Published: June 15, 2009
Among other things, the second half of 2008 was marked, from a market point of view, by the steep drop in the price of raw materials after its mid-year peak.
We all knew that the prices were over-evaluated. The global economic growth supported the price of commodities for a long time. Yet this market is characterised by its great adaptability. When the demand drops, the producers adjust their offer little by little (for non-agricultural matters that are subject to possible climatic contingencies).
The relative gap between the spot price and the future price has hit record levels. The spot price which we notice the most, is decidedly that of petrol (almost divided by four as compared to its highest level in 2008!). But for the prices to stabilise, there must be a balance made between offer (production to be reduced and adjusted) and demand (dropping), providing that intrinsic elements influencing the price do not interact (i.e. cold or warm weather, storms, floods, freezing, etc.). In the short term, no one predicts a real rebound of raw material prices. In fact, adjustment of the production is never immediate and the increase in production requires an activation period. The elasticity has a certain technical or seasonal inertia. In the long term (2010), an increase is expected. However, 2008 will not be forgotten. Even at USD30 a barrel, everyone would like to pollute less, consume less, recycle what can be recycled and use more renewable energy. Demand is not always driven by lower prices.
The extreme volatility of raw material markets has pushed a number of businesses to cover their exposure even more. The turning of the markets disturbed them; some were even over covered. As always, it is in a period of crisis that we feel compelled to review our hedging strategies of raw materials.
In certain cases, since raw materials are most often labelled and quoted in USD, the European company will add to the risk component on raw materials, the risk of the exchange rate USD/EUR.
Some have covered more and more in a growth market context. Today, they are puzzled and questioning their entire hedging strategy. Yet the strategy must be independent of the fluctuations of the raw material demand, which can be big. The strategy is certainly not static, but requires a certain longevity to be useful. Some companies have been burnt when first, they did not cover enough, then they became over-covered. And what should they do now?
One must add to this dimension of volatile commodity markets, the volatility of the US dollar, which adds a layer of difficulty to any treasurer’s job. Any strategy must be harmoniously articulated. Besides the price risk and the exchange risk (for a European), there remains the risk of illiquidity for certain raw materials. The last factor of complexity could come from the absence of an organised identical market. One must then make use of the hedging of similar underlying (highly) correlated stocks (ammonia and natural gas; jet fuel and Brent; Arabica and Colombian coffee, etc.) Too often the buyer cannot reflect the cost overrun on their sales, nor negotiate the agreements with their suppliers in order to ‘cap’ the purchase price.
Besides the hedging of the flows linked to buying raw materials, there are the purely speculative operations, which have been mushrooming. It is in fact useful to give volume and liquidity to the markets. Senior management and procurement have involved themselves in the hedging process, notably by adjusting the group's strategy through the purchase committees for commodities (a kind of organ of collegial decision-making). In general, policies are set for six months, as the markets move more quickly than before.
Today, climate factors (with temperature changes and pollution), political events (i.e. Russia and Ukraine for the transit of gas to Europe, conflict in the Middle East, etc.) and economics (less demand in a recession period) strongly influence the price of commodities, and not always in a controllable way. [[[PAGE]]]
It is clear that the company exposed to the price of raw materials will - as far as possible:
(1) Implement a common management framework between the purchasing department and financial department. From now on, the treasurer is directly involved in this type of hedging strategies.
(2) The company will generalise the increase of the selling prices based on the indices or commodity price evolution as far as possible. It will also try to fix and cap prices as much as possible.
(3) It will improve its forecasts to more precisely determine the needs, and by doing so, avoid over covering. This implies active monitoring and constant updates of forecasts to adjust the resources to the demand.
(4) Finally, it will apply a hedging strategy allowing for smoothing over time the impact of these variations. Sometimes, this needs the help of a consultant and certainly a new organisation and co-ordination between departments. Appropriate reporting must also be implemented for a regular follow-up of the open positions. The strategy and financial products to be used will also be well-defined in a policy validated by top management.
In certain cases, since raw materials are most often quoted in USD, a European company will add to the risk component on raw materials, the risk of the exchange rate USD/EUR. This rate can mitigate a rise in the value of the underlying stocks bought, or worse, increase the risk. The correlation of the two impacts can make the European company less competitive than its American competitor (when the dollar is strong). Therefore, we see that the risk is linked to the underlying stocks or even sometimes the closest and most correlated underlying stocks and the quoted currency, without mentioning the political risks that can sometimes dry up a market if the production is highly concentrated on a geographic area.
The efficiency test and the 80-125% corridor explains that sometimes a hedging is inefficient from inception since the closest and most correlated underlying stocks are different. The risk of ineffectiveness is greater from the start than for the hedging of an interest rate or exchange rate, for example. This explains why certain treasurers have suggested removing this restriction so at least the effective part, as weak as it may be, can be recognised as such and not impact the income statement. This proposed measure, notably by the “group of the four corporations” within the FIWG (Financial Instrument Working Group created by the IASB), takes on all its meaning here. It is one of the rare measures for which we could reasonably expect obtaining its removal.
Finally, treasurers must equip themselves with the appropriate tools or solutions to promote hedging, must transmit the reports and disclosures requested by IAS 39 and IFRS 7, and must test the effectiveness and sensibilities of the hedging in place. It is far from being a simple task technically.
The communication of the strategy used is always delicate. One must talk about it without talking about it too much or risk giving an advantage to a competitor. Some do not even dare address this point or do so in extremely vague and brief terms. Any shareholder has the right to know how the group is covered, even more so in a highly volatile period. This exercise in transparency is very delicate and highly sensitive for a number of CFOs. Here again, the listed company is penalised by a more organised and more formal publication or by the use of more restrictive IFRS accounting standards.
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