A Bespoke Approach to Commoditised Products
by Helen Sanders, Editor
As I sit here with my morning cup of tea and toast, with the radio on, while the rest of the country seems to be out on the beach eating chocolate ice cream and/or drinking flasks of lukewarm coffee, depending on where in the world you happen to be, it occurs to me just how reliant we are on commodities. Energy, metals, grain, rice, tea, coffee, cocoa are all essential features of our lives, virtually every day of the year (or in the case of precious metals, they don’t feature quite enough for my liking). For corporations, the reliance on commodities either as inputs or outputs is often fundamental to the business. Over recent years, we have seen unprecedented volatility in the price of commodities of all sorts, fuelled by supply peaks, a decline in demand, currency fluctuations, ongoing economic uncertainty and growing demand for commodities by the investment community. So as it is often said that opinions are the cheapest commodities in the world, what could we witness in the future, and how is the corporate community responding?
A little crystal ball gazing
According to the IMF’s World Economic Outlook (WEO) in July 2010, world growth is projected at 4.6% in 2010 and 4.3% in 2011. This forecast is around 0.5% higher for 2010 than previously stated in April 2010, reflecting stronger than anticipated activity during the first half of the year and enhanced by attractive prospects in Asia, particularly China,
“Overall, macroeconomic developments during much of the spring confirmed expectations of a modest but steady recovery in most advanced economies and strong growth in many emerging and developing economies.” (WEO, July 2010)
However, the IMF also comments that in parallel with steady growth, downside risks have risen sharply amid renewed financial turbulence, in countries such as Greece and Spain,
“Nevertheless, recent turbulence in financial markets — reflecting a drop in confidence about fiscal sustainability, policy responses, and future growth prospects — has cast a cloud over the outlook.” (WEO, July 2010)
Concerns over both sovereign and banking sector risk stemming from the European crisis have been yet another storm that has buffeted equity, commodity and currency prices. Looking at commodity prices, many of which seemed to have steadied following unprecedented volatility in recent years, the IMF commented,
“Prices of many commodities fell during the financial market shocks in May and early June, reflecting in part expectations for weakened global demand. Prices recovered some ground more recently, as concern about the real spillovers of the financial turbulence has eased. At the same time, waning appetite for risk prompted gold prices to settle higher. In line with futures market developments, the IMF’s baseline petroleum price projection has been revised down to $75.3 a barrel for 2010 and $77.5 a barrel for 2011 (from $80 and $83, respectively, in the April 2010 World Economic Outlook). (WEO, July 2010)
Commodity hedging is in many cases, a relatively new activity for treasurers.
A new task for treasurers
When we consider the heady post-$100 a barrel oil prices of relatively recent years, it might seem that large users of fuel can heave a sigh of relief and start browsing for a last minute holiday package. Not so. If the past few years have taught us anything, it is not only that the unexpected should be expected, but that something no-one has thought of might just happen too. So where does this situation leave treasurers? Firstly, commodity hedging is, in many cases, a relatively new activity for treasurers, as Jiro Okochi, Chief Executive Officer, Reval explains,
“Treasurers are taking more ownership over the commodities hedging process, an activity which would historically have been undertaken by procurement. In the past, hedging was typically more seasonal, based on historic trends; treasury tends to be more methodical in assessing the potential impact of current and future market risks.”[[[PAGE]]]
The increasing focus on risk management is a key driver in treasury’s increasing responsibility for commodities hedging, as Ashish Advani, Director of Derivatives at Royal Caribbean explained in his article that appeared in the 2009 Treasurer’s Guide to Hedge Accounting published by TMI,
“While identifying and hedging our risks has always been a very important part of RCL’s treasury activities, risk management has become an extreme task with breathtaking uncertainty.”
As treasurers are increasingly recognised as the specialists in financial risk management, they are therefore increasingly sharing the role of commodities hedging with procurement; however, as Jiro Okochi, Reval continues,
“This is a considerable shift in mindset for many companies, and treasury often needs to convince those who deal with procurement that they need to work with treasury to hedge commodity risk. After all, for a major commodities producer or purchaser, the economic impact of changes to commodity prices can be far greater than shifts in FX or interest rates.”
Not only are treasurers becoming more involved in the hedging of commodity procurement, but their risk management role also needs to extend to the other end of the financial supply chain, as Richard Childes, Corporate Treasury Solutions, OpenLink outlines,
“By becoming more involved in commodities hedging, treasurers are becoming more engaged with front line sales activity. For example, energy and raw material prices may fluctuate considerably during the course of a one-year fixed customer contract. There may also be an FX implication if the contract currency differs from the company’s base currency; therefore, the sales price needs to reflect these variables.”
Commodity hedging becomes fundamental
Despite the materiality of many companies’ commodity exposures, commodity hedging has not necessarily been a priority in the past. As Jiro Okochi, Reval describes,
“There is often a major difference between companies’ approach to hedging. While some take a very active approach, with sophisticated risk management systems, other very large firms have been less active in the past. With the market volatility we have seen in recent years, this is now changing and we are seeing new entrants to the commodities hedging market.”
In the past, the lesser focus on commodities hedging has been partly the result of treasury’s lack of involvement, but also because companies tend to formulate their strategy in comparison with competitors. For example, as fuel prices affect every airline in the same way, if companies hedge in a similar way, they are no more or less competitive than their peers, if an airline spends a great deal on fixing the fuel price while its competitors do not, it could be financially compromised. Referring to the major commodities producers or purchasers, Jiro Okochi, Reval explains,
“These companies will take a different approach to commodities hedging than those with less significant risks. For example, rather than simply looking to hedge 100% of their exposure to a particular commodity price, they will adapt their hedging strategy according to what their competitors are doing. Furthermore, these companies typically do not have the same natural offsets that they may have for other types of risk.”
When considering how to hedge commodities effectively, there are five key factors to take into account:
i) Identifying risks
ii) Devising and delivering a strategy
iii) The choice of hedging instruments
iv) Transactional and risk management
v) Achieving hedge accounting treatment
Identifying risks
Achieving visibility over commodity risks is just as challenging as currency and interest rate risks, particularly where the company adopts a decentralised approach to all or part of its commodity purchasing. While cash flow forecasting is typically the elusive discipline in treasury, the same challenges typically apply to commodities forecasting. However, just as many treasurers have made significant progress in cash flow forecasting by implementing web-based communication with business units, have improved integration with internal systems and educated business unit users about the importance of accurate forecasting, the same disciplines can very usefully be applied to commodities exposure forecasting.
Devising and delivering a strategy
When devising a hedging strategy, there are clearly a variety of complex elements that will be involved, including the materiality of risk, the approach to hedging taken by competitors, the cost of hedging and the ability to achieve hedge accounting treatment. Increasingly as the board becomes more engaged in risk management, the risk appetite is set at board level, which is particularly important in the case of major commodities producers or purchasers.
Achieving visibility over commodity risks is just as challenging as currency and interest rate risks.
Many companies’ commodities hedging strategies were found to be inadequate over a period of extreme volatility in 2008 and 2009, forcing new approaches, as Ashish Advani, Royal Caribbean explained in his 2009 article,
“Like many firms, we have found it difficult to respond in time to the new market conditions. We have analysed our hedging position extensively, and we are being forced to take unconventional approaches to solving unfamiliar problems.”[[[PAGE]]]
As Jiro Okochi, Reval explains, reflecting commodity price volatility in hedging strategies is becoming a more difficult but significant requirement,
“Volatility has become a major feature of the commodities market, not least because they are frequently targets of speculation, with growing hedge fund activity. Many tend mistakenly not to hedge when prices are stable, but when significant, volatility makes the risk element very real.”
The choice of hedging instruments
The commodities hedging market has been well-established for many years, with futures typically used for hedging commodities such as agriculture and oil, where physical delivery actually takes place. However, as companies take new approaches to hedging to deal with greater volatility, and commodities trading increasingly takes place without physical delivery, the use of options is increasing, as highlighted by Jiro Okochi, Reval,
“While corporates have not significantly changed the instruments they use to hedge, there is more of an appetite for option-based products in commodities, with more CFOs authorising an option premium budget. Part of this is due to companies not wanting to lock in their upside risk, especially if their competitors are not buying forward contracts.”
Transactional and risk management
A more active approach to risk identification, hedging strategies and the use of a wider range of hedging instruments brings a range of implications, not least that treasurers need the technology to manage their transactions, identify, monitor and manage risk. As Richard Childes, OpenLink summarises,
“As treasurers become more involved in commodities hedging, they need to extend their technology infrastructure to support transaction processing and risk management for commodities transactions.”
While many treasury management systems support commodities transactions to a greater or lesser extent, treasurers are increasingly using specialist commodities tools such as SunGard’s Kiodex, or risk management systems such as Reval®, which may then be integrated with core treasury management systems. In addition, there are new entrants to the corporate market such as OpenLink. Richard Childes, OpenLink explains,
“The advantage of a specialist tool for commodities is that it can support not only the financial elements but the logistics, capacity and inventory etc. Users can model the impact of different variables in combination, based on the end product, not just the components.”
He continues,
“There is also the ability to determine where best to manufacture products based on raw material, energy and transportation costs in different parts of the world.”
Achieving hedge accounting treatment
While achieving hedge accounting treatment for FX and interest rate hedging has been a long-standing issue for treasurers, ensuring hedge effectiveness for commodities hedging is a more recent phenomenon. As Jiro Okochi, Reval explains,
“With the shift in hedging responsibility from procurement to treasury, achieving hedge accounting treatment for commodities hedges has become more significant and is in many cases instrumental in determining an appropriate hedging strategy.”
He continues,
“Achieving hedge effectiveness is often even more difficult for commodities than for FX and interest rate hedges. For example, the hedge has to be proved effective against the finished product, not just the commodities element. Consequently, it can be very complex to determine the actual exposure even before deciding how best to hedge it.”
Hedge accounting is also challenging for corporates due to basis risk. Jet fuel cannot be hedged specifically for example, so a company may hedge against the price of heating oil or light crude, whereas in reality, there may be quite a difference.
This issue is exemplified by Royal Caribbean, as Ashish Advani explained in his 2009 article,
“We are trying to move to more standardised commodity products. For example…we used to hedge US Gulf Coast as far as possible. One of the problems with this was the lack of a liquid benchmark, so now we are considering proxy hedging using heating oil, which is a highly liquid benchmark. While we will have to take on basis risk, we will be less liable to uncertainties of US Gulf Coast oil pricing.”
Jiro Okochi, Reval continues,
“Furthermore, the cost of a commodity will differ at each location, such as jet fuel at different airports, which cannot be reflected in a company’s hedges.”
Again, this is illustrated in Royal Caribbean’s experiences,
“Each ship uses a specific fuel type which is then delivered all over the world in accordance with each ship’s cruise schedule. Some of these fuel types are not commonly traded, making it difficult at times both to source and hedge the relevant fuel type. The largest fuel purchases are in US Gulf Coast which is not typically benchmarked against WTI (West Texas Intermediate, or Texas Light Sweet, used as a crude oil price benchmark) which can create problems. At some ports, such as in South America and Australia, there is no market in this fuel and therefore as it is not universally traded, there is no standard source for future prices. This is an issue specific to shipping companies and cruise lines as other fuel-intensive industries use more commonly traded fuel types, such as airlines which use jet fuel.”
Future of commodities hedging
Supply and demand of commodities, particularly in faster-growing economies such as in Asia, will be fundamental to price movements in the future. Furthermore, as the market becomes more automated, with emerging commodities exchanges in China and India, we are likely to see even greater interest amongst the investment community, particularly hedge funds, which will continue to have an influence on pricing distinct from physical supply and demand. Policy and regulatory responses will also play a role as governments and international agencies seek to ensure food and energy security in developing countries.
Supply and demand of commodities, particularly in faster-growing economies such as in Asia, will be fundamental to price movements in the future.
In addition to dealing with continued volatility in the prices of key commodities, treasurers will need to deal with the implications of new hedge accounting regulations. Richard Childes, OpenLink also highlights,
“Looking ahead, firstly, treasury needs to be better aligned with procurement as well as sales to ensure that risk is managed across the financial supply chain. Secondly, we are likely to see more demand for cross-asset capabilities, with analysis combining both financial instruments and commodities for those who want to manage their risk on a holistic basis.”
The importance of input and output commodities in a business accentuates treasurers’ key role in both the physical and financial supply chain. Commodities are a key connection between the two, and as commodities risk management becomes more sophisticated, we are likely to see the emergence of crucial new banking and technology solutions over the coming years.
