Investors who have or are contemplating taking positions in commodity based companies. Note: this article applies to hedging activities of commodity based companies only and not all companies who utilize hedging activities.

Zero Sum Game

In zero sum game situations, no wealth is created; rather it is transferred from one party to another. In theory, the party with greater expertise in the area being hedged will likely end up with a net gain; thus, by default, putting the counterparty into a loss situation. It comes down to which party you believe is in a better position to forecast the future movement in commodity prices, management or an army of analyst of the counter party financial institution. On average, financial institutions benefit from companies undertaking hedging activities (given that they likely have greater forecasting and analytical resources); thus, value is transferred from shareholders to the banks.

 Meeting Investors Needs?

This is more easily answered by looking into why commodity based companies enter into hedging arrangements, which typically is to ensure a stable and consistent cash flow levels despite fluctuating commodity prices. An investor in a typical company would likely sacrifice some value for consistent cash flows, but this doesn’t hold true for shareholders of commodity based companies. Hedging practices of commodity companies steal from investors the very reason they invested in the first place - to be exposed to gold, oil, coal, or other commodity price fluctuations. Management has taken away the upside commodity exposure the investor sought when selecting their company for an investment. Stable cash flows are likely not the main want of the investor in this instance; thus, management is not satisfying the investors needs given that investors can obtained stable cash flows in their portfolio elsewhere through diversification in holdings of other industries.

Where to go from here

Investors seeking an investment that will mirror commodity price movements in which exposure is desired should consider a direct ETF that tracks the commodity’s movement. Alternatively, if you'd still prefer to gain exposure via taking positions in publicly traded companies in the industry, keep a watchfully eye on the respective hedging activities as it'll impact future earnings estimates you place on the company as earnings will be less levered to commodity price fluctuations.