Some companies that depend on commodities, are now scrambling to hedge their exposure to rising prices. It’s a strategy which Amol Dhargalkar, Chairman and Managing Partner at Chatham Financial compares to buying insurance after they’ve crashed the car.
For commodity-dependent corporates, seeking protection from the rise in prices of vital commodity inputs as a consequence of the ongoing conflict in the Middle East, a pro-active and disciplined hedging programme is vital.
Yet for companies that have a policy decision not to hedge, Dhargalkar says it is also just as important to lean into that belief and resist the temptation to scramble for last minute protection in a reactive response to market movements.
“We have definitely had some regret conversations,” says Dhargalkar, speaking to Treasury Today from the company’s Kennett Square, Pennsylvania office.
Dhargalkar attributes reactive policy making to a number of factors. Top of the list is the propensity of some treasury teams to not have full visibility of procurement or the supply chain. Often times treasury will scramble to hedge exposures because they don’t want “to make things worse,” he says, adding: “Data is the first problem.”
Another reason why treasury teams might also press the button on last minute hedging strategies is the multi-faceted nature of commodity risk which often resides throughout an organisation.
Another contributor could be the fact operational levers to mitigate the risk, might not work. Take a shipping company, that has decided not to hedge fuel but charge a fuel surcharge instead. Yet abandons this policy because the company loses market share.
In another example, airlines often choose not to hedge their fuel exposure because they have operational levers they can pull like charging more, or cutting flights, to protect from a spike in fuel costs. According to DWU Consulting, US airlines have mostly abandoned sophisticated hedging programmes with three of the four largest US carriers now maintain zero hedging positions.
Another reason treasures might scramble last minute to hedge commodities is because they are more familiar with longer term interest rate and currency hedging programmes: commodity hedging is more complex and not something they are as comfortable with. “Commodity risk goes much deeper into the organisation; it requires credit, and more energy and infrastructure behind it. The cost might also be higher because the volatility is higher.”
He also reflects that hedging is often made more challenging by gaps in the skills set of the underlying treasury team.
Although larger firms have sophisticated treasury operations, even amongst these corporates, it is unlikely they will have dedicated derivative or hedging specialists. Typically, people run hedging programmes alongside other tasks and specialists are rotated around a treasury and finance team. In contrast, banks run highly specialist hedging teams who have been doing it their whole careers.
It can result in an asymmetry of information in skills but also access to the underlying data. Corporates won’t have sight of the trading, pricing and exposure data, he warns.
Higher cost of borrowing
Dhargalkar believes US corporates are focused on hedging strategies not just because of the impact of the war in the Middle East. It is also a consequence of the long-term overshoot of US inflation, and the fact that US companies are navigating a new perspective on interest rates. Many entered the year thinking rates would come down, but now most believe they are heading higher.
“The last time inflation was below 2% was March 2021,” he says. “It is really starting to get into CFO minds that rates aren’t coming down anytime soon.” Observing that many corporates are opting to issue debt now rather than wait in anticipation of a rise in borrowing costs.
Some companies are more vulnerable than others to higher borrowing costs, he says. Higher borrowing will be keenly felt by organisations involved in the build out of digital infrastructure, for example. Much of the capital flowing into the construction of data centres is highly levered and financed by private credit or banks. In one trend, he notices that firms are trying to hedge their exposure as early as they can via deal contingent hedges, the specialised derivative structures used in M&A and project finance where sponsors are protected by a walk away clause if the transaction fails to close.
“The cost of hedging has increased as measured by credit charges and some industries are more out of favour now than others,” he concludes.
