Commodity Risk Management: Time for Action?

by Olivier Cattoor and Olivier Kaczmarek, PricewaterhouseCoopers, Belgium

Introduction

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.

Success stories

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. [[[PAGE]]]

The fact that group treasury takes responsibility for managing those exposures presents several advantages:

• The procurement department can focus on the physical and volumetric aspects of the contracts with suppliers, taking into account the important parameters for the production cycle (e.g. security and flexibility of physical supply, quality, form, timing of delivery);

• Management of commodity price risk can be done by treasury using derivatives separately from the physical procurement life-cycle, which provides more flexibility in terms of hedging horizon and profiling of the commodity price exposure;

• The internal control environment surrounding transactions is generally strong within treasury functions; financial risk management competences are also well developed, and processes for the handling of financial transactions are already in place. Those factors provide a good foundation for adding CRM to the scope of the treasury function;

• The accounting treatment for CRM operations is similar to the treatment applied to other financial risk management strategies (e.g. hedge accounting under IAS 39);

• The link between CRM and other related risks is optimised and managed by the same team (foreign currency, liquidity and credit risks).

Lessons can also be learnt from airline companies where jet fuel procurement is usually centralised but where a major challenge lies with the definition of the appropriate CRM strategy: what should be the best time horizon for hedging jet fuel? What types of hedging instruments should be used? What are competitors doing? Those are questions driving future profitability that should be addressed with sufficient reflection, and taking into account worst case price or business scenarios.

Globalisation of the economy, market deregulation and strong demand from commodity-hungry emerging economies, have driven the commodity markets towards unprecedented price and volatility levels over the recent past.

Similar to the airline industry, heavy energy consuming industries (e.g. metal refining, glass manufacturers, paper producers, etc) have been hit by the surge of oil and gas prices during the first half of 2008 and by the collapse of these prices during the second half of the year. In the absence of a well structured commodity price risk management policy, some companies panicked and hedged massively at very high prices before last summer. The profitability of those companies will suffer, as decreasing commodity prices and competition are driving sale prices down, whereas commodity procurement costs have been fixed at a high level.

A similar reasoning applies to electrical construction companies, car manufacturers, the food industry and many other industries. It is in these exceptional market circumstances that one realises the need to align the CRM strategy with the long term profitability objectives of the company.

Tips and hints

What can be learnt from these examples:

• Do not start from the assumption that commodity risk is immaterial for the company. Although this may have been true in the past, current levels of volatility and commodity markets deregulation should lead many companies to reassess whether this statement is still valid. In order to perform such an assessment, there is no better way than performing simulations: how would the EBITDA look under various commodity price scenarios?

• Define the goal of the CRM strategy and agree on a policy/framework in line with the company’s risk appetite. This must be sufficiently flexible to benefit from the opportunities offered by a volatile market and sufficiently prudent to obtain protection from adverse scenarios.

• Align the CRM strategy with the company’s business model. Many criteria should be factored into the strategy to make it successful, such as the impact of the hedging programme on competitive position and the ability to pass-through a portion of the price risk to the final customer.

• Create a permanent communication channel between procurement and sale departments, and the commodity risk management function. Ensure that a policy clarifies the roles and responsibilities, and how the hedging strategy should be conducted.

Conclusion

Globalisation of the economy, market deregulation and strong demand from commodity-hungry emerging economies, have driven the commodity markets towards unprecedented price and volatility levels over the recent past. The financial crisis has now brought those prices back to low levels observed more than 5 years ago.

It is therefore important to transform those risks into opportunities to achieve better results through the creation of a competitive advantage in the commodity risk management area. A CRM strategy that balances the need for flexibility, with risk limits in line with the company’s risk appetite, can help companies seize today the opportunities that will distinguish them from their competitors in the future. Treasurers have an important role to play in this journey to success!