Copper marketing with forward and futures contracts: state-owned and private Chilean firms during the 1990s

Resources Policy 27 (2001) 261–272 www.elsevier.com/locate/resourpol

Copper marketing with forward and futures contracts: state-owned and private Chilean firms during the 1990s N. Altamirano ∗ Master’s Program of Area Studies, University of Tsukuba, 1-1-1 Tennodai, Tsukuba-shi, Ibaraki-ken 305-8572 Japan Received 8 April 2001; received in revised form 25 June 2002; accepted 31 July 2002

Abstract The use of futures in copper marketing became common during the 1990s, but little attention has been put on the reasons for it and its relationship with other elements of marketing such as forward sales and premiums. This study focuses on these issues and the benefit of futures relative to annual forward contracts. It argues futures complement annual forward contracts to secure the average market price rather than to maximize revenue. The paper analyzes empirical evidence for the six largest Chilean copper producers. This sample reflects well the entire Chilean industry during the 1990s. The analysis shows that forward sales became more volatile and futures seem to be the instrument to avoid income fluctuation at the end of the marketing process. However, the benefits of futures compared to forward sales are very modest. In the last section we suggest a better marketing instrument to maximize revenue may be premiums.  2002 Elsevier Science Ltd. All rights reserved. Keywords: Chilean copper firms; Copper marketing; Forward and futures contracts; State-owned firms; Codelco

Introduction An important change in copper marketing during the 1990s was the increase in futures transactions, brought to general attention after the world’s largest trader, Sumitomo, and the world’s largest producer, Codelco, declared loses in 1995 and 1994, respectively (Hussey and Quiroz, 1997; Guerrini, 1995; Kuwayama, 1994). Most attention has been put on the risks of futures and the nature of futures losses. However, little attention has been dedicated to understanding how futures connect to the entire marketing strategies of large copper producers. Why did copper firms need futures in the 1990s? Do futures minimize income fluctuation? Do state-owned and private producers use futures differently? Do futures increase the level of revenues significantly compared to traditional methods of trading? This paper argues that firms use futures to modify the price arranged in annual forward contracts in order to

Tel. +81-298-53-6842; fax: +81-298-53-6862. E-mail address: [email protected] Altamirano). ∗

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get at least the average market price of the year. Firms willing to accept high levels of risk would use futures to beat the market. However, because there is evidence that Codelco, the largest world producer, used futures to get the average market price during most of the 1990s, the paper evaluates the benefits of having such a conservative policy (Codelco, 1991). To unveil the reasons for using futures during the 1990s and find the relationship between forward and futures contracts, we study the main center of the world copper industry, Chile. First, we focus on the industry characteristics of the Chilean copper expansion, and secondly on the marketing behavior of individual firms. Aggregate data show that increased volatility of physical exports may have been a strong reason to intensify the use of futures during the 1990s, particularly after 1995. This result is confirmed at the level of individual firms. Individual data are also used to find that marketing practices are better captured if firms are split between refined and refined-concentrates producers rather than private and state-owned. Refined firms allocate physical exports differently from the other group, and the benefits from using futures against forward sales for both groups are not more, it is less than 0.4%.

0301-4207/02/$ - see front matter.  2002 Elsevier Science Ltd. All rights reserved. PII: S 0 3 0 1 - 4 2 0 7 ( 0 2 ) 0 0 0 1 1 - 9

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This paper contains five sections. A literature review and industry background is followed by an introduction to assumptions, methodology and data. The empirical results are presented in two parts: aggregate results and their implications for marketing, and individual results to evaluate the benefits of futures compared to forward sales. The last section includes conclusions and final comments about the results.

Literature review and background Futures transactions and big losses are not new in the copper industry. There are references to it since 1889 (Gibson, 1983). Thus, Sumitomo’s loss of $1.2 billion in 1995 and Codelco’s loss of $210 million in 1994 are just the most recent ones.1 However, it is in the 1990s that large copper firms got more involved in the London Metal Exchange (LME) than in previous decades (Marshall et al., 1993; Noemi Callejas, 1991b). Suffice it to say the number of registered brand names at the LME increased from 30 in 1990 to 63 in 1999. New brands came from developed and developing countries, as well as from private and state-owned firms. In particular, registered Chilean brands increased from four in 1990 to 12 in 1999. The Chilean state-owned firm and world’s largest producer, Codelco, had five registered brands by 1999 (Guerrini, 1995; www.lme.co.uk). Firms get involved in futures to hedge or speculate in the market, and all big losses are related to the risks involved in these transactions. Because of the nature of their business, producers and semi-fabricators use futures to hedge the market against undesirable price fluctuations. For instance, in October 1988 Codelco expected prices to go down below the costs of Andina, one of its high cost divisions. Thus, Codelco used futures to secure a price not lower than US$1 per pound and not higher than US$1.8 per pound for the entire Andina’s 1999 output (Guerrini, 1995). Similarly, semi-fabricators use futures to hedge against downward price fluctuations that could occur while they transform pure copper into industrial applications. While hedging reduces the risk against price fluctuations, speculating transactions take that risk in order to increase revenue. A semi-fabricator that receives its copper today and expects the price of copper to go down in 3 months, could sell its copper today and use futures to

1 The instances of big losses in copper futures markets include the Secretan Syndicate (1887–1889), Amalgamated Copper Company (1899–1902), Copper Exporters Incorporated (1926–1929), International Copper Carter (1935–1937), RST Group (1955–1956), Governmental Agreement between Chile and African Countries (1961 and 1966), and CIPEC (1967–1997). For a detailed explanation of these cases refer Gibson (1983). For Codelco’s case refer Guerrini (1995).

re-buy copper after 3 months. Notice that we assume the semi-fabricator sells and buys the same copper. The LME copper futures market ensures the quality of all 63 brands cathode A registered in 1999 were exactly 99.99% of pure copper, and it offered the buyer to receive any of these 63 brands. However, for some semifabricators this openness may be a risk they do not want to take. Selling 25 ton of AE SX-EW (one of the latest Codelco’s brands) and buying 25 ton of REC (ZCCM Zambian brand) may not be equivalent if, for instance, the semi-fabricator of high-speed cable communication has already perfected its technology to the specifics of the first brand.2 For these reasons speculating is more fitted to traders than producers or semi-fabricators, but the 1990s witnessed the involvement of producers in these practices too. How producers use futures depends on the level of risk they want to bear. Firms that maximize revenue and want to bear high risk may combine spot and futures sales. Hussey and Quiroz (1997) developed a model where a firm allocates its sales between spot and futures every month to maximize revenue. Using Codelco’s data from 1982 to 1995, the model finds that Codelco could get between 0.2 and 0.5% more revenue in the long run than solely using spot sales. Contrary to this extremely small gain, the model predicts large single losses in the short run. The highest monthly loss could result in a revenue as low as 73% of regular spot sales (Hussey and Quiroz, 1997, pp. 75–79). If we accept these results, why would any firm bear high short-term risks given the longterm benefits are so small? Why do copper firms use futures at all? Maximization models, like the one presented before, cannot answer these intuitive questions for maximization itself contradicts real firm behavior. In particular, there is no year from 1982 to 1995 that Codelco could maximize revenue as Hussey and Quiroz’s model suggests because there was no futures division before 1988 and, from then on, its logic was to ensure the average price of the market (Guerrini, 1995; Codelco, 2000). This objective remained for most of the 1990s. This conservative policy was compatible with Codelco’s high aversion to big losses, and also with the interests of the military and the government to increase revenue (Altamirano, 2000). Speculative actions based on maximization of revenue, as Hussey and Quiroz impose, were only allowed from 1992 to 1994. Also, even for those years the futures division was never allowed to commit all Codelco’s sales to speculation (Guerrini, 1995). To build a more realistic scenario we should consider futures transactions within the entire marketing strategy 2 Physical characteristics are important for copper products like electrical wire used in the communication industry, radiators and car parts in the automotive industry, and for special applications in the computer industry (Tilton and Landsberg, 1999).

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of large copper producers. Under this perspective, marketing or selling copper involves three complementary steps: annual forward contracts; futures contracts; and price premia. Copper producers have sold their physical output to semi-fabricators through annual forward contracts since the 1950s. Every year, during the Fall, there is a sales campaign where firms renew and sign contracts. It is common that producers allocate more than 90% of their next year output by December. These contracts specify quantity and quality precisely, distributing the total tonnage in monthly deliveries. Contractual prices are determined by a formula that relates to the spot market price of the LME.3 For the case of refined copper, for instance, the contractual price is usually the average price of the month of shipment (Felgran, 1982; Guerrini, 1995; Baeza et al., 1975). Therefore, contracts totally determine quantity and quality of copper, and leave the price open to the fluctuations of the LME. Contractual parties use futures to modify the price of their annual forward contracts without changing dates or quantities of physical deliveries. In this sense, futures complement annual forward contracts to accommodate the divergent interests on prices that copper producers and their semi-fabricator clients could have (Gibson, 1983; Guerrini, 1995).4 For this reason, buying and selling in the futures markets rarely results in physical transactions of copper. The transactions of physical copper in the LME and COMEX only represent between 3 and 7% of all world transactions (Baeza et al., 1975; Gibson, 1983; Guerrini, 1995). However, fine copper warrants transacted in the LME are 25 times the world copper supply (Guerrini, 1995). The important point is that all these transactions, hedging and speculating, bear a risk as we explained before. Market analysts argue that private firms are less risk averse than state-owned firms and more willing to speculate (Guerrini, 1995; Crowson, 1991). However, there are no empirical references to it. The last element of copper marketing involves two types of price premia. The first is a universal premium set by the world’s largest producers before they start their sales campaign in October (Guerrini, 1995). These

3 It is common that contract prices refer to the New York Commodity Exchange (COMEX) prices for sales in the American market and LME prices for the rest of the world (Kuijper, 1983; Slade, 1991; Gibson, 1983; Guerrini, 1995). 4 Sometimes contracts could harm producers, as in the case of back pricing or ‘unknown price’ contracts. The buyer has the right to choose the days he wants to use LME prices to value the monthly shipment within a determined quotation period. In other words the client can get the lowest price possible. It was introduced in the 1940s when producers wanted to attract clients after WWII and the financial crisis was over, but remained when market conditions changed. During the 1970s and 1980s, CIPEC unsuccessfully tried to stop back pricing. For a detailed historical evolution and current practice, refer Gibson (1983) and Guerrini (1995).

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producers, led by Codelco, charge a conservative premium, ‘not so high and not so low,’ to all regular clients around the world irrespective of quantity or distance.5 The universal premium was $12 per ton in 1994 and $38 per ton in 1999 (0.7 and 2% of spot prices, respectively). This premium or markup above market prices is independent of short market fluctuations and applies to all cathode A brands registered at the LME.6 The second premium is the market premium that reflects short-term scarcities in specific local markets. Market premiums are usually applied to copper sold by traders rather than producers. This premium could be higher than the universal premium. For instance, for the 27 warehouses the LME had around the world in 1994, the universal premium was $12 per ton while the market premiums in Rotterdam and Tokyo were $32 and $85 per ton, respectively (Guerrini, 1995).7 In general, semifabricators that buy copper at spot have to bear the risk of paying a market premium higher than the universal, which in turn may inflate their own costs above those of competitors. Semi-fabricators do not like universal premiums but accept them for the risks involved when dealing with traders at spot prices. It is not only the risk that market premiums could be higher than universal ones, as mentioned before, but also the risk of not receiving the specific brand they want for their activity. The LME offers through traders a homogeneous product of 63 brands without ensuring specifically which brand the buyer will receive, and for some buyers this is the most important factor for their business.

5 The universal premium applies to all transactions delivered from Santiago to any port in the world that has transportation costs less or equal to the costs of sending copper to Singapore (Guerrini, 1995, p. 110). Codelco’s executives argue this premium compensates for market imperfections. However, this concept was changed in 1999 when Codelco charged US$3 more in Asian markets than European markets. In 2000, it set US$48 for Japan, US$43 for Taiwan and South Korea, and US$53 for Singapore and Indonesia. Traders cited by Reuters said that this is a part of Codelco’s policy of focusing more on Europe and North America than Asia in its marketing strategy for 2000 (El Mercurio). It is not clear if this new policy will set a new standard in the industry. 6 The official LME price refers to a cathode grade A with 99.99% of pure copper. This price counts not only for quality (there are discounts charged to lower quality than cathode A) but also transportation costs. The LME copper price is the same for all 27 warehouses around the globe. All cathodes A receive premiums above the LME price. However, registered cathodes A at the LME receive a ‘universal’ premium higher than the premium of unregistered cathodes of similar quality. For a detailed description and evolution of premiums and quality of registered brands refer Guerrini (1995), Sanchez Albavera (1985), and Baeza et al. (1975). Complementary observations are mentioned in Bande and Ffrench-Davis (1989) and Marshall et al. (1993). 7 The market premium is different from fees due to transportation costs. In Rotterdam there is an LME warehouse, no additional transportation cost, but the market premium was $20 higher than the universal premium in October 1994.

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Summing up, copper marketing is mainly based on two separate issues, physical allocation of sales and price determination. Large firms use annual forward contracts to allocate sales physically. Their participation in futures and their setting of a universal premium are for price determination. Because futures are not risk free and firms accept different levels of risk, some firms may use futures to receive the annual average price of the market (hedging) and others to get a better price than the average (speculating). Therefore, the great involvement in futures during the 1990s does not replace but complement old marketing practices that involved annual forward contracts and premiums. It was said before that the key element of the 1990s is the extensive use of futures. Why did futures become important in the 1990s? Do futures minimize income fluctuations? Do state-owned and private producers need to use futures differently? How much more income do futures generate than annual forward contracts? By answering these questions with solid empirical evidence and analysis we expect not only to fill up the gap in the literature about real conditions to use futures and their benefits for producers, but also to update the discussion about state-owned and private firms and their marketing policies. Francisco Tomic, former president of the Mining Council in Chile, affirms the Chilean stateowned Codelco has the best research and marketing team in the entire industry.8 However, Dobozi (1993, p. 41) thinks that state-owned mining firms, including Codelco, have less developed marketing skills than private firms, favoring long-term supply agreements ‘barter arrangements with an emphasis on state-to-state deals’. The problem with these two appreciations is that there is no supporting empirical evidence for either one. Before going to answer the question about the reasons for using futures during the 1990s, we will discuss in the next section the explicit assumptions, methodology and data that support this study.

Assumptions, methodology and data The process of selling copper requires two steps. In the first step copper producers sign annual forward contracts that allocate output in monthly shares and specify a formula for the price. This formula normally relates to

8

Francisco Tomic (former president of Cyprus-Amax Chile) is the former president of the Mining Council in Chile, an organization created in 1999 to represent the interests of large mining producers, private and state-owned. This is the first organization in Latin America to represent both sides under the same umbrella. It seems that cooperation and competition between firms have reached new levels in Chile. The appreciation about Codelco was mentioned in an oral presentation entitled ‘The Mining Council and the Chilean Mining Industry’ at ECLAC’s weekly seminar ‘Charla de los Jueves.’ August 1999.

the LME price. The second step occurs at the month of shipment when copper producers with access to futures can modify the contract price but not the quantities. We assume copper producers want to receive at least the average LME price of the year after the marketing process is complete. This objective is achieved in two steps. At the time of signing contracts, firms can ensure that they will receive the average market price if the monthly physical export commitments are 1/12 of their respective annual production. Deviations could occur because producers have uneven flow of production, or their clients prefer to receive monthly shipments according to their own seasonal schedule. In any case, the selling process is not complete until the date of shipment. At the date of shipment the price formula specified in the contract takes effect. This is the price firms with no access to futures will effectively receive from buyers. However, producers with access to futures can modify this price by buying and selling warranties through brokers. The effective prices that these firms receive depend on the use of futures. Some firms may use futures to secure the average LME price and others to receive a higher price. Assuming Chilean firms behave in the mentioned rationality and strategy, six large Chilean firms were chosen to analyze empirically the role of futures in their respective strategies. These six firms represent the Chilean copper industry well. Between 1990 and 1995 they produced 90–99% of Chilean output. Their share went down to 85% in 1996 and 75% in 1998 for new firms started operations by 1995. Therefore, these six firms are mature players that not only account for most of Chilean exports during the 1990s, but also show diversity in terms of ownership and type of production (Table 1). Two of these six firms, Codelco and Enami, are stateowned. Codelco is the world’s largest producer. Enami was created in the 1960s to support small and medium mines. Enami refines concentrates from small and medium private mines on a toll basis. Both firms produce mainly cathodes. The other four firms—Escondida, Mantos Blancos, Disputada and Pudahuel—are private foreign investments, except Pudahuel, which belongs to the Chilean financial groups Grupo Cruzat and Javier Vial (60 and 40%, respectively). Escondida is a successful joint venture that became the world’s largest open pit mine (76% BHP, 30% RTZ and 10% Mitsubishi). It is the second largest Chilean copper firm, and unlike Codelco, it produces mainly concentrates (93% in 1998).9 Disputada, an Exxon investment, had the largest smelter in Chile by 1995 and produces blister and cath9

In 1998 the firm decided to produce more cathodes. As a result cathodes accounted for 15% of total output in 1999. However, because of low international prices, Escondida decided to close its new refining plant until prices recover. By the year 2000, Escondida produced fewer cathodes than before.

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Table 1 Mining firm profiles Ownership and registered LME brands

Observations

Production (1000 ton fine copper)

Pudahuel

60% Group Cruzat; 40% Javier Vial These are two financial groups in Chile. No registered brand

Planned to close in December 2000 after 3 years of halting operations. Equipment would be transferred to Cascada Mine to produce 20 million ton of cathodes per year. Relatively small operation

Cathodes: 1990: 13.7 1994: 15.0 1998: 12.9

Escondida

57.5%BHP-Utah Minerals; 30% Rio Tinto Zinc; 10% Mitsubishi Corp.; 2.5% IFC. One registered brand: ESOX

Has exported concentrates since December 1990. Started cathode operations in 1995, but because of low prices, stopped operations at Coloso cathode plant in 1999. World’s largest open pit mine produced 888 million ton in 1999 (84% concentrates). It is planning to start expansion Phase 4 once prices go up again

Concentrates: 1990: 8.3 1994: 432.1 1998: 780.5

Mantos Blancos

75% Anglo American. Mantos Blancos has two divisions. Mantos Blancos and Mantoverde. Two registered brands: MB and MV

Fifth largest producer in Chile. In 1997 exported 70% cathodes and 30% concentrates. Anglo American acquired Minorco in 1999, former Mantos Blancos owner, and became the world largest mining firm with a revenue of $16 billion per year

Cathodes: 1990: 66.4 1994: 54.5 1998: 117.5

Disputada

Exxon. No registered brand

It has the largest private copper smelter in Chile, Chagres. It produces cathodes and blister

Cathodes + Blister: 1990: 95.2 1994: 148.2 1998: 140.3

Codelco

Holding of Chuquicamata, El Teniente, El Salvador, Andina and Rodomiro Tomic. A new mine, El Abra, is a joint venture with Cyprus-Amax (Phelps Dodge). Codelco has 51% of it. Codelco also has alliances with semifabricating producers in Germany. Signed a mining joint venture with Pen˜ oles (Mexico) to exploit copper– gold deposits in Sonora in 1999. Six brands registered: AE; CCC; CCC-SBL; CHUQUI-P; AE SX-EW; cCc-SX-EW

World’s largest copper producer. Chuquicamata is the world’s second largest open pit mine after Escondida. El Teniente is the world’s largest underground mine. Chuquicamata produces 600×103 ton per year

Cathodes: 1990: 1113.0 1994: 1001.8 1998: 1400.3

Enami

100% Chilean State. One registered brand: ENM

Created in 1960 to support and enhance medium and small mining. It has no mines. Owns two refining facilities (Ventanas and Paipote) and five recovery plants (Taltal, Salado, Matta, Vallenar and Panulcillo). Enami subsidizes small miners when prices are low, and sells all its copper in international markets. It is currently under reform and partial privatization

Cathodes: 1990: 213.3 1994: 200.7 1998: 170.5

Source: Ownership information from Sonami (1999). Production data from Cochilco (1990, 1994, 1998).

odes. Mantos Blancos is a 75% investment of Anglo American (the rest distributed publicly on the New York Stock Exchange), and produces 70% cathodes and 30% concentrates. Pudahuel, contrary to the other private firms, produces only cathodes.10 To make the study operative, we have to find good 10 The ownership references correspond to the reality during the 1990s.

proxies for the quantities and prices determined under annual forward contracts. For the case of quantities, good proxies are simply the monthly physical exports per firm because firms do not change shipment commitments when using futures. Physical exports are recorded and published by the Comision Chilena del Cobre (Cochilco). For the case of contractual prices, we assume the price formula is the monthly average of the month of shipment. This assumption relies on the fact that the average formula is the most common for refined con-

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tracts, and we will focus on refined production. Monthly average prices come from the LME, and are also summarized by Cochilco. Profits are published by few firms in their annual reports. There are no data available about the effective price firms receive from futures transactions. Thus, our perspective to analyze the benefit from futures will be by focusing on what would be the benefit of futures compared to forward sales if firms were using futures to secure the average price of the year. In this study we are interested on the reasons for the extensive use of futures during the 1990s and their benefits for individual firms. We start by analyzing aggregate data for the entire Chilean copper industry. This is useful to understand the environment in which individual firms operate and to conjecture why the entire industry became more futures oriented than in previous decades. Next, we shift to the individual data sets for six large firms to evaluate whether our findings about the entire industry apply to individual firms. With this data set we also answer the questions about the benefits of futures with respect to annual forward contracts and whether or not private and state-owned firms need to use futures differently.

Aggregate results: implications for marketing The 1990s was a decade of unparalleled expansion in the Chilean copper industry. Output almost doubled every 5 years with production going up from 1.03 million ton in 1990 to 2.49 million ton in 1995, and up again to 4.38 million ton in 1999 (Cochilco, 2001). With such expansion the Chilean share of world output increased from 17.7% in 1990 to 35.5% in 1999 (Cochilco, 2001). Chile not only remained as the world’s largest producer of concentrates, but also became the first producer of refined copper. The latter transformed Chile into a center of technological innovation. It took the lead on SX-EW technology, the new and lowest cost refining technology available in the 1990s.11 Its world share of SX-EW output went up from 17.2% in 1990 to 60.1% in 1999.12 Therefore, because of its production expansion and technological lead there is no doubt Chile became the center of the world copper industry during the 1990s. Most of the Chilean copper expansion was privately driven and this changed the structures of both ownership and production. In terms of ownership, in 1990 the industry was state-owned, dominated with Codelco’s share of total Chilean exports at 71.6%. However, this 11

SX-EW stands for the Solvent Extraction-Electro Winning process. 12 The Chilean SX-EW refined copper, measured in thousand tons, was only 122.1 in 1990. This production went up to 372.5 tons in 1995 and 1361.4 tons in 1999 (Cochilco, 2001).

dominance diminished significantly by 1999, when Codelco’s share became just 36.3%. It is the private share that went up from 26.6 to 63.2% between 1990 and 1999. Therefore, the ownership dominance shifted from state-owned to private. The shift in ownership toward private majority came along with a relative increase on the production of concentrates compared to refined copper.13 While the share of concentrates on total exports went up from 16.8% in 1990 to 36.2% in 1999, the share of refined exports went down from 73.4 to 59.9% for the same years. On the surface, the pairs private/concentrates and stateowned/refined seem to characterize the huge copper expansion of the 1990s. The state-owned preference for refined copper and the private’s preference for concentrates are not new in Chile. Codelco, state-owned, has mainly produced refined copper since its creation in 1970 and this bias became even stronger during the 1990s when its own refined share of total exports went up from 78.0% in 1990 to 91.0% in 1999 (Cochilco, 2001). Codelco’s executives argue the refined market has more buyers and is less vulnerable to shocks than the concentrates market (Noemi Callejas, 1991a,b; Lima, 1999). At the end, they affirm, Codelco should improve its market position and get a better return. For the case of foreign private firms, there has been a tradition to prefer concentrates rather than refined copper across the 20th century. This bias was strongly manifested in the first-half of the 1990s with an increase in the share of concentrates in total private exports from 27.0% in 1990 to 54.5% in 1995 (Cochilco, 2001). This pattern reflects the interests of Japanese and European smelters that funded copper projects in order to secure future supply of concentrates.14 However, this traditional long-term preference was broken in 1995. A second generation of private investments also got involved in

13

Copper production usually takes the form of unrefined and refined copper with many varieties within each category. Most of the Chilean unrefined copper takes the form of concentrates. Refined copper varies depending on the pure copper content and refinement technology, being cathode A (99.99% of pure copper) the dominant Chilean form. Blister is an intermediate product technologically outdated and marginally produced in Chile. 14 Private ownership reflects a bias towards concentrates and export destination of output. Escondida produces concentrates and BHP (UK) controls 57.5% of total shares, RTZ (UK) 30%, JECO (Japan, Mitsubishi) 10% and IFC (World Bank) 25%. Candelaria produces concentrates, blister, gold and silver. The owners are Phelps Dodge (USA) 80% and Sumitomo (Japan) 20%. Mantos Blancos produces concentrates and cathodes. Anglo American/Minorco (South Africa) holds 75.38% ownership, and 700 stockholders hold 24.62%. Disputada produces blister (87% of output) and concentrates. Exxon Coal Minerals (USA) owns 100% (Sonami, 1999; Cesco, 1991).

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Table 2 Standard deviations of stationary production and exports series (1000 ton per month) Time perioda

Refined production

Refined exports

Refined exp/prod.

78:01–84:12 85:01–89:12 90:01–94:12 95:01–98:12

6.66 7.51 7.61 9.81

10.59 13.44 12.26 19.86

1.59 1.79 1.61 2.02

Concentrates production 5.02 6.31 9.24 16.70

Concentrates exports

Concentrates exp/prod

9.54 11.74 15.17 30.99

1.90 1.86 1.64 1.86

a

The time period specifies the year and month of the start and end of it. Thus, for instance 78:01–84:12 means a period from January 1978 to December 1984. Source: Calculated for 1978–1985 from Cochilco (1978-1985) and for 1986–1999 from Cochilco (1985–2001).

refined business since 1995.15 The direct effect was an increase of the share of refined copper in private exports from 31.8% in 1994 to 42.5% in 1999 (Cochilco, 2001). Thus, by 1999, a strict private preference for concentrates held no more. After 10 years of Chilean copper expansion, the concentrates business became exclusively private operated and the refined business became almost equally divided between private and state-owned firms. These results are evident after considering the private and state-owned contributions to both concentrates and refined exports. Between 1990 and 1999, the private share went up from 43.1 to 90.5% for the case of concentrates, and from 23.5 to 44.9% for the case of refined copper. The transition from a state-owned dominance to equally divided business began in 1995 when a second generation of investments started operations. To identify the relationship between private involvement in refined business and marketing we analyze the deviations around the mean of stationary export and production series per month from 1978 to 1998.16 The time span of analysis goes back to 1978 to show how the years after 1995 are not only different from the first-half of the 1990s, but also from all previous years. From the results of Table 2 we can conclude as follows. First, exports are not automatic reflexes of production plans for both concentrates and refined copper. In other words, what Chilean firms produce each month is not exactly what they sell that month. Furthermore, all export standard deviations are higher than their respective production equivalents. Export allocations cannot be explained only with changes of current production. Therefore, marketing is more dynamic than production. Secondly, the standard deviations of exports and pro-

duction had been increasing since 1985 for both concentrates and refined copper. But, it is only after 1995 that these values are statistically different from all previous years at 1% level of significance (Altamirano, 2000). Thirdly, the relative volatility of exports compared to production is statistically different at 1% level of significance after 1995, and only for refined copper. The export/production index (Table 2) for the case of refined copper went up from a range of 1.6–1.8 times before 1995 to 2.02 times after it. There is no such change for the concentrates case. This result suggests that there is a structural break in 1995 for refined exports and it is confirmed by Chow breakpoint tests.17 We should not forget that these increments of volatility go along with the more intensive use of futures in the 1990s. Marketing requires an initial allocation of physical sales through annual forward contracts and then a modification of prices through futures. Our data results and statistical tests reflect an increase of volatility of physical sales in the refined business. Therefore, the more intensive use of futures could be a consequence of it. Firms reluctant to experience revenue fluctuations may use futures to compensate for the increase of exports volatility.18 To analyze whether firms changed their pattern of export allocation after 1995, we will study individual firm data of the six Chilean largest producers. As we mentioned before, their relative weight on national output went down from 95% in 1989 to 75% in 1998. These firms represent mature copper producers and all, but

17 The Chow breakpoint test recognized two breaks, one in 1989:09 and the other in 1995:03. However, econometric regressions only confirmed the existence of the second (Altamirano, 2000). Chow breakpoint test: 1995:03

15

The second generation of private investors that emphasized refined and concentrates are Los Pelambres, Collahuasi and El Abra (joint venture between Codelco and Cyprus). Codelco also increased refined output in the second-half of the 1990s with Radomiro Tomic. 16 Table 2 shows standard deviations of stationary series. Exports and production increased significantly in the 1990s, and the mean and variance were not constant over time. Thus, both series were nonstationary and statistical tests could not be applied. These series became stationary after taking first differences.

F-statistic Log likelihood ratio 18

3.009635

Probability

0.007465

18.28409

Probability

0.005560

Futures cannot cause physical export volatility because futures transactions only change prices. Futures do not change physical allocations.

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Table 3 Variance of stationary exports per firm before and after 1995 Time perioda

Codelco

Enami

Pudahuel

Escondida

Mantos Blancos

Disputada

Var 90:01–95:04 Var 95:05–98:12 Test of equal varianceb Equal value test Probability

205.8224 726.2583

15.01960 15.25465

0.149752 0.254281

235.4928 1015.164

10.79761 16.63067

19.99174 46.45976

17.85427 0.0000

62.02928 0.4891

37.10216 0.0038

14.61443 0.0000

40.90330 0.0139

27.10904 0.0000

a

Var 90:01–95:04 stands for the variance from January 1990 to April 1995 and Var 95:05–98:12 means the variance from May 1995 to December 1998. These variances are from stationary series of exports (first differences). b This is a Chi-square test of equal variance. Source: Original data comes from Cochilco, Boletin Estadistico Mensual del Cobre. Table 4 Actual exports compared to an equal monthly allocation of annual exports (standard deviation of actual exports from an equal monthly export share of 8.33% of annual production per month)

1990 1991 1992 1993 1994 1995 1996 1997 1998

Codelco

Enami

Escondida

Disputada

Mantos Blancos

Pudahuel

Two-lowest standard deviation

Two-highest standard deviation

0.608452 1.058122 1.192893 0.932936 0.918779 1.731728 2.217756 0.521438 0.939115

1.943124 0.646066 0.886604 1.345862 0.914337 1.229997 1.487789 0.943785 1.501878

NA 2.735214 3.231127 2.628081 3.498627 4.062725 2.473067 3.319944 1.752544

2.350127 3.328180 2.506824 1.951520 1.892883 3.049637 4.024262 3.126618 2.148931

2.894997 3.325714 3.387805 3.392540 2.524894 4.691919 2.985670 1.740467 1.885118

0.970868 1.606664 0.649578 0.724743 2.614208 2.873741 2.372101 1.107950 2.902863

COD;PUD COD; ENA PUD; ENA COD; PUD COD; ENA COD; ENA COD; ENA COD; ENA COD; ENA

DIS; MBL DIS; MBL ESC; MBL ESC; MBL ESC; PUD ESC; MBL DIS; MBL ESC; DIS PUD; DIS

Note: In the last two columns COD, ENA, ESC, DIS, MBL and PUD stand for Codelco, Enami, Escondida, Disputada, Mantos Blancos and Pudahuel, respectively. Source: Calculated for 1978–1985 from Cochilco (1978–1985) and for 1986–1999 from Cochilco (1999).

Enami and Pudahuel, increased their volume of exports significantly during the 1990s.

Individual results: forward and futures sales The empirical data on stationary monthly exports per firm for the six Chilean firms of our sample (Table 3) show that export allocations became more volatile for all but Enami after May 1995. Furthermore, statistical tests reject the hypothesis that the variances are equal at 1% level of confidence before and after May 1995 (Table 3). Therefore, the increasing involvement in futures during the 1990s may effectively be a response to the increased volatility of export allocations in concentrates and refined copper. We can use the results of export variances per firm to make two more observations about the first stage of copper marketing. First, copper firms do not deviate substantially from the strategy that allocates equal shares of annual output each month. The standard deviations around 8.33% per year are small as it is showed in Table 4. These results support the initial hypothesis that producers try to allocate physical exports evenly. However,

as we explained in the methodology and data section, there are deviations due to production and demand constraints. Secondly, within the range of standard deviation values, there is a group with consistent high values and other with low values. These groups are presented in the last two columns of Table 4. On the one side, Codelco and Enami show the two lowest standard deviations 8 years out of nine, and on the other, Escondida, Disputada and Mantos Blancos show the highest standard deviations 6 years out of nine. The first group is state-owned and produces mainly cathodes (refined copper) and the three firms of the second group are subsidiaries of MNCs that combine concentrates and refined copper. Five statistical tests of equal variance confirm these two groups are statistically different (Altamirano, 2000, p. 145).19 All statistical tests cannot reject the hypothesis that Codelco and Enami have the same variance, or that Escondida, Disputada and Mantos Blancos, in turn, have also equal variances. Ownership and type of production

19 These five tests are F-test, Siegel–Tukey, Bartlet, Levene, and Brown–Forsythe.

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seem to determine this pattern. However, the case of Pudahuel suggests that type of production is more relevant than ownership. Pudahuel’s variance lies between the high variances of the other private firms and the low variances of the two state-owned firms. Statistical tests reject Pudahuel’s variance is equal to the multinational’s at 1% of significance, but cannot reject that it is different from Enami’s (state-owned).20 Therefore, the significant distinction in the Chilean copper industry is between refined and refined-concentrates producers. Do all firms need futures to correct for big losses that could come from the allocation of exports through annual forward contracts? To answer this question we will compare the prices of forward and futures contracts. As we stated in the methodological section, a proxy of forward prices is the average LME price of the month of shipment, and the futures price is the annual market average price, which is the price that could result if firms use futures to get the average price of the market.21 The findings of the difference between forward and futures prices are presented in Figs. 1 and 2. These figures illustrate the cases of refined-concentrates and refined producers, respectively. The results are as follows. First, these two graphs show a relatively minor scale of gains and losses in the refined side with respect to the concentrates-refined side. While the largest positive difference on the first group (Codelco, Enami and Pudahuel) is 0.5 cents (Fig. 2), on the other group (Escondida, Pudahuel and Mantos Blancos) is 1.6 cents

Fig. 1. Forward prices are the annual average price producers get considering the quantities and LME prices of the month of shipment [SUMPi × Qi / SUMQi,i ⫽ 1,…,12]. Futures prices are just the annual LME average price, the price conservative futures transactions have to ensure. Source: Market prices from Cochilco, ‘Boletı´n Estadı´stico Mensual’ (December issues). Adapted from Altamirano (2000, Chap. 3, Fig. 9).

20

Two tests find these variances are different at 1% of significance, two tests suggest variances are different at 5% of significance, and one test cannot reject the hypothesis that variances are equal (Altamirano, 2000, p. 145). 21 For each firm the annual average price of annual forward contracts is computed by SUM (Qj / Q) × LMEj, j ⫽ 1,…,12. Here Qj is shipment of exports in month j(ton), Q the annual exports (ton) and LMEj is the average price at the LME in month j. This price is published by the London Metal Exchange Inc.

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Fig. 2. Forward prices are the annual average price producers get considering the quantities and LME prices of the month of shipment [SUM Pi × Qi /SUMQi,i ⫽ 1,12]. Futures prices are just the annual LME average price, the price conservative futures transactions have to ensure. Source: Market prices from Cochilco, ‘Boletı´n Estadı´stico Mensual’ (December issues). Adapted from Altamirano (2000, Chap. 3, Fig. 8).

(Fig. 1). Similarly, the largest negative difference of 1.9 cents corresponds to concentrates-refined firms. Secondly, considering all six firms together, 59.3% of the time the futures price is higher than the forward price (negative side in Figs. 1 and 2). This percentage is 63 and 56% for refined-concentrates producers and refined producers, respectively. Thus, the conservative strategy of using futures to secure the average market price is better than just using annual forward contracts. However, as the standard theory of futures predicts, using futures to change forward contractual prices would not always improve revenue during the 1990s. Therefore, these results support the use of futures to complement annual forward contracts, and suggest refined-concentrates producers could benefit more than refined producers. How do these forward and futures prices reflect on levels of revenue between 1990 and 1998? Tables 5 and 6 summarize these results. The average market value using futures is higher than the revenue firms would receive through annual forward contracts alone (Table 5). For instance, Codelco’s revenue evaluated at forward prices is $23.6 million less than the revenue at futures prices (LME average price) in constant values from 1990 to 1998. For the case of Escondida, the second largest producer, the revenue at forward prices is $5.13 million less than what could be at the average LME price. From 1990 to 1998 all six firms could have been better off if they had used futures to receive the average LME price. But how significant are these results? Table 6 presents losses compared to the total revenue calculated at forward contract prices. The $23 million (base 1995) Codelco would have received by using futures is just 0.13% of total forward sales from 1990 to 1998. Disputada shows the highest percentage, and this is just 0.26%. For Escondida, the benefit would have been just 0.07%. However, it is also clear from Table 6 that these benefits

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Table 5 Revenue comparison: difference between the revenue based on annual forward contracts and the hypothetical revenue if firms received annual average prices on all sales (constant million US dollars, 1995) Time period 1990–1998 1990–1994 1995–1998

Codelc ⫺23.652 ⫺0.220 ⫺23.432

Enami

Pudahuel

⫺2.335 0.7969 ⫺3.132

Escondida

⫺0.250 0.144 ⫺0.394

⫺5.137 ⫺10.186 5.049

Disputada

Mantos Blancos

⫺5.639 1.895 ⫺7.534

⫺2.920 ⫺2.222 ⫺0.699

Note: The deflator is the IFS Commodity Price Index, ‘International Financial Statistics Yearbook 1999’, IMF. Source: Adapted from Altamirano (2000, Chap. 3, Table A.4). Table 6 Revenue comparison: futures sales compared to forward sales (percentages)a

1990–1998 1990–1994 1995–1998

Codelco

Enami

Pudahuel

⫺0.13 0.00 ⫺0.27

⫺0.07 0.04 ⫺0.22

⫺0.11 0.11 ⫺0.38

Escondida ⫺0.07 ⫺0.43b 0.11

Disputada

Mantos Blancos

⫺0.26 0.18 ⫺0.69

⫺0.23 ⫺0.38 ⫺0.11

Source: Adapted from Altamirano (2000, Chap. 3, Table A.5). a These percentages are the values estimated in Table 5 divided by the respective revenue based on annual forward contracts. b This value is over estimated because Escondida started operations in December 1990.

are relatively higher after 1995 than before for all six firms but Escondida. Codelco, Enami and Disputada would have increased revenue by 0.27, 0.22 and 0.69%, respectively, after 1995. Escondida is the only one that would have lost 0.11%. Thus, the gains from using futures to hedge physical exports in order to ensure the average LME price seem to be relatively small. As a last step we can measure the gains of using futures conservatively compared to annual profits. Unfortunately we only have profits data for Codelco and Enami (Table 7). From 1993 to 1998 Codelco’s real profits were $4.6 billion, thus the aggregate gain of using futures could have been 0.45% of that amount. For Enami, the aggregate gain could have been 2.74% of its profits between 1991 and 1998.

Conclusions and final comments We started this article with four questions. Why did copper firms need futures in the 1990s? Do futures minimize income fluctuation? Do state-owned and private producers use futures differently? Do futures increase the level of revenues significantly compared to traditional methods of trading? Copper marketing involves forward and futures contracts. Our empirical results show that both private and state-owned firms try to allocate forward sales equally over 12 months. This physical allocation combined with the most common price in annual forward contracts, the average of the month of shipment, shows that the objective is not to avoid income fluctuation per se. The objec-

Table 7 Revenue comparison: futures sales compared to actual profits? Year

1991 1992 1993 1994 1995 1996 1997 1998 Total

Codelco’s Profits (constant Codelco’s value in Table 5 Enami’s profits (constant US Million dollars, base divided by Codelco’s profits US Million dollars, base 1995) (%) 1995)

105.786 866.3292 1763.6 862.7806 784.3808 200.3892 4583.266

⫺0.05755 0.01012 0.00012 ⫺0.01305 ⫺0.01129 ⫺0.01766 ⫺0.00453

22.7897 19.3941 14.366 13.6764 29.2 9.2276 5.7424 ⫺9.9264 104.47

Source: Data on profits from Codelco (issues 1990–1999)and Enami (issues 1995–1998).

Enami’s value in Table 5 divided by Enami’s profits (%) 0.02663 0.02054 0.00449 ⫺0.05838 ⫺0.02874 ⫺0.20933 0.03183 0.05481 ⫺0.02738

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tive is to get the market average income of the year. Given this objective, our empirical results show that physical distributions through annual forward contracts became more volatile in the 1990s compared to the 1980s, and volatility is even higher after 1995—a consequence of the massive Chilean production expansion during the 1990s and also perhaps a change in world copper demand that we do not analyze in this study. The point is a higher volatility of forward allocations combined with price fluctuations could generate lower income than expected. The expected income is the one that comes from equal physical monthly sales and the average price of the market. Under these conditions, futures are the necessary complement to avoid income fluctuation. Futures just perfect the initial strategy. The mentioned forward sales allocations are common to private and state-owned copper firms. Then, we could say that both groups of firms have the same marketing objective i.e. an income based on the average market price of the year. This pattern did not change during the 1990s. It is only that deviations became bigger for both groups. However, the allocations of refined producers deviate consistently less than the deviations of refineconcentrates producers. Therefore, to distinguish firms in marketing analysis it is better to consider the variable type of production rather than ownership. This study does not present direct evidence that all Chilean copper firms use futures to hedge instead of speculating. There are only direct references for Codelco. The paper concludes that this conservative behavior also fits the other firms well. On the one hand, all producers show the same physical allocation through annual forward contracts. These forward sales are the way producers build and sustain long-term commercial relationships with their clients based on brand name (physical characteristics) and universal premium. On the other hand, futures and annual forward contracts are both part of a single marketing strategy, and the study finds the empirical support from all firms that this strategy is the one of Codelco. To evaluate the benefits of futures compared to annual forward contracts from 1990 to 1998, the paper analyses prices and revenue differences. Futures prices are higher than forward prices 63% of the time for refined-concentrates producers and 56% for refined producers. In terms of revenue, futures transactions improve income revenue above forward sales over the decade for all firms. However, this improvement is very small—0.13% for Codelco and 0.07% for Escondida, the largest refined and refined-concentrates producers, respectively. Smaller players get relatively higher returns, for instance 0.26% for Disputada. These low increments are compatible with previous findings that assumed futures were used to maximize profits and beat the market. Hussey and Quiroz (1997, p. 79) found firms like Codelco would increase their rev-

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enue at most by 0.45% once costs of transaction are included. Our results, less than 0.26%, are lower because futures are used to hedge rather than to speculate. However, the main point is the gains are small in both hedging and speculating strategies. Thinking on the implications of such small benefits, some would argue that accepting forward and futures sales differ by less than 0.3%, copper producers should not bother in doing futures at all. Traditional marketing based just on forward sales should be enough. Our reading is a little bit different. Futures are not instruments to maximize revenue. They are instruments to receive the same income annual forward contracts would give but with less risk. Futures just perfect the strategy that begins with forward sales and that basically consist of getting the average price of the market. Ex-post, we found the monetary value of that risk (what producers would not receive if they do not use futures) to be less than 0.3% of total forward revenue from 1990 to 1998. Thus, Chilean copper firms that use futures seem to be low risk takers. This behavior may relate to the fact that the copper industry has profits rates (5% from 1973 to 1999) that are lower not only compared to manufacturing but also to other mining sectors (Humphreys, 2001). In addition, copper marketing is a ‘past-dependent’ activity with traditional procedures and practices that remain in place even if they do not seek to maximize profits strictly speaking. The instances we mentioned in this paper are universal premiums and back pricing. Futures may be another practice that became well established in the industry and remains in place even if the benefits from it are very small. Copper firms, of course, would like to maximize and improve their levels of revenue, but futures transactions are not the right instrument. A better instrument, mentioned but not studied in this paper, would be premiums. For instance, the universal premium of $38 in 1999 represented 2% of the LME average price, a gain that is not only bigger than what futures transactions could give, but also free of the risks associated to them. Its relevance is even higher because of the changes in marketing since the year 2000. On the one hand, Codelco broke the traditional logic of the universal premium, by setting premiums based on local market conditions. On the other hand, large copper companies are organizing a global organization to sell physical copper through the internet. Both changes are just signs of big changes to come. The study of the new competition and cooperation between large copper producers, and the use of market power to set premiums, are topics for future research.

Acknowledgements In the initial stages I received great comments from Fernando Sanchez Albavera, Eduardo Chaparro and the

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