The recent announcement by Nucor of a long-term agreement with Encana which locks up the steel makers natural gas needs for the foreseeable future is possibly indicative of a shift in corporate mindset regarding the hedging of input costs. Under this agreement, Nucor will pay a portion of the drilling costs , in exchange for a volumetric agreement covering all of its natural gas needs. The agreement states that drilling will be suspended if prices fall below a predetermined price. Nucor in effect has purchased a call option on all of its natural gas needs. What is interesting is that an industrial company would commit a part of its balance sheet in order to hedge a real cost exposure. This is hardly indicative of a deflationary mindset amongst those buyers that not only must manage the costs but the volumes. This type of arrangement harkens back to the period when industrial companies looked to integrate back into their supply chain in order to control their cost structures. While natural gas is hardly in short supply, this type of agreement provides a template for those companies looking to strategically hedge out their exposure. We think that one could extrapolate this out into other input cost areas, particularly given the weakness in a number of sectors and the dearth of financing available in those sectors.
We anticipate that you will see many more examples of such a mindset shift in the months and years to come, all of which will occur in the context of a supposed deflationary environment. We label this blog: Back to the future for this very reason. In our opinion, proactive management, as well as investors, will be actively positioning themselves for an inflationary environment much different than the one we are currently experiencing.