Nickel prices shot up like crazy in a matter of days in the global markets. It created a firestorm of panic and margin calls which we have not seen before. This is an interesting and developing story that has many different levels and implications.
Some background first. Nickel prices had been climbing up to all-time highs of $25k recently. The global supply chain had been slowly trying to unblock itself after 2 years of Covid lockdowns and disruptions. Raw material prices have been rising.
Nickel is mainly used as an ingredient for producing stainless steel. But the upcoming importance of EV cars means that the demand for their lithium-ion batteries will also require more of it as a component.
The Ukraine situation with the invading Russian forces pretty much created a super short squeeze in the futures markets. Nickel surged to 100k, a 4x increase within a day of trading. This had created a huge overnight margin call situation as positions are MTM (Marked to Market) on a daily basis.
Russia is one of the top countries that supply Nickel. As the world implements sanctions on the country for the invasion of Ukraine, almost 20% of the global supply vanished overnight. Nothing can move in or out of Russia as long as the restrictions are in place.
The LME had to suspend trading on Tues and even started to cancel some trades in order to try to stabilize the situation. This was an unprecedented move that could have long term repercussions on how commodity futures will be traded in the long run. The futures exchange remains closed for the rest of the week as financial institutions try to sort out the mess and address the overdue margin calls that can go into the hundreds of millions.
Who are the players that are caught on the wrong side of the trade and why do they have large short futures positions? Surprisingly, they are the major Nickel producers of the world. The futures market acts as an efficient hedging tool for miners as it helps them to navigate volatile price swings. It provides an ability to better forecast and financially plan production schedules.
By selling the contracts regularly, they offset against the nickel that they will mine from the earth. This helps them to calculate a good estimate of production cost. For example, they may sell a June futures contract for delivery for that month and eventually sell the physical mineral in June to a buyer. This forward selling effectively helps them to hedge their risk exposure from now to that month.
While this sounds all good and logical on paper, there is a basic timing risk that the producers have to bear. In the futures exchange, one has to place funds upfront as collateral before one can take a position. The required margins are different for various types of contracts and there is a maintenance margin process that has to be followed strictly.
Future exchanges follow a MTM (Mark to Market) procedure where the daily closing price of the instrument is used to calculate against all outstanding positions of its members. If the difference is a loss, they will have to provide additional funds to cover the margin shortfall. If it is a profit, they can withdraw the excess funds accordingly. This usually has to be done by the next day in order for its members to maintain the integrity of the exchange and protect it from unnecessary risk. All members effectively guarantee that the exchange will not fail.
In the Nickel situation this week, the margin calls posted were too large that financial institutions had to scramble for funds. Their end clients may also not be able to have that much liquid funds to post in time. Some had asked LME for more time given the extraordinary intraday price action.
If the exchange declares a default, this may trigger a chain reaction where the banks can foreclose the client’s positions. In normal times, this may be an acceptable action plan. But in this case, there was a large China mining company plus many others having these short futures positions.
This could trigger off a domino effect that can immediately bankrupt many healthy mining companies. This in turn will also cause future physical deliveries to fail. Prices will then likely shoot higher and it will snowball into a total shitshow. Hence LME had to take the unprecedented step to give the banks more time to top up margins and even allow the unwinding of some of the positions.
This episode also reminded me of the oil hedging strategy of Singapore Airlines that resulted in more than a billion-dollar of losses during Covid. As a prudent strategy, they had a plan to buy oil futures to hedge against their jet fuel requirements. Using financial forecasting, they will project outwards to 12, 18 or even 24 months to map out their likely jet fuel requirements. They would then use futures to buy a strip of contracts for around 25 to 50% of their forecasted needs on a periodic basis.
Because of Covid, their financial forecast planning went terribly wrong. Demand for flights went to almost zero as countries lockdown to stop the virus. All of SQ’s partial hedges became meaningless as there is no need for them anymore. The futures contracts became outright speculative bets on rising oil prices.
But demand for oil during Covid had also dropped like a brick too. It even dropped to negative at one time! This double whammy of being caught with their pants down and having lower oil prices resulted in big MTM losses for their long positions.
It was also compounded by the fact that the exposures were hedged out to many months into the future which became large periodic negative outflows that suck out precious liquidity/capital. They had to raise billions of bonds just to stay afloat. Besides revenue falling off a cliff, this hedging strategy also ate a large chunk of it too.
The Ukraine situation is almost 3 weeks now and everyone seems to expect it to get worse. Putin doesn’t seem to want to stop until the country surrenders. The Ukrainian people vowed to have a bitter fight till the end to defend their country. Do we see a stalemate with more bloodshed coming?
Talks are getting nowhere and the longer this drags out, the more fatalities and destruction will happen. Let’s hope that sensibility will eventually prevail and that everyone can de-escalate the violence in this no-win war.
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