Five Steps to Managing Commodity Risk and Adding Value
by Koen Timmermans, Group Financial Risk Manager, Borealis AG
Borealis has become well known across the treasury community for best-in-class cash, treasury and risk management. In this article, Koen Timmermans describes the company’s approach to commodity risk management, an increasingly important area of responsibility for many corporate treasuries.
An emerging treasury responsibility
We started to build our new, centralised, best-in-class treasury organisation in 2002, a business function that has subsequently evolved to meet changing business needs, market and regulatory requirements. During this period, commodity risk management emerged as a more important priority for the business and was ultimately brought under treasury’s control. Originally commodity risk was managed by each business unit, but in 2006 a reporting line to treasury was introduced and a new, overarching central financial risk management function, combining the oversight of all financial risks and their interdependencies for the group. From 2009, treasury took on direct responsibility for commodity risk management, so it is now dealt with alongside other forms of risk such as foreign exchange. In summary, our approach to commodity risk management can be described as five key steps.
Step 1. Building the treasury infrastructure
As part of the treasury function, we have a group financial risk manager, responsible for all financial risks, including market, commodity and credit risk. Our trading risk office provides back-office support for all trading and commodity hedging activities, and middle-office reporting of risk exposure and traders’ performance. These functions work closely with the treasury analyst responsible for USD exposures.
By maintaining a consistent approach to commodity risk as part of a treasury and financial risk policy, we can manage the interdependency of risk more effectively, such as between currencies and commodities, but inevitably our risk policies for commodities are highly specific, and cover the full range of commodity risk issues. For example, we specify maximum trading limits by tonnage, whereas for FX we set limits by currency and exposure.
We have also developed our systems environment to support commodity risk. Although we have a treasury management system (TMS), we found that like most other TMS, although it supports some commodity hedge pricing, it is not designed to provide specialist commodity risk management capabilities, such as logistics. In 2008 therefore, we introduced Commodity XL from Triple Point Technologies. This solution allows us to monitor our commodity flows, logistics, sales and price risks efficiently, with comprehensive analytics and reporting. We have also built a performance management tool in-house, and we have a clearing set-up for measuring financial derivatives on feedstock.
Step 2. Defining our exposure
While the infrastructure is important, it is essential to be precise in the way that we define, monitor and manage our exposures. Firstly, defining our exposures is not necessarily clear-cut. As a business, we purchase raw materials for our production plants in both USD (e.g., hydrocarbons: ethane; propane; butane; naphtha) and EUR (e.g., monomers: ethylene; propylene). The prices of these raw materials are closely linked to the price of oil and are therefore very volatile. Meanwhile, the plastics we produce are mostly sold in EUR. Due to high volatility, in both raw material prices and EUR/USD rates, and uncertain demand, it is very difficult to budget for our raw material spend.
A logical response might appear to be to hedge our raw material costs and exposure to EUR/USD volatility: in fact, we are able to budget our net profit with greater accuracy than our raw material costs. A low/high oil price level, and/or a weak/strong USD does not necessarily lead to high/low profitability, as when oil prices increase there is frequently the opportunity to increase sales prices, and vice versa.
There is linear regression between raw material prices and sales prices, so we study market prices closely. We then use this to analyse our data and identify the consequences. For example, most European competitors have naphtha crackers (cracking is the process of modifying carbon molecules in naphtha to produce olefins, including ethylene and propylene). Therefore, the main production cost is the naphtha (i.e., feedstock) price, which is closely correlated with polyolefins prices. There is thus no price risk on floating priced feedstock, as additional raw material costs are offset by higher sales prices. More important than the USD raw material cost is the EUR equivalent. For fixed price feedstock, we are subject to full price risk.