A recycler buying metal today may hold, process, ship, and eventually sell that material weeks or months later. During that period, the market price can move significantly. The margin that looked profitable when the material entered the yard can shrink or disappear altogether before the transaction is complete.

Hedging, in the form of derivatives — in this case futures contracts — is designed to protect against that risk. This form of risk management allows recyclers and buyers to lock in the price of a trade in advance of the physical transaction, protecting both parties against commodity price volatility.

"The physical transaction takes place whenever they want it to," says Harsha Ramesh, CEO of Pillar, a risk management platform for commodity and currency markets. "Recyclers continue business as usual. This is almost a form of insuring themselves from negative margins on their trades."

Hedging doesn't change how a recycler buys or sells physical material.

"You can essentially [have] your physical operation run the same way it always has," adds Daniel Freedland, COO of Pillar. "Meanwhile, the risk that you would normally take if copper price goes up or down 10 percent has been transferred off to somebody else in the financial market." The party taking the other side of that transaction could be an investor, a bank, a manufacturer, or any other participant in the financial market.

Protecting profit margins through commodity hedging

Consider a simplified aluminum transaction. A recycler purchases material for 65 percent of the current London Metal Exchange (LME) price and expects to sell it two months later for 75 percent of the LME price. Using simplified figures to make the math clear, Freedland puts the current LME aluminum price at $4,000. At 65 percent, the recycler pays $2,600.

On paper, buying at 65 percent and selling at 75 percent appears to create a healthy spread.

But the two percentages are being applied to the market price at different times. If aluminum falls to $3,000 by the time the material is sold, 75 percent of that price is only $2,250. Despite selling at a higher percentage of LME than they paid, the recycler has lost $350 on the metal.

"When you're not hedged, that's a very real risk," Freedland says.

The reverse is also true. If the market price rises, the recycler may gain on the value of the physical material while losing on the corresponding financial hedge. The objective is not to profit from either direction of the market, but to reduce the effect of those price movements on the margin established through the physical trade.

This gets to a common misconception about hedging: because it involves futures markets, hedging can look like another form of betting on commodity prices. Ramesh argues that the objective is precisely the opposite.

"If you're dealing in that unhedged example and just holding the material, hoping that the market rises or stays the same, that's the express definition of gambling, is it not?" he says.

Hedging attempts to remove that gamble. The goal is not to make additional money by correctly predicting where copper or aluminum will go. It is to protect the economics of the underlying physical business.

According to Ramesh, companies hedge "to control what they can control and make sure that they are making money from their consistent business model as opposed to getting lucky with where copper prices are heading."

Is hedging right for your recycling operation?

Not every recycler currently manages commodity exposure this way. Ramesh says hedging has traditionally been more common among larger organizations and trading companies, while many recyclers have relied on the margins within their physical business to absorb price movement. He says that equation is becoming more difficult as trading margins tighten while commodity markets remain volatile.

"In the past, let's say people were making a healthy 10, 15 percent margin and the volatility on average of the material was 5 percent," Ramesh says, using hypothetical figures. "A lot of people were like, ‘I don't need to hedge. It seems complicated. In the end, this will net out with me making money.'"

The trend, he says, has moved in the opposite direction, leaving less room within the physical margins to absorb larger market swings as competition tightens margins and geopolitical and economic uncertainty drives volatility.

Against that backdrop, Pillar has seen growing interest from metal trading companies as well as recycling yards with brokerage operations. Ramesh says Pillar sees more interest in hedging copper and aluminum than ferrous scrap, which tends to be less volatile and more commonly traded through fixed-price purchases and sales.

That history has also contributed to the perception that, as Freedland puts it, "Hedging is just for the big guys."

"If you've got any copper in your yard, any aluminum in your yard, then you have something that you can hedge," he says.

That does not necessarily mean every recycler has the same need to hedge. A company that consistently buys and sells on a fixed-price basis may be a less obvious candidate. Formula pricing tied to an exchange such as the LME or COMEX (a U.S.-based metals futures exchange) creates a clearer exposure because the eventual purchase or sale price moves with the market.

The length of time between buying and selling material also affects the potential exposure to price movements. Freedland says, "If you're holding material for more like a month, two months, maybe between when you're fixing your price and actually able to sell it, then you become a really, really great candidate for it."

Commodity type matters, too. Copper, aluminum, nickel, lead, and steel vary in volatility, so the risk associated with holding each material differs.

How much of that exposure a company chooses to hedge also depends on its business model, margins, pricing power, and risk tolerance. Ramesh says businesses operating on particularly thin margins may have less capacity to absorb commodity price swings.

Why commodity hedging is complicated in practice

If the objective is simply to offset commodity price risk, why isn't hedging routine for every recycler carrying that risk? Complexity is one reason.

A recycler may be managing numerous purchases and sales at different weights, prices, dates, and pricing formulas. The challenge is that the hedge has to keep pace with changes on the physical side of the business, from final weights and shipment timing to purchases and sales.

Traditional tools can be surprisingly basic.

"If you asked who our biggest competitors are on the how-you-should-hedge side, it's a whiteboard, a piece of paper, or an Excel spreadsheet," Freedland says. "At the end of the day, as scary as hedging can seem, as . . . esoteric as it feels, it's math."

The math becomes harder to manage when a metal trader is making 30 or 40 transactions a day, with material simultaneously on its way in, sitting in inventory, and shipping out to customers.

Freedland says experienced hedgers have shared stories with Pillar about what he calls the spreadsheet from hell: dozens of tabs attempting to reconcile physical transactions with their corresponding hedges. That gap between a relatively straightforward risk-management concept and the complexity of executing it is where Pillar sees its opportunity.

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