Commodity Hedging in Volatile Times

At the Frankfurt meeting, European Treasurers Council (ETC) members discussed specific commodity hedging models useful for treasurers. A company with, for example, energy, metal and grain needs, is particularly susceptible to the current turbulence in the global commodities markets. For example, the price of barley has more than doubled in the past five years, while the price of aluminium has risen sharply since 2009.

This means that actual and budget prices could vary significantly, in turn affecting cash management. Additionally, suppliers have become increasingly reluctant to take on risk in the wake of the financial crisis. The emergence of new financial products to manage commodities, including exchange traded funds (ETFs) and exchange traded commodities (ETCs), as well as new derivatives becoming available, have also made commodity hedging simpler and more attractive to corporates.

A Model for Mitigating Commodity Risk

The prevalence of commodity hedging naturally varies by sector. For fast-moving consumer goods (FMCG) companies, commodities hedging has become relatively common, with the largest FMCG companies hedging commodities including aluminium, gas, corn, sugar, oil, wheat and rice.

Some companies have taken the decision further, centralising their specialist functions such as purchasing, while retaining different departments for sales and marketing activities. The group discussed the model of moving to a more centralised system whereby the group purchasing department was a legal entity standing between a company’s suppliers and the different organisational departments, allowing the purchasing department to take positions to manage risk and provide the operating departments with a stable input price. This is known as a ‘buy/sell’ model.

One reason for moving to the buy/sell model that one treasurer mentioned related to the impact of supplier relationships on the business. For example, hedge positions have to be disclosed to suppliers – and the company also has to bear an exposure to its clients. Suppliers also pass on the cost of their risk management as well as their investment in people and systems. Proxy hedging (a price-correlated financial instrument used where a direct hedge is not available) is also not possible in cases where the exposure is not explicit.

Putting a separate entity between the supplier and the purchasing departments within a company therefore has a number of advantages in how a firm can deal with suppliers. For example, where cash flow issues caused by different contract lengths previously had to be absorbed by the client company, the used of a commodity hedge would mean that this was smoothed out.

A number of key first steps were suggested when implementing this type of system. The project team, from either treasury or purchasing, should interview the purchasing category directors on the hedging practices they currently use and the costs attached. It is also important to identify current spending and commodity exposure. The project team should review available market practices and financial instruments, as well as considering which products to use. In addition, they need to consider risk management objectives, such as the reduction of volatility, as well as exploring new market opportunities and cutting supplier costs.

One treasurer queried whether this wasn’t just a way of centralising the procurement of commodities. Others agreed, since the group procurement was basically collecting all the balances but noted that this centralisation also allowed a platform for companies to put other strategies in place. As a senior treasury professional in the room explained: “What that does mean, and that is to your point about policies and position taking, is that you are setting up a trade hub, and it becomes much more active commercially, with the way that it is trading.”

There are three main areas of focus when tackling the centralisation and the differentiator in this particular model of commodity hedging. These are:

  1. Commodity risk management.
  2. Foreign exchange (FX) risk management.
  3. Supply chain finance.

Enabling fixed transfer pricing for a specified period, for example one year, as well as reducing supply volatility and costs, can be addressed by setting up a committee to tackle specific risks. These could include hedge policy and commodity risk management. In terms of FX, the model frees individual subsidiaries from the responsibility of managing FX risk, as well as helping to harmonise a group FX risk management policy and providing netting opportunities. The intended effect of implementing a supply chain financing programme as part of the new model could be to increase payment terms and optimise supplier relationships, as well as achieving leverage on a corporation’s strong credit rating, if it has one.

The hedging approach would depend on the amount of market knowledge the company has about its supplier. For example, where the company knows little, a fixed proportion of the exposure can be hedged, for example every week or month, avoiding peaks and troughs in this exposure. By contrast, a more flexible policy can be adopted where more is known about the company. However, this runs the risk of results below the market average.

One of the treasury participants was concerned that this model could introduce volume risk, whereby the company ran the risk of having an overstock, meaning it had to rid itself of the excess commodity due to having an insufficiently flexible purchasing model. A lack of flexibility could potentially work against the concept of the global economies of scale the model was put in place to solve. “The whole netting concept is based on the fact that you can get rid of volume differences globally,” he noted. As a way to solve this, he suggested that the scope for negotiation of the volumes bought be written into the supplier contract. “You can build flexibility into local contracts so that you retain the netting component of it, giving you the advantage of reduced commodity exposure but the flexibility of volume locally.”

Other discussion points included the potential value that could be added to the model by reassessing global relationships as part of putting a new purchasing structure in place. The global data afforded by such a system would play a big part in the effectiveness of such a model.

Organisational Structure

The group also considered where, in the organisational structure of the business, the commodity hedging should be executed. One member said this varied depending on whether the risk in question was core to the business or not. If so, “execution would take place in a separate department, such as a centralised risk management team controlled by the risk management committee. That is a decision with the proper middle and back office operations behind it.” Where the counterparty was already known to the treasury, execution would take place there. He added: “In recent years we have seen commodity risk management activity in general move from the purchasing department to treasury. This is a long-term evolution that we see in the market.”

Overall the meeting saw a full exchange of best practices between the treasurers in the room. The next European Treasurers Council meeting will be taking place on 7 September at the Hotel d’Angleterre in Geneva.

European Treasurers Council

The European Treasurers Council (ETC), established by gtnews and sponsored by Deutsche Bank, provides a forum for high-level treasury professionals to meet face-to-face to discuss issues and solutions.

This year the ETC has convened in London and Frankfurt, with meetings in Geneva and Brussels still to come in 2011. The locations of the ETC meetings are chosen for the wealth of high-level treasury professionals located in these centres, thought leaders who are orchestrating the treasury world’s cutting edge implementations.

The next meeting of the ETC will be at the Hotel d’Angleterre in Geneva on 7 September. For information on the agenda, and to apply to join the meeting, email joym@gtnews.com.

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