Commodity Risk Management: Time for Action?
by Olivier Cattoor and Olivier Kaczmarek, PricewaterhouseCoopers, Belgium
A treasurer’s job description includes protecting the company from adverse financial risk movements. While this is a commonly agreed paradigm with respect to foreign exchange, interest rate, liquidity and credit risks, the above statement is not necessarily true for commodity risk.
We will first examine why some companies exposed to commodity risks have not yet started to actively manage those exposures. We will then focus on a few examples of companies which successfully manage commodity risks. Finally we will seek to highlight from these examples, tips and hints that can be applied to better manage commodity risks.
Reasons for inaction
With the exception of a limited number of companies with significant commodity exposures at the core of their activities (e.g. airlines, metal refining companies, etc), it is surprising to note how few treasurers and CFOs have a clear view of the commodity exposures of the company. This situation is worrying in a context of increased deregulation and volatility of energy and commodity markets.
Here are some of the potential root causes for this situation:
- First of all, information regarding commodity exposures is usually spread throughout various departments (generally procurement / sales departments) and throughout the various subsidiaries. Hence, the first difficulty companies encounter when setting up a Commodity Risk Management practice (“CRM”) is the identification and mapping of the exposures;
- The second reason for inaction relates to the difficulty of correctly quantifying the commodity exposures the company faces (i.e. taking into account any exposure pass-through mechanism or natural hedges). This exercise requires a good understanding of the various business models applied throughout the company;
- The third difficulty to overcome is for management of the company to agree on the objectives and strategy. This exercise is delicate, as senior management often has different viewpoints on risk management objectives (e.g. reduce earnings volatility, lock-in a budget price, or keep some benefit from potential favourable commodity price movements over the long term);
- For companies which have already successfully passed these first steps, the next challenge is to measure the performance of the selected CRM strategy. The point here is to define the appropriate KPI’s and how to practically follow these up;
- Many other factors could be added to the above list among which, to cite a few, who should be responsible for this process: the head of procurement or the treasurer, the difficulty to find the appropriate hedging instruments or the lack of liquidity on some financial hedging commodity markets.
The road to a successful Commodity Risk Management approach is full of traps. The examples below illustrate that some companies have found their way through the maze.
Some large industrial groups understood a long time ago the benefits of actively managing commodity risks. The following example of a manufacturer of equipment illustrates the point. This company has an important exposure to metal on the buying side with with a limited ability to pass through any commodity price increase to the customers in sale prices, in view of the price competitiveness in this market. This situation gives rise to a one-sided metal exposure. While purchases of metal may remain decentralised, all subsidiaries communicate and regularly update their metal purchase forecasts to group treasury which has the responsibility for hedging a portion of those exposures in order to secure the metal procurement costs over the medium term.