Risk Management

Commodity price risk

Published: Mar 2013
Portrait of Krishnan Iyengar
Krishnan Iyengar, Vice President of Global Solutions, Reval:

We’re seeing an increasing number of corporate treasury departments institute programmes to manage the risks associated with volatile commodity prices. Historically, commodity price risk management resided in procurement, but because treasury already manages exposures from fluctuations in foreign exchange (FX) and interest rates, bringing commodities into the purview of treasury’s holistic approach to risk management makes sense.

Sustained periods of commodity price volatility since 2005 have materially impacted corporate performance. For example, coffee prices fluctuated dramatically between 2011 and 2012, while during the same time metals dropped 68% and then spiked by 172%. This type of volatility has wreaked havoc on profit margins and many companies’ ability to price their products. It is natural that treasury, with its mandate to strategically guide the company’s financial health, manages risk across all asset classes.

We also have seen a decoupling of price risk from supply chain risk. This decoupling has allowed procurement to concentrate on managing supply chain risk (the risk of procuring commodities and delivering them when they are needed by the organisation), while treasury take ownership of managing the price risk associated with procuring these commodities. The major trigger for this decoupling seems to have been the global financial crisis, which allowed treasury departments to showcase their financial risk management acumen and cast into the spotlight the inherent risks prevalent in physical fixed price contracts.

Prior to the financial crisis, the most common method for procurement departments to use in managing the price risk of commodity purchases was to require suppliers to provide their commodities at fixed prices over a given time horizon. In times of low volatility, this strategy worked well; however in times of extreme volatility, this strategy pre-supposed that the supplier had the appropriate risk management acumen to run its own business. As the global financial crisis made painfully clear, this was not always the case.

The results we have seen from companies taking over the management of commodities indicates that treasury has successfully applied the financial risk management techniques they have always used, including examining natural offsets across the enterprise and the prudent use of derivatives.

Portrait of Michael Schwartz
Michael Schwartz, SVP, Chief Marketing Officer, Triple Point Technology:

The short answer is yes. Corporate treasurers must make managing commodity price risk a high priority in order to protect profits and remain competitive. Volatile commodity prices cause fluctuations in the cost of ingredients and subcomponents that, if not properly managed, will adversely affect profit margins and ultimately earnings. According to Gartner’s Predicts 2012 report, without effective risk management processes, commodity volatility easily translates to a double-digit percentage hit to the bottom line.

Many manufacturing and consumer products companies make the mistake of assuming that price spikes are a temporary thing, and think that they don’t need a strategic, long-term strategy for managing volatility. The fact of the matter is that commodity volatility is here to stay and companies that don’t take steps to mitigate its effects are in severe danger of being left behind.

In order to be successful in today’s environment, organisations must see commodity management as a strategic issue, not just a procurement challenge. They must move away from spreadsheets and embrace technology solutions that are specifically designed to manage commodity risk, such as Triple Point’s Commodity XL™. Commodity XL™ enables manufacturers to manage costs and risk exposures related to the price of raw materials, packaging and energy. It provides full transparency into commodity risk across all categories, divisions and geographies, along with access to real-time data and analytical tools that drive fast, accurate decision making.

Commodity risk exposure is no longer an issue confined to traditional commodity buyers, sellers and traders – it now encompasses companies further down the commodity value chain. Commodity volatility is not going away and the companies that implement a viable long-term strategy to manage volatility that includes leveraging the appropriate technology will secure a large competitive advantage. Those companies that continue to bury their heads in the sand, relying on massive, error-prone spreadsheets to manage commodity exposure, are setting themselves up for failure.

Portrait of Jeff Wallace
Jeff Wallace, Managing Partner, Greenwich Treasury Advisors:

If commodity risk is a significant factor in the pricing of the company’s revenue, then the answer is no treasury should not be concerned. In that case, the company is economically a trader in commodity risk and needs to profitably manage that risk. Trading skills are needed and typically corporate treasury by deliberate design has hedging, risk minimisation skills – not trading, profit-maximisation skills. The two mind-sets are quite different.

However, if commodity risk is a significant factor in the manufacturing input process, then the answer is yes. The alternative is allowing the purchasing department to manage the risk, and purchasing managers typically do not have any training in managing market risk, trading derivatives or hedge accounting, nor do they have the systems infrastructure. However, what they do have is an understanding of the supplier market in which the commodity is purchased, a market which is often quite different than the applicable derivative market.

Since the biggest challenges in any corporate commodity hedging programme is managing the basis risk between the particular purchase index and adder and the derivative index used to hedge it, the purchasing department should be involved as part of the commodity hedging team with treasury, accounting and operating management.

The volatility of this basis risk – which can vary substantially if the physical index is not highly correlated with derivative index and/or there are significant, frequent changes in the adder – can affect the economic and accounting effectiveness of hedge. Purchasing’s expertise is needed in negotiating purchase contracts that have indices more highly correlated with the available derivative indices and have adders that are fixed for as long as possible.

However, it is treasury’s job to explain to purchasing the contract restructuring alternatives for achieving this better matching. It is also treasury’s job to have a good technical understanding of the commodity derivative market, who the major market makers are (which are not always the global banks), buy the derivatives on a competitive basis, manage the counterparty risk and explain how the hedge accounting will work for the accountants.

These are easily transferable skills from treasury’s FX hedging. Since the objectives of hedging purchased commodity risk and FX risk – smoothing volatility or to lock in rates – are often the same, the trading tactics treasury uses to manage FX risk are often directly applicable to managing commodity risk. In addition, and equally critically, the systems infrastructure treasury uses to manage FX risk can be quite easily adapted to manage commodity risk.

The next question

“How can treasurers improve the quality of their cash forecasts?”

Please send your comments and responses to qa@treasurytoday.com

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