Treasury Today Country Profiles in association with Citi

Over-supply and demand: living through an asset rout

Close up of a nugget of gold

Commodities pricing is at the mercy of a number of factors as diverse as market mood, political intervention and the weather. For corporates, managing the risk of price swings is crucial to protect the bottom line. Where does risk materialise, why, and how can it be mitigated?

Commodities such as gold and oil have, for a long time, proven to be a rich seam of literary inspiration as the quote, “there’s gold in them thar hills – and there’s millions in it,” from Mark Twain character, Mulberry Sellers, attests. But in today’s volatile markets, they can also be a source of great consternation for corporate end-users.

Commodities are the key elements used in just about every production facility the world over. As raw materials, commodities will either be soft (agricultural products such as wheat, coffee, cocoa or sugar) or hard (mined or extracted products such as iron ore, copper, gold or oil). Although traded in the primary economic sector (as opposed to the manufactured), they still appear to have a life of their own. Indeed, from a financial perspective, the purchase and sale is often carried out using futures contracts through the 50 or so specialist regulated commodity exchanges around the world – in Asia the list includes the likes of Central Japan Commodity Exchange, the Vietnam Commodity Exchange, the Hong Kong Mercantile Exchange and the Australian Securities Exchange. Derivatives of futures are also increasingly traded using spot prices, forwards, futures, and options.

All commodities exchanges operate to a standardised quantity and minimum quality (the basis grade) of the commodity being traded. This helps to satisfy the sale so that in effect, the commodity is pretty much the same wherever it is bought. The problem with commodities traded in this way (and in this quantity) is that price can be very easily affected by political and regulatory change, seasonal variation, weather, technology and general market conditions (including supply and demand). All of this, for the commodity-exposed corporate, translates into risk which must be managed. And at the moment, there is much to consider as the commodities markets demonstrate just how fragile they are.

According to a December 2015 edition of the BondSquad ‘Making Sense’ newsletter, commodity prices have been “beaten down” for more than a year and for the past several months conditions have “deteriorated dramatically”. As with most asset routes, the crash in commodity prices started with the fundamentals, said the report’s author, Tom Byrne. These include lower-than-expected demand (or demand growth) and significant over-supply of many commodities. Oil is a case in point as the over-production war between OPEC and the US rages on, but other commodities have been impacted too as production capacity had been massively expanded to feed Chinese and EM market growth that has stalled, leaving the world in a state of glut. For buyers, this seems like a good thing, but it is not as simple as that.

The regional view of a rollercoaster ride

Asia Pacific is a major source of global commodity exports. The UN Economic and Social Commission for Asia and the Pacific (ESCAP) Trade Insights paper issued in Q2 2015 reported that regional economies currently accounted for 38% of global mineral and metal exports, as well as 29% of global fuel exports. Asia Pacific harbours many commodity-exporting economies, accounting for over a quarter of global fuel and metal exports, as well as over a third of global mineral exports. Some countries in the region play a significant part in global commodities production, with Australia, for example, producing 28% of global mineral supplies. The extent to which extraction and trade of commodities forms part of some economies means that if markets fall they can have a serious impact on local economies – there are 18 net commodity-exporters in the region, with commodity-trade surpluses ranging from 0.11% of GDP in Myanmar to 59% of GDP in Brunei Darussalam. When prices slump, ESCAP notes that export revenues and economic growth can expect negative impact in these countries.

At a macro level there is cause for concern as some international commodity prices continue to fall. In August 2014, oil stood at $115 a barrel but prices settled under $37 a barrel (the first time since the financial crisis) after data from the OPEC reported in mid-December 2015 that the group increased its crude production in November. Furthermore, recent stock market falls are perhaps based on the pain likely to be felt by oil producing countries and the companies that sell to them (luxury goods and car manufacturers remain on edge).

ESCAP reported on continuing falls of many commodity prices (from June 2014 to January 2015) which extended across all commodity sectors in the region. Energy saw a 50% decline, metals and minerals a 16% decline and agriculture a 7% decline. In the energy sector, oil and gas prices fell between 37% and 54%. In the minerals and metals markets, coal, copper, lead and tin prices fell between 12% and 24%, while iron ore prices plunged 47%. In the agricultural sector, corn, cotton, palm oil, and soybean prices also fell between 12% and 26%. However, the prices of some commodities actually increased. Zinc, aluminium and nickel prices increased in the period due to export bans and supply-side issues, whilst orange, cocoa, cattle and coffee prices rose, due to crop failures and poor weather.

Metal market mayhem

A business using base metals will need a certain amount of raw material on its factory floor at any given time. The nature of the business and its prevailing business model will inform the precise stock level, according to whether it needs to hold substantial inventory or if it can take delivery just-in-time. Of course, high volatility brings great opportunity to those corporates heavily exposed to such metals if they are in a position to lock in record-low prices now through a derivatives strategy enabling future gain. On the other hand, those with a large unhedged inventory have a challenge on their hands: not only does forecasting become difficult, but also a price crash could be seriously damaging to their balance sheet.

This volatility underscores the importance of taking a proactive approach to commodity trading and risk management for corporates. Today we are seeing a ‘what-if’ scenario made real as base metals head out on a wild rollercoaster ride, with iron ore prices plummeting to 2009 levels and copper also sinking to its lowest level in six years. What’s interesting about the dramatic fall in the copper price is that it was triggered by a seemingly unrelated factor – problems in the Chinese equities market where in August 2015 it very nearly saw the biggest possible decline.

Although the metals market can exhibit periods of relative stability, with steady rises or falls, prices tend to be more generally mobile compared to other asset classes, with rapid movements often being driven by major economic events or even just talk of an event. In the past, the main market players, apart from a small group of speculators who created the liquidity, were the mines, the processors and the end-users. Whilst the industrial supply and demand of metals changes little from one period to the next, even more volatility has been introduced because metals started to gain traction as investment products for fund managers, ETFs and macro-economic hedge funds, many of whom are now trying to bail out.

The current level of movement is therefore not likely to be just a blip that can be ridden out by commodity-exposed firms. As investors are becoming more sophisticated in terms of the investments they make, they are still looking at metals and other commodities as an asset class, albeit a bumpy one. And as long as this pattern of behaviour exists (and OPEC and the US producers slug it out over oil), there will be spikes of volatility in the market and these spikes will impact the industrials as they go about their day-to-day business. There is thus increased urgency for treasurers in these organisations to mitigate risk. Hedging against price volatility is a common response but the decision to hedge is far from simple.

Measure and analyse

The simple spreadsheet is still the technology of choice for some businesses when managing their commodities deals. Unsurprisingly, this is becoming less of a practical proposition as volatility, compliance issues, regulatory reporting and market complexity reigns. Indeed, it is becoming increasingly necessary for treasurers to analyse what happens to their portfolio of commodities contracts as market prices rise or fall and they need to correlate this information with the downstream effects on functions such as production and sales in terms of cash and planning. But whilst it is important to understand the ‘here and now’, it is advisable also to evaluate a number of what-if scenarios, to stress-test all assumptions about pricing and risk and create optimal hedging strategies for a number of outcomes.

The need is to be able to see what the production plans are, what the requirement is for components for these plans, what is held on inventory, what the forward commitments are in terms of those components, and what has to be purchased. As this is being calculated, it will be necessary to assess the effects on the overall position of assumed price, currency and interest rate changes over that period. Armed with this information it will be possible to create different hedging strategies based on these scenarios actually playing out.

From a treasury perspective, gaining insight into the real exposures and risks of multiple contracts for different commodities across all regions could be a major challenge. If a particular exposure cannot be fully rolled up across the group, there is a chance that inefficient hedges will be placed. Treasury is also faced with the challenge around understanding and gaining visibility to the sub-components of physical purchases and their embedded risk. Without an ongoing appreciation and understanding of the organisation’s positions in relation to market conditions, it is possible that hedging policy becomes stale very quickly. The goal surely is to protect the downside so that if prices move against the organisation, it already has an appropriate hedge in place. But hedging by region, plant or even by individual trade simply because the bigger picture is not available will be more expensive than leveraging a consolidated global position, particularly if those hedges are placed individually with banks or brokers.

An accurate and timely view of commodity inventory, current forward purchases and exposures across the business, can facilitate more accurate tracking not only of the pricing of each deal but also of how effective existing hedges are. The challenge is being able to handle all the physical commodities contracts, with their underlying sub-components (such as basis, freight and grades) and combine that information with the financial hedges. Being able to report this view inside treasury will give the treasurer better insight to their overall risks and underlying cash flows. Having this information means that as prices move, the decision to exercise any options, for example, becomes that much clearer. To this end, a number of trading and risk management solutions are available from vendors such as OpenLink, Reval, Thomson Reuters, SunGard or Triple Point. Again, there is a cost and another layer of complexity to consider but these have all been tried and tested using years of best practice and market knowledge; the business case for in-house development and maintenance may not withstand close scrutiny in this light and in any case having all commodities and treasury functions on a single platform is an advantage.

With a fuller appreciation of commodity positions – calling upon data from purchase contracts, production requirements, procurement needs and sales forecasts – comes the opportunity to engage with more sophisticated (and thus effective) hedging tools (beyond simple futures and options). Being able to understand and isolate the component risk of non-financial items (now permissible under IFRS 9 Hedge Accounting rules) for example, is potentially far more effective and efficient: an airline’s jet fuel trades may only need hedging of the crude oil component. Of course, where a non-US airline or other business is hedging in USD (because that is how oil and many other commodities are priced) as USD strengthens, so the embedded currency risk of the deal fortifies; this is another consideration for treasury.

The sustainable model of production

Despite the current slow-down in countries such as China, continued economic growth in emerging markets has driven demand for resource. This contributes to higher and more volatile commodity prices. The projected growth for steel consumption between 2010 and 2030 has been reported as high as 80%, with the demand for energy set to increase in the same period by 33%.

Manufacturers can create value, cut costs, and reduce exposure to volatile commodity prices by improving their resource productivity, according to McKinsey & Company. The concept it espouses effectively means using fewer resources for each unit of output. In the spirit of sustainability and corporate responsibility initiatives, collaboration with suppliers and customers “can keep used products, components and materials in circulation”. Rather than engaging in the traditional supply chain, which creates a linear relationship between stakeholders, McKinsey refers to a business model that requires rethinking ownership of materials in terms of a “supply circle”. This proposes the regeneration of natural assets through repair, maintenance or recycling of materials or products at every stage of production, across the full supply circle.

At the core of this effort is a need to analyse how raw materials are extracted, how components are produced, how products are designed and how return (recycling) markets are organised. McKinsey suggests that large companies can start to exercise influence in the supply circle where previously it would have no direct control.

There is a cost. McKinsey warns that without digital supply chain management, it will be almost impossible to co-ordinate all the moving parts a circular supply chain requires in real-time. There may be a need to consider a new business model, where producers lease rather than sell in order to retain ownership of materials embedded in products (the automotive industry could adapt in this way). There may even be a requirement to rework the cash flow demands of a circular supply chain, compared to a linear one, and although margins might improve, the suppliers’ need for cash may change which will need addressing.

Take a decision

The prices of commodities have generally fallen in recent years but this situation will not last forever. Some businesses are better prepared for change than others. In 2008, Southwest Airlines in the US took the decision to lock in the price for about 70% of its jet fuel based on oil at $51 per barrel. For 2009, it locked in 55% of its jet fuel based on that same price, and its strong financial position allowed it to continue to lock in fuel prices over the next few years. Many did not understand this move at the time, but as oil went to $100 and beyond, Southwest’s strong financial position allowed it to turn a profit when most others were reporting losses.

For corporates in Asia, managing commodity risk and any imbedded currency risk is now an essential part of the job: taking a proactive stance at the right time can – as Southwest demonstrated – make all the difference. In essence, real-time visibility of commodities trade allows treasury to become a more pro-active partner for the rest of the business. For companies where margins are thin to begin with, this approach seems logical. However, the proactive management of commodities risk is not an Asian issue per se; there is clearly a commonality of themes and issues across all regions. For treasurers, knowing when and how to react is becoming another crucial part of the skillset and making sure they have the right tools to do the job can set them apart from their competitors.

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