The price of many commodities, from oil and nickel to sugar and corn, has in the past year reached long-term highs. The question is: will they rise further, or has the push run out of steam? The answer is important because the cost of a commodity to be delivered today has a strong influence on the price of the same item to be delivered in several months or years. These future prices are of more concern to corporate treasurers, who often make decisions based on prices that are six, 12 or even 18 months in the future. For example, take Rexam, the UK-based packaging company. More than a third of operating costs – £1.2bn – were accounted for by the cost of aluminium, which it uses for making drinks cans. So buying the metal at a good price is very important to Rexam. Last year, the average aluminium price rose 40 per cent, which contributed to the 18 per cent rise in group operating costs last year. Aluminium prices now stand at less than 85 per cent of their 18-year peak reached in May. Rexam has taken the view that the metal price will be lower this year than last. It has decided it needs to have 50 per cent of its 2007 aluminium needs hedged. “We are less hedged than we have been in the past,” said Leslie Van de Walle, Rexam chief executive last week when the packaging group reported its 2006 year earnings. “Currently we are expecting a reduction in metal spot prices as we progress through 2007,” he said. Getting it wrong could be costly. George Stinnes, group treasurer at British Airways, says the airline needs to pay less for oil for delivery today – known as the spot price – than for the same product to be delivered in the future. This is because oil markets are factoring in a tight balance between supply and demand over the next five years.. “When you are locking in prices for delivery in 12 months time that are already $4 or $5 above the spot price, it can be a bit nerve-racking,” says Mr Stinnes. When commodity markets show futures prices above the spot price this is known as contango. The reverse scenario is known as backwardation. Contango is normal for a perishable commodity that has a cost of carry, so grains such as corn and wheat, and sugar, are often in contango. This means food companies often face the same issue as airlines, transport companies or refiners and other big consumers of oil. Since early 2005, the crude oil market has been in “contango”, meaning futures contracts for a given product are priced higher than that same item for near-term delivery. This change in the market has prompted airlines to change their hedging strategy. Basically, nowadays a barrel today is cheaper than a barrel in the future. This has not always been the case. Mr Stinnes says that, traditionally, the majority of hedging transactions were swaps, which locked in lower future oil prices. But airlines have adjusted their strategy now that the simple strategy of saving on today’s price by purchasing oil for future delivery has disappeared. He says one method is to set a price with a floor and a ceiling by using a collar hedge, a feature not offered in a swap which is a fixed agreement. However, collars and swaps are not the only prongs to an airline hedging strategy. The relationship in prices between oil, jet fuel and gasoil, is also important. Airlines may have to look at carbon emission permits, a market expected to widen and deepen over the coming years as more countries look to develop their own trading schemes. This in turn will bring more liquidity into the market as most big industrial companies emit enough carbon to qualify them for the scheme. “The emissions market is a growth area, as more industry needs to either buy or sell carbon permits,” says Edouard Neviaski, head of commodities trading at Société Générale. He says the emissions market is opening up around the world, which provides industrial companies with more choices on how they can either buy or sell permits. When industrial consumers implement hedging programmes, the counterparty is often the investment bank, which will net the risk off in the futures market, or place some of the risk with producers, who naturally seek the opposite position to consumers. However, banks are also seeing increasing business from producers looking to lock in forward sale prices. Mr Neviaski says banks also take on risk from the hedging associated with project finance, or through takeovers when one resource company takes over another and needs to lock in income by using forward sales contracts or futures contracts. He says this provides more liquidity to the market and also opens options for industrial consumers. This is an extract from the Financial Times