, but also deteriorate the survival environment of copper enterprises.

From 1965 onwards, Tongling Nonferrous Metals Group has started to produce copper rod (upstream raw material of copper cable). Now it has 41 production lines and equipment with production capacity of 9.395 million tons. Due to the equipment aging and failure to operation commencement under low profit, production capacity of 3.095 million tons is subjected to abnormal operation and discontinuation, however.　　

According to Wang Conglin (Head of Copper Material Section of Commerce Department of Tongling Nonferrous Metals Group), the domestic copper rod market currently suffers from general operating loss and continued shortage of funds for projects. In fact, the current domestic cable consumption is less than 6.5 million tons every year, industry-wide operating rate is lower than 50%, and consumption growth is not enough to support the production capacity. Downstream cable market is confronted with more gloomy situations, which saw consumption growth by only 3% in 2016. As products are highly homogeneous without core competitiveness, market profit level keeps declining trend. During 2015-2017, “reshuffle” happens in the industry. Small factories successively shut down. Less than 3,800 cable factories linger out a feeble existence, but their current operating rate is only about 40% on the whole. Too low profit is one of the main reasons for current insufficient operating rate of cable enterprises.　

In addition, concept of “aluminum substitution for copper” also inspires electrical industry to make use of alloy to reduce copper consumption, thereby reducing product costs. This situation is particularly evident in the domestic air conditioning and refrigeration industry where copper consumption is second only to that of electricity industry. According to Huang Zhen (Nonferrous Sector Researcher of Zhongda Futures Co., Ltd), every air conditioner consumes 5-7.5kg of copper, which decreases by 40% compared with the previous consumption volume of 12.5-15kg.

Hedging Escorts Business Operation of Tongling Nonferrous Metals Group

Because of its unique pricing mechanism, futures market can provide enterprises with raw material and product prices characterized by openness, fairness, impartialness and authoritativeness so that enterprises can take on proper grounds in the control of business risks. As the first Chinese enterprise engaged in copper collection, smelting and processing, Tongling Nonferrous Metals Group is also one of the enterprises in the first batch of hedging on the futures market. In recent years, with the simultaneous development of industry and futures market, futures market is not only a hedging site for enterprises, but also an important tool for asset management of enterprises.

As revealed by the data of SHFE, the monthly spot price for contractual clearing and delivery of Shanghai Copper Futures was RMB46,645/ton on average in the first half of 2017, which was 0.2% lower than the average price of Shanghai Copper Spot Market during the same period. This proves that domestic copper futures price fully embody the domestic supply and demand changes and maintains high correlation with domestic spot price, which can be regarded as the domestic spot trade pricing benchmark.　

For Tongling Nonferrous Metals Group, due to its extremely high dependence on external resources, lack of domestic copper resources and insufficient supply, raw materials are mainly imported copper. But domestic and foreign copper price spreads exist, while exchange rate fluctuations greatly agitate the market. Since 2003, approved by the State Council, Tongling Nonferrous Metals Group has launched overseas futures hedging, which is one of the domestic enterprises pioneering in overseas futures hedging.

At present, Tongling Nonferrous Metals Group applies “price parity hedging” mode for imported ore hedging which accounts for the largest proportion. Different from hedging mode of domestic procured minerals only in a futures market, the imported ore hedging calls for simultaneous operation on domestic and international futures markets, i.e., opposite position operations in view of domestic and foreign copper futures price spreads on the domestic and foreign futures markets. According to Xu Changning (Senior Economist of Nonferrous Business Department of Tongling Nonferrous Metals Group), this hedging mode not only applies to the domestic and foreign copper futures spreads hedging, but also applies to evasion from exchange rate fluctuation risks.　　

In fact, not all scenarios are suitable for hedging, which depends on the specific enterprise dynamics and domestic and international market environment. Xu Changning told journalist that in 2007, Tongling Nonferrous Metals Group failed to hedge imported raw materials because the domestic copper price was always lower than the international copper prices. At that time, when China encouraged the import of electrolytic copper and restricted export of electrolytic copper, the domestic spot market fell into oversupply. Moreover, expected RMB appreciation dragged domestic copper prices so that domestic copper price presented stagflation or creeping inflation. After April 20, 2007, the domestic copper price was always lower than the international copper price. As the biggest difference even reached RMB-5,527/ton, hedging with imported raw materials turned impossible.

Without doubt, under normal circumstances, hedging played a significant role in help enterprises avoid risks. For example, in the 2008 financial crisis, hedging positions played a key role in profit smoothing of Tongling Nonferrous Metals Group.

Xu Changning told journalist that by the end of September 2008, Tongling Nonferrous Metals Group held short position of 4,625 tons in China, and the price was RMB56,762/ton at that time. By the end of 2008, shocked by the financial crisis, futures clearing prices fell to RMB23,800/ton. It can be said that Tongling Nonferrous Metals Group gained high profit from the domestic futures market alone. Of course, Tongling Nonferrous Metals Group carried out “price parity hedge”, and also held a certain position in foreign countries. Therefore, profits and losses from foreign futures markets must be also included into specific income. However, in general, hedging still successfully helped Tongling Nonferrous Metals Group avoid the risks brought by the financial crisis and smooth the corporate profits.

Well-established System Props up Success of Hedging

As mentioned above, effective hedging can help enterprises evade business risks and solidify profits. Without doubt, futures market is demanding for the professionalism of participants because of unique leveraged transactions. How does Tongling Nonferrous Metals Group launch effective hedging on volatile market? Relevant heads of Tongling Nonferrous Metals Group point out that clear-cut hedging concept, professional hedging organization and perfect hedging system are required in this regard.

Since Tongling Nonferrous Metals Co., Ltd (predecessor of Tongling Nonferrous Metals Group) entered the futures market, it set up Futures Section under Marketing Department to take charge of specific operation related to futures, and developed basic principle of “insisting hedging and putting an end to speculative trading”. After 2003, as one of enterprises permitted by the State Council for overseas futures hedging in the first batch, Tongling Nonferrous Metals Group always adhere to its own conservative hedging concept, and submits overseas futures operating statements to Anhui Securities Regulatory Bureau. In the past decade, it didn’t involve with any violation case.

According to Xu Changning, the professional hedging organization and perfect hedging system lay a foundation for effective hedging.

It is reported that in the process of corporate development, Tongling Nonferrous Metals Group forms a stringent and professional hedging organization. At present, Futures Section plays backbone role in futures operations, which is not only responsible for the specific hedging operations, but also collects market information, puts forward hedging plans, and provides operation recommendations. Raw Materials Section, Copper and Precious Metals Section, Finance Section, Legal Affairs Section and Jinyuan Futures also join and design hedging plans so as to design preservation programs which are the most consistent with the current corporate situation.　　

In addition to the original four systems (value preservation plan design system proposed and summarized at all levels; mark-to-market system; regular meeting system; regular market analysis and forecasting system), in order to cooperate with foreign futures institutions to carry out overseas futures business, Tongling Nonferrous Metals Group also additionally implements overseas futures business authorization system so as to ensure legal and compliant operations at abroad, and facilitate the regulatory authorities to investigate corporate transactions, funds and other related circumstances at any time. Among them, value preservation plan design system proposed and summarized at all levels is of fundament significance for hedging business.

According to this system, in the formulation of hedging plans, Futures Section firstly predicts copper prices of following year, and then refers to cost data of previous year as provided by finance department and annual amount of assets, and works out a rough hedging strategy. Afterwards, such a strategy is submitted to superiors tier upon tier and repeatedly discussed, which is ultimately implemented under the authority of the board of directors. In case of major changes in the market, relevant departments will modify hedging plans according to the latest market conditions. Therefore, such hedging plans are basically comprehensive representations of the market viewpoints, and boast strong maneuverability.