Updated: Jul 7, 2025
When minor indexation features can derail hedging plans
We have seen in the previous episode that indexation clauses should, as much as possible, refer to hedgeable indices. This at least makes hedging a real possibility, whether this risk is ultimately covered or not. But even so, some features embedded in the indexation mechanism can complicate the whole hedging exercise: this week’s episode is about some of them.
Rooted to the spot
On some commodities, markets trade based on the monthly average of the underlying index: this is the case for example for Platts Gasoil indices. If, on the other side, the indexation clause uses a spot value (observed on a single date) to adjust the contract’s price, there will be a mismatch between the company’s underlying risk and the available market instrument.
Getting a hedge provider to quote for the perfect, single-observation hedging instrument will also be tricky (and/or costly). In such a situation and before contemplating any hedging transaction, the company will need to make its own assessment for the value of the basis risk between European style (single look) and Asian (average) observations.
Schrödinger’s index
Some contracts include indexed pricing but leave the door open for the counterpart to choose the actual index to be used (within a given list). For example, an offtake agreement can provide that the oil being produced will be purchased using the price of the Brent (North Sea) benchmark or using the Dubai benchmark instead, as published by Platts.
This flexibility can be presented as a way to ensure a robust process (in case an index is temporarily unavailable for instance) or to compensate for uncertainties (as the counterpart might not know in advance where the commodity will be sourced from/sold to), but in practice the choice will be automatic based on what is the most beneficial financially for the counterpart, not based on their operational constraints.
This option cannot be hedged and should definitely not come for free: to assess this value, the company should have a clear understanding of how the various indices in the list evolve in relation to one another.
Striking issues
Some indexation clauses provide for a small buffer before escalation kicks in. For example, such a mechanism makes it possible to account for a ‘natural’ 2% annual inflation rate: below this value, the contract’s price will remain unchanged.
These are all valuable clauses obviously, but they can also complicate hedging: the company’s underlying risk is now asymmetric and tilted to the upside. Noticeably, the company will not profit from decreasing prices and trading a standard hedge would mitigate the upside risk but at the same time create an unwelcome downside risk exposure.
The natural hedging instrument for such a situation is a call (or cap) option, protecting the company from prices increasing above the buffer (the strike of the option). Unfortunately, these instruments are more complex than simple futures and may not always be traded (this is the case for Argus HRC steel for example). And when a market exists for such options (on LME copper for instance), they are notoriously expensive – even more so as their underlying index is volatile (and remember we’re looking at commodities here where price swings can be significant).
In the end, the value of such a buffer on the upside should be appreciated against the giveaway on the downside, and the additional challenges this buffer poses to securing the commodity price with a cheap hedging instrument.
Alien currency
Consider a contract with prices in EUR and an indexation clause linked to a USD-denominated underlying commodity (LME copper for instance): how would the indexation handle the currency conversion?
Let’s take an example and imagine that copper prices are initially at 10,000 USD/ton with EURUSD at 1.10 (effectively 9,091 EUR/ton for copper in EUR).
Copper prices then move to 9,500 USD/ton (5% decrease) while EUR depreciates to 1.00 which gives a price in EUR of 9,500 EUR/ton (4.5% increase). Should the contract payment follow the price in EUR and therefore see an increase of 4.5% (we call it a compo conversion) or should it look at the commodity in its natural currency and therefore have a cut of 5% instead (quanto conversion)?
Choosing how the indexation handles currency conversion will impact the ability to find a corresponding hedge: using a compo conversion is easily managed by the hedging provider and is thus standard but conversely, using quanto conversion creates covariance risk for the potential hedging trader – who may therefore be unwilling to offer such a product at low cost (if at all).
ESTER is there to help you manage the commodity risk embedded in these tricky indexation clauses:
in-depth analysis of your contract to determine the most prominent exposures
derivatives market expertise to identify problematic features and potential replacements or proxies
precise quantification of the basis risks to make informed decisions.
