Few financial terms can instill as much apprehension as the word “derivative.” From the collapse of Barings Bank to the Long Term Capital fiasco, these instruments have a habit of making fools of their supposed masters.

One sector that makes frequent use of derivatives to manage risk is mining. Metal prices tend to fluctuate widely over time, which is a big problem because mining is capital-intensive, and a few cents either way can easily make the difference between maintaining loan payments or going down the tubes.

Unfortunately, some mining companies have used derivatives for more than the hedging of risk. These firms cross the line from insuring against the threat of poor commodity prices to actually making a bet on what those prices will be. When they guess wrong, derivatives claim another victim.

Aur Resources Inc. (AUR-TSE), the Toronto-based company that is this country’s purest copper play, is having none of that. Under the scrutiny of chief financial officer Ron Gagel, the hedge game is being played conservatively.

We bought into Aur a couple of years ago when the company was being pummelled for a series of prospective deals that never quite crystallized. Aur was a small firm struggling for mid-tier status, and the consensus on the Street was they didn’t have the right stuff to play in the bigger league. We took a more sanguine view, appreciating management’s patience about finding the right combination, and scooped up our position at $1.91.

Aur finally found what it was looking for with the Quebrada Blanca mine in Chile. Instantly the firm changed from one with a pristine balance sheet to a heavily leveraged outfit. To appease the banking syndicate that fronted the money, Aur entered into a hedging program to sell forward a large portion of production for 2001-2004.

Unlike buying put options, selling forward doesn’t cost anything in terms of cash. But insurance is never free, and what the company gave up was the opportunity cost should copper move above 83 to 87 cents (US) a pound. Instead, copper prices have tumbled relentlessly and Aur’s guaranteed price has boosted earnings.

In late October, with spot copper around 62 cents, Aur took a step to restore the company’s upside should copper rebound sharply over the next few years. They purchased sufficient call options at a strike price of 83 cents to exactly balance the amounts that were sold forward.

This restores Aur’s upside potential if the economy recovers strongly while maintaining the minimum price if it doesn’t. As the consensus outlook for copper is currently clouded by recession, those calls were cheap: just over a penny a pound. Copper has had a sprightly rally over the past few weeks so those call options have already appreciated nicely.

Will the rumours of a global cut in copper production come true? Will this essential metal come back to challenge its high of $1.38 (US) a pound in 1995 from about 67 cents at present? Nobody knows — and that’s exactly the point.

Rather than pretend to know what the future will bring, Aur is sticking to the basics of optimizing its prospects under a variety of scenarios. When we chatted with Mr. Gagel about his auspicious timing, he readily admitted that getting the call options so cheaply was sheer luck. Maybe so, but as Louis Pasteur said, “Chance favours the prepared mind.” With the share price currently at $3.25, our target price of $6.45 indicates that we believe Aur will continue to get its share of attention from Lady Luck.