Risk Management

Effective commodity risk management in a volatile economic climate

Published: Jan 2020

Commodity prices can be subject to extreme volatility – as has been demonstrated in recent years. As a result, managing commodity risk has become an increasingly important area of responsibility for many corporate treasuries across different sectors. In the current economic climate, where security, liquidity and efficiency are key, having an effective commodity risk management framework in place is essential.

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Commodity prices are often characterised by a high degree of volatility, and any fluctuation in the price of a commodity has the potential to affect a business’s production costs, its pricing and its earnings – not to mention the availability of credit.

There are a number of inherent risks for any business operating in today’s commodity markets. For both producers and consumers, the most important is price risk – the uncertainty which surrounds future commodity prices.

Recent research by United Nations Conference on Trade and Development (UNCTAD) found that, between September 2008 and September 2018, the average spot price of Brent crude oil fluctuated between US$125 and US$31 per barrel. In the same period, the average monthly price of copper at the London Metal Exchange fluctuated between US$9,900 and US$3,000 per ton.

Price isn’t the only risk associated with commodities. Agricultural yields, for example, are subject to production risk, whilst the delivery of commodities from producers to traders, and then on to consumers, is associated with transportation risk. Throw in counterparty risk of a supplier’s creditworthiness, currency risk and climate-related risk, and the task of managing commodity risk is anything but straightforward.

“The impact that this can have can be very dramatic – particularly in terms of credit risk,” says Ian Tobin, Head of Credit Risk at Brady plc. “Apart from settlement risk, the real concern is replacement cost – the loss associated with replacing the transaction with another counterparty at a worse price if the original counterpart defaults.”

Any volatility in commodity prices means that it is essential for any business reliant on a specific product to manage the impact of potential price fluctuations across its entire value chain. Having an effective commodity risk management process in place is therefore the only way for a business to manage both its financial performance and its overall profitability.

FX and commodity risk

But commodity price volatility can impact different businesses in different ways, depending on where they lie on the value chain. A UK airline dependent on the daily price of oil, for example, could be more impacted than a business in the same country that produces products reliant on commodities which aren’t typically as volatile, such as wheat or sugar.

This is because there is an underlying link between commodity and FX price risk. As the US dollar is the worldwide pricing mechanism for most raw materials, any changes in the dollar’s value against any other currencies often translates into buying or selling pressure in commodity prices.

Should the price of a commodity fall, it could decrease sales revenue for producers. This, in turn, will impact profitability, and production levels may be altered in response to lower prices. For businesses that consume such a commodity, this could potentially increase profitability and thereby increase the value of the business.

On the other hand, if the price of a specific commodity rises, it will increase the sales revenue for producers, thereby increasing the value of the business. As producers start to see the benefits of the price increase, competition in the space may intensify as new entrants seek to take advantage of the higher prices. Furthermore, the profitability of consumers of the commodity could reduce, which could potentially have a negative impact on the value of the business.

For David Daniels, Group Treasurer at National Express, commodity risk and FX risk can be managed separately or together – it all depends on a number of factors such as organisation policy, the size of exposure to a commodity and the capability of the organisation.

“You can hedge your commodity risk in USD and enter into a separate contract to cover resulting transactional FX exposure – which may result in double spread,” he says. “Any organisation should have systems and processes in place to identify other activities which can also offset the exposures.”

Yet for David Stebbings, Director, Treasury Advisory at PwC, there remains an inherent problem in the management of both commodity risk and FX risk, in that in the past they may have typically been managed independently within many organisations. But this is changing. “Previously, the price of a commodity was typically a procurement issue rather than one for treasury except in the most obvious cases such as airlines. Treasury may previously have only hedged the FX risk, but now they are getting much more involved in commodity price hedging decisions,” he says.

However, he notes that this has brought internal challenges for some organisations. “Some procurement departments believe that price is their domain because treasury may not understand the key determinants of price such as the quality of the commodity – particularly soft commodities such as corn or grain,” Stebbings says.

“What treasury must do is work with procurement to determine a strategy as to what and how to hedge and which financial instruments to use. A lot of companies have struggled with commodity risk, simply because they do not have a strategy in place that is joined up between procurement and treasury.”

Commodity hedging instruments

There are various financial instruments that can be used to manage commodity risk. Known as derivatives, these instruments include futures, forward contracts, options and swaps. Over the past few years their complexity has steadily increased. The main ones used in this arena are:

Commodity futures

Futures are essentially contracts to buy or sell a commodity at a specified future date. They are typically cash settled and rarely end in physical delivery. Futures are not typically contracts between producers or buyers looking to hedge price risk, but are used more by investors from outside the commodity space who aim to make a profit from movements in commodity price volatility. They are traded on numerous exchanges across the world, such as the London Metal Exchange (LME) and the Chicago Mercantile Exchange (CME).

Forward contracts

Although forward contracts share many similarities with commodity futures, the main difference is that they are not traded on exchanges, but are traded ‘over the counter’ (OTC) – in other words, negotiated between two parties. With no clearing house involved, forward contracts carry the risk of default by one of the contract parties. Unlike commodity futures, forward contracts are often used by physical commodity traders to hedge price risk.

Options

As the name suggests, options are instruments which give buyers the option of buying or selling a commodity at a designated price until a designated date. Traded on both exchanges and the OTC market, the buyer pays the counterparty a premium for the right to buy or sell the underlying commodity.

Commodity swaps

This is a contract where two parties agree to exchange cash flows which are dependent on the price of an underlying commodity. They are typically used by commodity consumers and traded OTC in order to lock in commodity prices over the medium to long term.

For an airline company, for example, a commodity swap would allow it to hedge the risk of rising oil prices. Should the price of oil rise beyond the pre-specified price, then the company would receive payment equivalent to the price difference.

“The management of commodity exposure using any of these instruments would largely be dependent on the company risk management policy and would vary by sector,” says Daniels. “A major oil producer might use options to reduce earning volatilities, while end users like airlines might use a swap to hedge the risk of rising fuel and fix procurement costs.”

There are a number of benefits of hedging commodity price risk, and top of the pile are the cash flow benefits it brings, because when commodity prices fluctuate, so does a business’s cash flow. The task of forecasting and protecting future cash flows is therefore paramount. Any difficulty in liquidity means that a business may have to undertake a short-term financing arrangement to deal with the deficit, and this could impact the bottom line.

In essence, hedging can shield a business from any volatile price movement, whilst stabilising cash flow volatility through offsetting the risk.

“Don’t go about it the wrong way”

Andy Hartree, Senior Adviser at Gneiss Energy, believes that too many treasurers go about managing commodity risk in the wrong way. He explains:

“The corporate treasurer is in no better position than anybody else in trying to anticipate commodity price movements.

“What I have seen in over 20 years of watching people trying to anticipate market fluctuations is that far too many of them don’t follow the first golden rule in managing commodity risk: focus on your business. Treasurers need to look at the business and think:

  • What are the objectives of my business?
  • How do potential market movements threaten my ability to achieve my objectives?
  • How do I mitigate those threats?

“Once treasury has identified what puts the business at risk, it’s vital to analyse how big a particular commodity risk is: whether it’s existential, or whether it is just a mild irritant. Only then can treasurers judge it accordingly and come up with ways of how best to manage it.

“It is far too common to find companies that almost go around managing commodity risk the wrong way. They start with a ‘we need to do some hedging’ attitude, and don’t come at it from actually working out what they are trying to achieve with the hedging process – proving the adage that ‘hedging is not risk management!’ Only if you do the work to understand the impact of price (or any risk factor) on your business, can you devise a risk management strategy with clear objectives. Then, when you hedge as part of that policy, you can objectively assess the effectiveness of your actions to achieve those objectives.”

Measure for peace of mind

Aligning any hedging strategy with the overall business strategy requires ongoing and close cooperation with senior management. Communication and integration of hedging is crucial, and doing so will improve the business’s ability to respond to changes in commodity prices, whilst ensuring a shared sense of responsibility for results.

However, businesses should not be complacent. “A business should be able to identify their exposure to commodity risk before being able to reasonably measure the risk,” says Daniels. “This requires a holistic review of operations and key business areas that are impacted by commodity price movements – and this is a good place to start. A business must also have tools to provide appropriate and timely data in order to measure the risk.”

For Andy Hartree, Senior Adviser at Gneiss Energy, the first step in this analytical framework should be to embed commodity price projections. In doing this, there are two important elements: first, to make objective price assumptions. The only thing we all know about price forecasts is that they will always be wrong, but more seriously, they are inevitably biased. This raises the risk that not all scenarios are properly considered. Secondly, the business should be reviewed across a price range. By using even a simple model based on an objective understanding of how prices move (regardless of market drivers), this can throw enormous light on a business’s sensitivity to different price environments. And this leads to a much better understanding of the business’s real exposure to commodity price. Then you can devise an appropriate strategy to mitigate that exposure.

Hartree says that the second step is to work closely with senior management to agree risk management policy. Treasurers are in a key position, because they ‘have all the right information to be able to do the analysis at their fingertips’. “They can say to the board ‘this is what the risk profile looks like’ and make a sensible policy proposal about how commodity price risk should be managed,” he says. “The more self-evidently aligned that policy proposal is with the core business objectives, the easier it becomes to secure the all-important senior management buy-in – because it will be obvious it is what needs to be done.”

Brady plc’s Tobin, agrees – but adds that managing commodity risk comes down to not only having effective tools that can predict future commodity prices, but being able to react faster to adverse credit events and mitigate exposure increases.

For example, if a ratings agency issues an outlook that is deteriorating for a particular counterparty, the credit team can quickly place trading restrictions or request some form of credit mitigation, such as a letter of credit or guarantee. “This means that traders will instantly know what the restrictions are for this particular counterparty,” says Tobin. “It’s really about speed when it comes to reacting to market events.”

Align to thrive

Regardless of how a business chooses to manage commodity risk, tackling this area successfully can be a significant game changer when it comes to maximising business performance for those that are involved in trading commodities. Companies involved in this ever-changing marketplace, particularly within consumer and industrial products, have to be active in their management of risk.

When it comes to managing commodity risk, one thing is clear – it is imperative to align all areas of the business, from the board to finance, and from treasury to procurement. Only then can commodity risk be successfully managed.

The insurance benefit

Commodity price risk insurance can be a useful tool in the treasurer’s armoury.

For Keith Flury, Chief Analyst at Stable, which is a price insurance company for food and farming businesses dealing in commodities, price risk insurance is a no-brainer. “What we do at Stable is offer a more democratic way to deal with commodity price risk,” he says. “We offer a product that can give treasurers piece of mind and offer a risk management tool for a commodity price, be it anything from eggs to walnuts.”

What Stable aims to do is allow treasury to peg a price risk to a specific index – anything from those published by the US Department of Agriculture (USDA), to an egg index offered by a local municipality in the Netherlands or a grain index offered by a price reporting service such as Reuters or Bloomberg.

Because these indexes give a very good indication of local regional prices, and often do so in a local currency, treasury has the opportunity to take out a price insurance policy to put a limit on exposure to price risk. “If you were a buyer of walnuts in the UK or the US for example, commodity price risk insurance can resolve worries such as a major drought, weather issues or geopolitical tensions,” says Flury.

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