Economics & Finance,Globalisation

The story of failed hedging in the nickel crisis

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Nickel crisis nearly caused the London Metal Exchange and its members to collapse. An expert at CUHK Business School unveils how failure to recognise a thin line between hedging and speculation contributed to the catastrophe

The reopening of the global economy has seen strong commitments from countries around the world to achieve net-zero emissions by adopting electric vehicles to replace traditional diesel ones. As a result, the demand has turned nickel, one of the main ingredients in rechargeable batteries and stainless steel, into the most sought-after material.

However, nickel almost brought down the London Metal Exchange (LME), the world’s largest and oldest trading venue for industrial metals, two years ago. Over the course of three days, the nickel price traded on the bourse surged by more than 270 per cent from US$27,080 per tonne to more than US$100,000 on 8 March 2022 before falling to around US$80,000 per tonne.

nickel crisis

The LME took action by suspending the trading and returning the price to the previous date, cancelling billions of US$ in transactions. The 147-year-old bourse saw it necessary to prevent a “death spiral” that could have led itself and its members to collapse. One of the members, a Chinese company and world leader in nickel production, Tsingshan, was saved from the verge of losing US$8 billion.

“The trigger point for this sudden price surge was the Russian invasion of Ukraine, which started on 24 February 2022,” says Dr Anson Au Yeung, Senior Lecturer in Finance at The Chinese University of Hong Kong (CUHK) Business School. “Market participants expected a sanction on Russia, which produced around 17 per cent of the global supply of nickel.”

In a masterclass on “Risk Management Strategies in Financial Derivatives: Hedging vs Speculation?” in January 2024, Dr Au Yeung delved into the complexities of the incident and how Tsingshan could have avoided the predicament.

Series of unfortunate events

As a major producer, Tsingshan’s profit and loss are highly affected by nickel prices. To protect itself against price fluctuations, the nickel producer sells a financial instrument called futures, which is a contract to buy or sell a particular commodity asset at a predetermined price at a specified time in the future.

With this contract, the company can protect itself against price drops by entering into short positions in futures, which means it locks today’s price to be sold in the future. If the company expects rising prices, it can enter long positions by locking in a future purchase price. This strategy to limit risks in financial assets is called hedging, and Tsingshan has built up a massive short position since 2021.

Dr Anson Au Yeung
Dr Anson Au Yeung shares his insights during the master class.

“Hedging is not simple,” says Dr Au Yeung. “We need to question whether Tsingshan is actually doing hedging or speculation.”

Before the fiasco, Tsingshan had accumulated a short position of 300,000 tonnes in early March 2022. Although the company produced around 600,000 tonnes of nickel annually, around 120,000 tonnes of these total productions were nickel matte, which only has 70 per cent purity, well below the LME’s strict requirement of a minimum of 99.8 per cent purity.

This indicated that the company hedged the high-purity nickel with low-class nickel. In the good days, the prices of both nickels were highly correlated, but the company didn’t expect the prices would deviate greatly during the crisis.

“A perfect hedge is not possible. The cross hedging replaces commodity price risk with basis risk,” says Dr Au Yeung. “Using the LME nickel to hedge lower-class nickel would also introduce an additional risk called short-term basis risk, and this risk should not be overlooked as it can be very huge.”

Basis risk is the potential risk that arises from mismatches in a hedged position. “The spread between high-quality and low-quality nickel widened to 8 to 12 per cent due to sanctions against Russia.”

Weighing the escape routes

Dr Au Yeung argues, Tsingshan could have considered three scenarios to deal with this short-squeeze situation before the LME intervened. The first one was retaining the short position, which mainly hoped the price would go down. The second one was to surrender and accept the loss. The third one was buying nickel from the market.

Hoping the price to go down would require Tsingshan to continue satisfying the margin call, prompting it to settle initial and variation margins. When the value of an account drops below the maintenance level, a margin call is triggered to require the account holder adding funds to bring the account back to the initial margin, which is the amount of money needed to initiate a futures contract.

If a company doesn’t have good risk management practices, even though it makes a significant profit, it can lose all of the money very easily

Dr Anson Au Yeung

On 4 March 2022, the LME increased the initial margin requirement by 12.5 per cent, which would require Tsingshan to deposit US$7.5 million. It also required the company to deposit an extra US$6.35 billion on 7 March, based on the variation margin derived from the difference between the closing price on both days, multiplied by 300,000 tonnes.

If surrendered, at the US$80,000 per tonne level on 8 March, Tsingshan would expect to lose US$18 billion. The last option, buying nickels from the market, mainly from Russia, was impossible due to the sanctions announced in February.

nickel crisis

“The futures contract has a zero-sum game principle, which means when the seller loses, the buyer wins, and vice versa,” says Dr Au Yeung. “So, why did the nickel buyers were willing to take the opposite position? Because they did see one weakest point, Tsingshan’s liquidity management.”

Small mistakes, huge consequences

In early March 2022, the LME’s nickel inventory only had 76,800 tonnes ready for physical delivery. Meanwhile, the total outstanding contract or average open interest in the contract reached 1,158,000 tonnes.

“This means the counterparty already foresaw Tsingshan would not be able to get the physical nickel in the freight because there was not enough nickel in the market, and it takes time to source and refine the nickel,” says Dr Au Yeung.

Tsingshan management also underestimated the market volatility of nickel. Looking at the standard deviation, the magnitude of the maximum daily three-month price growth and the number of times daily three-month price moves, nickel price is more volatile than other metals like lead, zinc, copper and aluminium.

“The buyers saw a low nickel inventory and it triggered the market speculation,” he says. “The imbalance between the market expectation and the physical supply increased the price volatility and risk.”

Hedging through the futures contract met the margin calls requirement. However, when the market suddenly becomes so volatile, it would cause a huge cash flow impact.


When wealth grows on inventories

“When making any risk management or financial decisions, the management needs to have an accurate estimate of the worst-case scenario,” Dr Au Yeung says. “In this case, Tsingshan did not fully estimate the worst case.”

Finally, he highlights that having good investment decisions and financing strategies is not enough. “If a company doesn’t have good risk management practices, even though it makes a significant profit, it can lose all of the money very easily.”