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To Hedge or Not To Hedge Raw material price management and added value from treasury For years, treasurers have been tackling the problems of interest and exchange rates in an analytical and structured manner, in order to get to grips with the effect on overall profits and interest expenditure. In particular, commodities buyers have had to cope with extreme price increases and price fluctuations. Where it was not possible to cushion or pass on the effects of the price rises, they often had a negative impact on company profits.

In this article, Wolfgang Frontzek discusses why an active financial risk management process is necessary and the questions that treasurers must answer in order to evaluate risk strategies and make use of derivative instruments.

Additionally, treasurers can discover the right situation in which price hedging is recommended, and how a good hedging strategy can make and implement necessary adjustments in order to maintain or expand the competitive position, as well as save a significant amount of time.

To Hedge or Not To Hedge

- Raw material price management and added value from treasury

by Wolfgang Frontzek,  Director of Group Treasury/Corporate Finance, Wilo

In recent years, commodities buyers have had to cope with extreme price increases and price fluctuations. Where it was not possible to cushion or pass on the effects of the price rises, they often had a negative impact on company profits. Rising raw material prices are not the only problem that buyers have, as the buyer is responsible not only for a fixed calculation or price basis but also for ensuring continuity of the production process, certainly over the medium term and thus over a planning period of 12-24 months. Price volatility presents the same problem, as it makes commodity prices genuinely unpredictable.

An active financial risk management process is necessary, to answer the following questions:

  • How high is the exposure?
  • What percentage of the production costs do raw material costs account for?
  • What effect does the price fluctuation of raw materials have on total profits?
  • Can price fluctuations be passed on?
  • What is the competition doing?

Only when these analyses have been made and the links clearly understood is it recommended to evaluate risk strategies and make use of derivative instruments.

This is where the experience of the treasury division is of benefit to the purchasing function. Long before there was much discussion of high volatility and unpredictable price fluctuations this was a common scenario for the treasurer. For years, treasurers have been tackling the problems of interest and exchange rates in an analytical and structured manner, in order to get to grips with the effect on overall profits and interest expenditure.

For years treasurers have been tackling the problems of interest and exchange rates in an analytical and structured manner.

Point of departure

The company buys around 3,000 tonnes of aluminium alloys a year. Given the situation as of January 2009, one tonne of aluminium is priced at a record low of USD 1.150 on the LME. The total purchase volumes based on the current market price currently amount to USD 3.5m.

The historical volatility is around 45% and the peak is USD 2.860.

Based on this peak, the company is exposed to a price movement risk of USD 1.700 per tonne or a total of USD 5.1m.

Accordingly, the price opportunity on the basis of the record low in 1997 of USD 1.000 is relatively small at USD 150 around per tonne or around USD 500,000.

In addition to the market price risk, raw materials prices have a significant effect on production costs.

Interpretation

In table 1, the average costs of raw materials influence the production costs at a rate of around 50%. The raw materials costs again account for around 80% of the materials costs. The proportion accounted for by aluminium is about 20% of materials’ costs and consequently a notable factor in comparison with the company’s total production costs.

If the costs for aluminium, for example, rise by just 10% then

  • production costs rise by 0.8%
  • materials costs by 1.6%
  • raw materials costs by 1.7%

A productivity increase of 0.8% (EUR 800,000) would be needed in order to neutralise this 10% rise in costs. As it is not always possible for a processor of aluminium components to achieve this in the short term, no additional explanation is needed. 

In this respect, time can be saved through a good hedging strategy to make and implement the necessary adjustments in order to maintain or expand the competitive position. 

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