- Koen Timmermans
- Group Financial Risk Manager, Borealis AG
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.[[[PAGE]]]
Step 3. Quantifying the risk
Having built up a detailed view of where and how our exposures arise, we need to quantify these risks. As we have established, our price risk is created when either/both costs and sales are at a fixed price; in addition, we are also subject to risk where pricing is agreed in advance of delivery. We measure this through a risk position, which is our physical position (fixed price deals, the priced part of floating deals that have yet to be delivered, and the unpriced part of delivered deals) plus our derivative position (unrealised element of financial swaps) minus neutral stock. If our position is long, and prices go up, our profits increase; if short, and prices go down, we lose money. We are also exposed to risk in the price difference between commodities (e.g., between propane and naphtha) and differences over time.
Step 4. Balancing risks
We are then in a position to decide how to tackle these risks. Different companies, even in the same sector, will inevitably approach this in different ways depending on their risk appetite, as defined in the treasury policy. One approach is to avoid all price risk by managing the supply of raw materials only with long-term supply contracts with prices set according to floating indices. This approach would also involve holding stable, minimal inventories, and only selling finished products at prices linked to floating indices. The problem, however, is that by eliminating risk, the ability to grow is also eliminated as the company has no commercial levers when selling to customers. The alternative is to manage price risk intelligently: be prepared to take opportunities as they arise; be prepared to carry excess inventory temporarily, and be creative in customer offerings. This approach requires a detailed awareness of changing price risks and the expedient use of financial derivatives to manage the risk position.
At Borealis, we take the latter approach. We prefer to secure our raw material supply, which leads to price risk, as some suppliers prefer fixed price deals, and feedstock (such as naphtha) is stored before it is consumed. We also aim to reduce costs wherever possible, which again results in price risk. We maximise the value of cracker flexibility wherever possible, leading to multiple feeds. In addition, opportunistic buying may lead to higher inventory levels. We then aim to reduce this price risk to an acceptable level. The pricing of physical trades determines our price exposure, which we hedge using financial swaps, converting fixed price to floating, and converting LPG-related floating prices to naphtha-related floating prices.
Step 5. Establishing a risk management framework
This approach requires clear policies and mandates, continuous monitoring of price risk exposure, and both expertise and systems capability to manage financial derivatives. Furthermore, we need to measure the benefit of an active versus passive approach to managing risk. We constantly measure and value our exposures, and monitor current and projected inventory levels in real time. We then calculate for each purchase, sale and hedging contract to what extent the price is fixed. To hedge our risks, we monitor spot and forward prices in real time, our credit risk and clearing margin requirements daily. We transact deals according to a clear process flow, with segregation of duties between deal entry, approval and settlement. Given the investment in skilled resources and technology that is required to maintain an active approach to commodity risk management, we benchmark our performance against benchmark prices, and define normal inventory levels. We provide regular reporting on our performance so that it can be monitored independently and challenged when required.
Adding value to the business
From our experience, and particularly bearing in mind the significant market volatility, commodity risk management should be high on the treasury agenda for companies that have a heavy reliance on traded commodities. Production companies should fully understand the risks and rewards of the commodities used in their supply chain and focus specifically on financial price risk management as a distinct activity outside the scope of a normal procurement or sales process. Commodity risk is not a single dimensional activity, and it is important to recognise the interdependencies between different commodity prices, foreign exchange rates, and the impact on working capital. Treasury is well-equipped to take on this responsibility, bearing in mind its expertise in managing complex, high value financial risks, and policies, processes, systems and reporting capabilities. As its role has significantly developed over time, treasury also has the ability to build connections and encourage dialogue between related departments. By doing so, the ability for treasury to add value to the enterprise, and limit the company’s vulnerability to price volatility can be enormous.
