Managing Risk and Creating Opportunity through Extreme Volatility

by Mark O’Toole, Vice President Commodities & Treasury Solutions, OpenLink

As the oil price starts to shoot up again following a period of sharp decline, and the value of the RMB falls again after China’s FX reserves posted their biggest monthly fall in history, investors have had plenty to keep them busy in recent weeks.

While this may not be great news for investors who have lost out as a result of these events, the falling RMB coupled with a spike in the oil price is, at least, proving more positive for companies with large commodity exposures. Usually, when input prices fall, profitability and margin increase as companies typically reduce consumer prices more slowly. Inevitably, however, market volatility goes up as well as down. Generating additional profits when the oil price plummeted may have lulled treasurers into a false sense of security, but a recent 20% increase reinforces the importance of having systems in place to hedge against larger price rises. Similarly, when the RMB finally does start to rise, prices of raw materials will again be on the upswing. It is difficult to predict when the RMB is likely to strengthen, but corporate treasurers need to act now to manage their risks.

While market volatility is something that treasurers expect, recent extreme price volatility has significantly increased the extent to which corporates can be caught out by price swings through inefficient commodity risk management. On the flipside, businesses that manage their commodity risk in a more centralised and sophisticated manner have an increased chance of gaining an edge over rivals that don’t.

Rethinking buying habits

An important first step for corporates to get on top of their risk is to rethink buying habits: instead of the traditional short-term approach, treasurers should look to lock in low prices through longer-term contracts. This is especially pertinent for the automotive industry. Gone are the days of major car brands signing five-year agreements with manufacturing companies to receive their critical raw materials. Today, the maximum length of these contracts is typically 6 or 12 months. While this brings flexibility, it also increases counterparty, credit, volume and operational risk.

In addition to reviewing hedging policies, forward-thinking CFOs are removing the barriers between treasury and procurement, enabling a single and timely view of both commodity and currency risk across the business. This has significant technology implications, particularly integration of ERP, procurement and treasury management systems to allow better communication and collaboration. Properly implemented, a more integrated approach to treasury and procurement allows businesses to make smarter procurement decisions, far more quickly, in response to the commodity and currency market fluctuations seen recently. It also opens the door to the use of sophisticated analysis and financial commodity hedging, should this be appropriate for the business. For example, creating ‘what if’ trades and developing stress tests enhances treasurers’ ability to create effective hedging strategies. Furthermore, for a business previously reliant on spreadsheets, it pays dividends in terms of man-hours, reduced operational risk and lower error rates. Ultimately, the outcome should be an improved bottom line.

A more complex market

As the RMB continues to weaken and the oil price recovers, treasurers and CFOs need to contemplate a more complex market with higher levels of volatility, giving rise to greater potential risks. Businesses active in the commodity markets, such as oil and gas companies, merchant traders and utilities, have been well positioned for some time. Given the increased pressures of volatility and the potential negative impact on the business, treasurers need to act now to manage risks and leverage opportunities.[[[PAGE]]]

For corporates to manage through the current situation and prepare for future challenges, they must shore up their approach to risk management by ensuring they cover both physical and derivatives contracts and ensuring this flows into treasury for an enterprise view of consolidates risk. Then, and only then, will they be able to get a fully aggregated view of positions and risk, as well as potential profit and loss. Those corporates that stick to the same old way of doing things will be running unnecessary risks that could lead to problems further down the line.