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Futures Daily: Futures and Spot Combination Leads to Prosperity of the Zinc Industry


Futures Daily: Futures and Spot Combination Leads to Prosperity of the Zinc Industry

Reported by Chen Donglin, Journalist from Futures Daily

Shanghai zinc futures promote the transformation and upgrading of industrial enterprises  

Futures and spots are combined to serve entities. Shanghai zinc futures have infiltrated into the whole industry chain.

In research, the journalist learned that the shutdown of mines and smelting plants at the last stage was the main reason for the current low zinc ingot inventory. Coupled with the relatively satisfying downstream demand, zinc ingot price continued to rise in the first half of the year. Due to the constraints of environmental policy and industry cycle, it is difficult to increase the production capacity of mines and smelting plants within a short term. In the case of tight supply, the demand-side changes caused by macro economy may make zinc price fluctuate at highs.

In the current market environment, zinc industry chain-related enterprises make active use of futures-based financial derivatives to control risks and lock in profits, and different enterprises also establish the corresponding risk management measures and comprehensive assessment systems integrating futures and spots based on their own situation to ensure the smooth development of hedging business. With the increased popularity of futures in the whole industry chain, relevant enterprises are making further use of futures in price discovery and comprehensive application such as warrant pledge, import and export trade, cross-industry analysis, etc.

As zinc price has climbed to a decade high, more and more enterprises are strengthening the use of futures means to control risks and improve corporate benefits. According to the relevant data of SHFE, in the first half of this year, the number of institutions participating in zinc futures hedging increased by 60.56% over the same period last year, average daily hedging positions increased by 58.13% year on year, average daily trading volume increased by 48.16% year on year, and hedging efficiency was maintained at a high level.

Bi Youzhen, Deputy Head of Futures Department of Chihong Industry Development (Shanghai) Co., Ltd. (hereinafter referred to as "Chihong Industry"), said that the company internally attached great importance to the use of futures and other derivative tools to assist operation and actively played the role of the futures market in price discovery and risk management to stabilize the production and operation of the company and lock in the expected profits from the perspective of "finance serving the real economy". As for specific operations, the Board of Directors determined the annual hedging quota at the beginning of a year in accordance with the production and operation of the company, the Marketing Decision Committee was the decision-making body of hedging, the E-commerce Center of the head office was responsible for organizing implementation and risk monitoring, and Chihong Industry, a subsidiary of the Group, was responsible for the specific hedging operations. "However, it must be noted that the total amount of hedging cannot exceed the quota set by the company, and hedging must be based on the spot risk exposure."

In addition to the upstream mining and smelting enterprises that use zinc futures to lock in profits, the downstream zinc coating enterprises can also use the futures tool to effectively reduce purchase cost and ensure smooth production. Zhang Xi, General Manager of Non-ferrous Metals Department of Galaxy Futures, introduced that due to a shortage of zinc ingot supply in the second quarter of 2017, the spot premiums continued to increase, leading to high zinc ingot price and difficulty in purchase, and the price of the downstream galvanized sheet also rose with it. A galvanized sheet plant in East China got downstream orders at good sales price, but the upstream enterprises wanted to stock up on inventory, they were unwilling to deliver the goods and continued to raise the spot premiums. By comparison, Galaxy Futures found that the price of Shanghai zinc futures contract was more reasonable compared with the spot goods, so it advised a spot enterprise to classify existing orders to find orders where delivery can be delayed for several days and give such orders certain discount. Through measurement, after deducting the discount costs, the contracts in recent months still had room for profit after buying the corresponding galvanized sheet orders after delivery, so the enterprise established a buying position in the contracts in recent months. Later, due to the rapid rise in prices in recent months and the sufficient supply of spot goods, the company advised the enterprise to liquidate positions directly in the futures market and use the profits of long positions in recent months to buy spot zinc ingot so as to complete the orders. Zhang Xi said that the enterprise would be afraid to risk accepting downstream orders if purchase cost was not locked in by futures. If so, the enterprise would have lost a deal as well as a stable client. This has fully reflected the significant role of zinc futures in price risk management. At the same time, due to the good liquidity of the zinc futures market, enterprises can conduct flexible conversion between futures and spot goods in accordance with the actual market situation to maximize benefits with minimum costs.

Enterprises take measures to ensure strict risk management and scientific hedging assessment of zinc futures

During the visit of CHIHONG Zinc&Ge, the Futures Daily journalist found that with the deepening of hedging business in enterprises, establishing perfect risk management measures and a futures and spot income evaluation system combined with corporate production and operation had become more and more important.

Bi Youzhen introduced that Chihong Industry had established and gradually improved a set of risk management measures appropriate to the actual situation of non-ferrous metal trade enterprises similar to Chihong Industry. First, each business module would identify its own hedging demand based on business needs, and the futures department would prepare hedging plans according to the hedging demand reported by the business modules and reported the plans to the company for group discussion; the authenticity of the hedging demand of each business module should be ensured; next, in terms of business exposure management, the company gave authority to departments and departments gave authority to business personnel; on the basis of authorized management, level-based authorization of exposure size should be conducted, and each level should determine its maximum exposure size to ensure that the overall risk exposure of the company was under control.

Bi Youzhen said that in addition to strict management authorization, Chihong Industry also carried out risk management through real-time and dynamic information inspection and distribution of hedging tasks to specific individuals. In terms of real-time and dynamic information inspection, traders will send screenshot of daily execution to business risk management personnel after the close of a trading day, and business risk management personnel will prepare the daily exposure report based on the overall execution information from the traders and conduct full and dynamic monitoring of the status of uncovered positions through the daily report. Distribution of hedging tasks to specific individuals refers to that specific individuals should be designated to be responsible for hedging operations of different transactions, and the person to whom a transaction is assigned should be responsible for the hedging of the transaction.

To successfully serve production and operation, hedging business shall be based on sound risk management measures, and developing a futures and spot income evaluation system based on the specific situation of the enterprise is also particularly important. Bi Youzhen said that the Group conducted a unified assessment of the futures and spot income, futures were used to help achieve the overall business objectives of the Group, if the Group was loss-making after combined settlement of futures and spot goods despite the fact that it had made profits from futures, there would be room for the optimization of hedging operations. In view of the current zinc price fluctuations at a high level, Bi Youzhen told the journalist that they always adhered to the idea of hedging and the futures and spot goods combined evaluation system, combined target-oriented hedging with trend-oriented hedging, and carried out hedging based on the purpose to optimize company management.

Zhang Xi said that at present more and more industrial enterprises began to combine the income of futures and spot goods to measure the effectiveness of hedging. For example, in 2015, a zinc smelter in the west suffered a decline in profitability and a tight cash flow due to long-term drop in zinc price. At that time, zinc price was lower than the cost, which means that how much you have sold is equivalent to how much you have lost. However, the already tight cash flow would be tighter if the products were not sold, and there might even be capital chain rupture. Through the research and data analysis of domestic and foreign smelters, the Non-ferrous Metals Department of Galaxy Futures believed that the then zinc price had fallen below the cost of most smelters, it was an unsustainable price and there was probability of future increases. On this basis, its team helped the enterprise participate in futures trading and establish long positions in futures while recovering cash flow by selling spot zinc ingots, which was equivalent to the establishment of a virtual inventory. In the then context of common decline in commodity prices, as the expected price, the futures price dropped away from the spot price. Later, prices became rational again, rising above the industry average cost. Compared with the spot price, the futures price had higher increase. The enterprise not only achieved reasonable profits, but also got some income from premium and discount while ensuring cash flow. After this experience, the smelter also realized that combining futures and spot goods when setting daily purchase and sales prices and managing cash flow was more scientific and modern, so it gradually abandoned the traditional business model that relied only on stocking up with goods, betting on the price, etc.

In terms of the assessment of effectiveness of corporate hedging plans, all the interviewed market participants believe that it is a very important issue for business development. In addition to the understanding and implementation of the relevant accounting standards, what's more important is that the market and the media shall not conduct separate analysis of the amount of "futures income and loss" when interpreting the annual reports of enterprises, but shall make a comprehensive assessment based on their spot production and operation.

Decade of efforts in Shanghai zinc futures have effectively promoted the transformation and upgrading of business entities

In addition to using the futures market for traditional hedging, futures can also be used for price discovery, assisting import and export, warrant pledge, cross-sector comprehensive analysis, etc.

Zinc is the third non-ferrous variety listed by SHFE. Since the listing in 2007, its trading volume has gradually increased, and good liquidity can meet the need for risk hedging of most business entities. From the perspective of price discovery, zinc futures have become an important price indicator for the domestic zinc industry. The price of zinc futures has been highly positively correlated with the Shanghai spot market quotation for a long time. In the first half of this year, the difference rate between futures price and spot price after the zinc futures contract expired was only 0.44%, indicating that the futures market can effectively, truly and objectively reflect the supply and demand changes in the spot market.

Zhang Xi told the journalist that zinc was the second non-ferrous variety to set price with futures and premium and discount on a large scale in the domestic non-ferrous metal market. After years of spread, so far, the premium and discount-based pricing mechanism has been established in the markets in North China, East China and South China. The pricing model, which is based on futures pricing and supplemented by the spot premium and discount, can well reflect the supply and demand situation of each market, and promote trade flow to be more rational and prices to be more transparent and fairer.

Bi Youzhen said that the downstream clients of CHIHONG Zinc&Ge generally accepted pricing in zinc ingot purchase. In this way, the downstream clients could have greater initiative in pricing. In view of this pricing model, the upstream suppliers must combine futures with spot goods to avoid the risk of price fluctuations caused by changes in the pricing model. "More and more operators in the industry chain use futures to hedge risk, which provides a good foundation for improving market activity, giving full play to the role of the futures market and diversifying trade models."

In recent years, the domestic zinc mines have gradually become more and more dependent on foreign trade. Zinc price rise by smelters as an intermediate link means not only sales increase, but also an increase in concentrate import cost. However, it takes several months from zinc concentrate pricing to import and then zinc ingot production, so there is great risk of price fluctuations in intermediate links. Zhang Xi said that foreign pricing and domestic hedging by smelters at the appropriate time could make them effectively avoid the risks caused by long import cycle, and they could lock in substantial profits in the intermediate trade and smelting links in advance when the price parity between the domestic market and the overseas market was appropriate to stabilize price fluctuations and achieve stable operation.

Xia Cong, an expert from the Lead and Zinc Team of Beijing Antaike Information Co., Ltd., said that when the absolute value ratio of SHFE's zinc futures price to LME's zinc futures price was around 8.5, there would be opportunities for import. In the first half of this year, the import window was open to the domestic market in June. It was expected that there would be another opportunity in the second half.

"Zinc is mainly used for galvanized materials in the construction industry, so there is usually a great correlation between the trend of rebar among the ferrous goods and the trend of zinc." Xia Cong said that the rebar market was often ahead of the zinc ingot market, so business entities could keep an eye on the market of relevant ferrous goods and consider it as a pre-indicator while following the fundamentals of zinc ingots.

In addition, according to industry insiders, the warrants of non-ferrous metals can be used as collateral for financing in many cases due to the inherent advantages of their commodity characteristics. It is introduced that the zinc warrant pledge business of some banks requires enterprises to establish corresponding futures positions to hedge the risk of price fluctuations while leaving the warrants with the banks as a pledge, so that the banks can provide the enterprises with funds based on a 90% loan-to-value ratio, thus reducing the financial pressure of the enterprises in operation.