Energy storage players might consider the benefits of financial derivatives

Risk management is an investment choice. It’s up to the investors to determine the volatility of their company’s profits. Steady positive returns are attractive to some, but others might prefer chunky periods of profitability where the risks provide outsized rewards.

Companies that practice risk management techniques in the volatile battery raw material (BRM) space will likely benefit from consistent investment flows. Volatile profits driven by fluctuating commodity prices can yield hefty rewards as well as unattractive losses. While there may be varying perspectives, it’s crucial for companies to effectively communicate their hedging rationale and strategies to align with investor expectations.

BRM volatility

The price of lithium, a key component in energy storage technologies like batteries, can be highly volatile due to various factors such as supply-demand imbalances, changes in production capacity and geopolitical events. Financial derivatives, such as futures or options contracts, can provide a mechanism to mitigate price risk and stabilize costs.

To put the price volatility in perspective, the historical annualized monthly average volatility of the Fastmarkets lithium hydroxide (LiOH) index was 41% in January 2024 and monthly historical volatility has been above 40% for the prior nine months.

These statistics equate to a monthly average change of approximately 12% per month, which might go directly to a firm’s bottom line. Persistent and large double-digit profit swings can raise concerns about a company’s ability to withstand economic downturns.

Managing financial expectations

Energy storage players often require a consistent and predictable cost structure to manage their budgets and plan for future projects effectively. By hedging lithium prices with financial derivatives, energy storage system (ESS) companies can lock in a predetermined price for future purchases, ensuring stability and reducing uncertainty.

Energy storage projects, particularly those that require funding, may involve providing a hedging program to insulate a lender from changing prices. Hedging with derivatives can protect against potential price increases during the contract period, giving assurance and reducing the risk of unexpected cost escalations.

By hedging lithium prices, energy storage players can gain a competitive advantage by securing a stable cost structure. This situation allows ESS companies to offer more competitive pricing to customers or improve profit margins in a market where lithium prices exhibit significant volatility.

How can ESS players manage risk? 

The key to managing commodity price risk is understanding your exposure and having a physical benchmark for procurement and an index for derivatives trading.

For example, an ESS company might purchase batteries that are based on the prior month’s average of a physical benchmark such as the Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price cif China, Japan & Korea, $/kg.

A significant benefit of using a physical benchmark is that it is also a financial benchmark used to settle several exchange-traded and over-the-counter (OTC) derivatives.

Exchanges that use the Fastmarkets lithium hydroxide index include the Chicago Mercantile Exchange (CME), the London Metals Exchange (LME), and the Singapore Commodities Exchange (SGX). Additionally, several swap dealers in financial institutions use the Fastmarkets lithium hydroxide index to settle OTC swaps and options.

The transformation of a physical benchmark

Physical commodity benchmarks are vital in bringing transparency to opaque commodity markets by providing standardized price references for the underlying commodities. Physical benchmarks are the linchpin in generating a robust commodity futures market, which can provide the liquidity needed to change an opaque market into a transparent market.

The transparency journey relies on the market participants to broaden benchmark acceptance. Derivative markets are critical in enhancing physical commodity benchmarks.

As markets develop, moving from bilateral agreements to those transacted based on a price index, futures contracts, and OTC agreements generate a globally acceptable benchmark that can be used to set physical contracts for commodity producers and consumers.

What is a price benchmark?

Benchmarks serve as a reference point for price discovery. As a benchmark becomes more acceptable, it attracts market participants and fosters liquidity, providing a common basis for trade execution. Increased liquidity enhances market depth, reduces bid-ask spreads and improves price stability.

What is a futures contract?

A futures contract is a financial agreement or contract between two parties to buy or sell an asset at a predetermined price and date in the future. This type of contract is commonly used for commodity hedging or speculation on the underlying asset’s future price movement.

A futures market is a marketplace where standardized contracts for future delivery of a commodity are bought and sold. These contracts typically have specific terms, including settlement dates, quantities, and quality specifications. Participants in the futures market use these contracts to hedge price risk.

What is an OTC commodity derivative?

An OTC commodity derivative is a financial contract that derives its value from an underlying commodity. Unlike exchange-traded derivatives that are standardized and transacted on organized exchanges, OTC derivatives are privately negotiated contracts between two parties.

In the context of commodities, an OTC derivative allows participants to hedge against price fluctuations or speculate on the future price movements of various commodities. These derivatives can take multiple forms, including swaps, options and forwards.

The main characteristic of OTC commodity derivatives is that they are customized to meet the specific needs and requirements of the parties involved. For example, market makers often quote average quarterly or average annual swaps. 

What is a cash-settled derivative?

The futures and swaps that are traded outside of China are cash-settled. The benefit of cash-scheduled futures and OTC derivatives is that the buyer and seller do not have to handle the issues and costs related to physical delivery. Participants are only responsible for the difference between where they buy and sell an index, or the entry price of a transaction on an index, and the settlement price of the index.

A cash-settled futures contract is where the settlement is performed in cash rather than through physical delivery of the underlying asset, with a settlement based on the average of an index over a specific period.

A physical benchmark index is a reference point representing a particular commodity’s price in the physical market. It is often used as a benchmark for pricing other transactions or settling contracts in the industry. Robust futures markets can contribute significantly to the establishment of these benchmarks.

The appeal of financial derivatives

As a benchmark gains acceptance, a broadening of trade begins within the financial markets. Financial derivatives are appealing to trade for several reasons.

Derivatives allow traders to control a more extensive exposure to the underlying asset with a smaller upfront investment. This leverage amplifies potential gains or losses by mitigating the capital required to control a specific commodity volume. This scenario can offer higher returns than physical commodity trading.

A mature derivatives market tends to be more liquid than physical commodity markets, meaning a higher notional value of trading activity exists. This liquidity makes entering and exiting positions easier, facilitating efficient price discovery and providing a broader range of trading opportunities.

The derivatives market offers greater flexibility for speculation and hedging purposes. Traders can speculate on price movements without owning the physical asset, allowing them to take positions regardless of the availability or storage of the underlying commodity. Additionally, derivatives enable market participants to hedge against price risks by establishing offsetting positions to protect against adverse price movements.

Trading derivatives often involves lower transaction costs than physical commodity trading. Derivatives are typically traded on electronic platforms. Additionally, the standardized nature of many derivatives contracts streamlines trading processes and lowers transactional expenses.

The acceptance of a physical benchmark initially relies on physical players. Still, as the market grows and financial players agree to broaden liquidity, the derivatives market begins to drive volumes.

The bottom line

The upshot is that ESS concerns will likely need to incorporate risk management into their budgeting framework to successfully negate the volatility experienced when using lithium batteries to store power.

Current historical volatility levels equate to a monthly average change of approximately 12%. In any instances, this type of movement would filter into the bottom line, creating potential problems for those lending to ESS concerns. By hedging their exposure, an ESS company can reduce this impact on their EBITA and provide stable cash flow that reduces their bottom line volatility.

The best way to coordinate your commodity hedging is to use a futures contract that mimics the commodity index that you use for your physical procurement. For example, the Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price cif China, Japan & Korea, $/kg, is used by futures exchanges, OTC derivative transaction and physical procurement. You can learn more about ESS risk management using BRM derivatives by contacting our risk solutions team.

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