Risk Management Comes of Age in New Commodity Management and Trading Systems

Commodity trading systems are complex to build and operate, but every organisation in the world is somehow involved in a commodity trading system, whether they know it or not. The complexity in these systems comes from the ever-increasing need in today’s world for faster, better information about an organisation’s exposure to the world of commodities. Every company buys and uses energy, currency and resources and all of these can be captured and effectively managed by a good commodity system. But finding the right system for your organisation can be a daunting and difficult task if you are uncertain of what you are looking for. If you know what you need and what the different commodity systems can do for you, and more importantly how they were and are currently built, the financial rewards to any organisation can be very sizable, often in the millions of dollars per month for even a small Fortune 1000 organisation. Consider an auto manufacturer and all of the commodities and components that go into the production of automobiles and how a change in the value of those components can drastically affect the bottom line of that organisation. In fact with commodity prices entering an era of high volatility, managing price changes and inventory valuations may be critical to survival in this increasingly competitive world.

Commodity systems come in a variety of flavours and most have been built to service a specific niche in the market. Oil and gas, power, metals, currency – each have either fundamental or ‘bolt on’ components that are customised for each software companies’ specific areas of expertise. But there are some very real underlying components that are inherent in any commodity market and these components form the building blocks of every organisation and should form the basis of any commodity system:

  • Contracts.
  • Pricing.
  • Valuation.
  • Risk.
  • Logistics.

Each of these forms the basis of a handful of primary objects in robust commodity systems such as ‘base data’ or ‘flows’ or ‘inventories’. Any well-designed and well-built commodity system builder clearly understands and can articulate these objects and their symbiotic links to your organisation’s operations with ease. A software company that goes the next step and understands your world and listens carefully to your requirements is the company to look at carefully.

Looking for Value in the Right Places

So why do regular organisations need to concern themselves with commodity trading and logistics systems? Almost all organisations buy and sell commodities in one form or another. What company doesn’t use fuel or energy or have resources, even if they are human? Companies are really only structures of flows and inventories. They move resources in, through and out the door. In exchange they get revenue and the process starts all over. Managing these flows and inventories is the essence of being in business. So being able to see and value these flows and inventories is exceptionally valuable to smart organisations. Whether you’re selling frozen concentrated orange juice or producing oil, you have an interest in not only understanding the relationship between the price of your commodities and your bottom line but you also want to capitalise on that understanding to add value to your organisation. In risk management, the added value is the ability to hedge the volatility in the market to help smooth out wild swings in values that can dramatically affect profits and losses. Risk managers perform this task by staying on top of market movements through information and strategy. A big part of successful risk management is having a real time view of your position as measured against the market.

Marking your inventories and flows and hedges to market, or revaluing all your underlying flows and inventory to a current market price and then comparing that to the current prices inherent in the underlying contracts, is a critical tool for the risk manager. It tells them exactly when they are losing money and when they can make money.

One of the most valuable components of mark-to-market reporting is the measure of underlying flows and the inventories those flows create when they come to rest. With good information on how much oil or ethanol or jet gas you have, or can produce, have pre-sold or have hedged with a futures contract, a good risk manager with a good commodity system can tell exactly if the hedge is ‘effective’ or if it is in the money or out of the money. It’s the value in that information that is critical to any organisation and without a good commodity management system, the organisation could face the loss of millions if the market were to move against them, even if they are not hedging. But aside from saving the organisation from itself, good, fast, accurate information about your commodity flows and inventories also provides the company with the opportunity to take advantage of anomalies in the market such as location-based price movements. It’s the anomalies that provide hedge funds with the massive returns they record each year by spotting arbitrage opportunities and the systems they most often use to do this are logistical commodity systems. Now many ordinary global companies are doing exactly the same thing to make additional profits from the same arbitrage opportunities by doing the same things they do every day, only in a much smarter way.

Foundations of Good Commodity Trading Software

There are four primary foundations from which all commodity management software is built:

  1. Software built from a risk management and trading perspective.
  2. Software built from a logistics and contract management perspective.
  3. Software built from a pure commodity operations perspective.
  4. Software built from a finance or accounting perspective.

If you ask each of the vendors in the market about the capability of their software, the request for proposal (RFP) will be filled out with a series of ‘yes’ responses and the online demo will carefully show the capability of the system. What you cannot trust is your RFP responses and the demo. It is pretty clear that you can produce information to look just about any way you want in a demo and almost every RFP question can be answered ‘yes’. The reality is that the suitability of each of these software packages for a particular organisation is far more difficult then a ‘yes we can do that’ answer. No software has been built to perfection and all have inherent and severe weaknesses that can only be measured by an in-house test implementation. The problem is deciding who will pay for that test, the vendor or the prospective client (in most cases today it’s the client, as part of their Sarbanes-Oxley (SOX) due diligence).

Looking Under the Hood

You wouldn’t buy a car based on a printed set of specifications prepared by the salesman, nor would you buy one based on looking at it through a sheet of glass. You would probably do what most people do and prepare some research, take a test drive, look at other models and always look under the hood and inside the car. And yet many organisations buy software purely on the basis of the songs and dances that lead up to implementation. There is no shame in testing software. It’s the best way to understand its capability. There are certainly some constraints on this, such as you can’t allow one vendor to play on another vendor’s software, but most of these are manageable. And don’t forget to do your research, including the most important aspect of all, deciding what you really need. There’s no sense in buying an advanced risk trading module that you will never use. Nowhere is this more important than in commodity management. Contract management systems that are inflexible, inventory valuations that don’t handle complex components like negative inventory revaluation, risk management components that are weak or bolt on that do not understand the basic principles of how to manage risk, or accounting modules that don’t know International Financial Reporting Standards (IFRS) from the Financial Accounting Standards Board (FASB).

To help, here are some valuable things to consider when purchasing a new commodity system:

  1. Does the system adequately capture the nature and data structure of your contracts and do they use that information throughout the commodities life cycle in the system? What you are specifically looking for is the ability to tag and group like items at the contractual level and then report on those same attributes throughout the system.
  2. Can the system handle the complex nuances of your business such as netbacks in oil and gas, nominations in pipelines, aggregation and processing in manufacturing, intermodal and interline transport functionality, etc?
  3. Can the system handle the complexities of risk management such as the ability to model and attest to hedge effectiveness through direct linkage to the underlying flows and inventories? What you are looking for here is the ability to link various hedges and components of hedges to the underlying flows together with instant revaluations when things change. Risk-based systems usually don’t have the direct connections to underlying systems and logistics based systems usually can’t measure the effectiveness of complex trading structures.
  4. Can the system easily handle complex valuations of inventory positions including the lower of market or realised value? If they can’t handle new methods of valuing inventory and, more importantly, handle complex valuation like negative revaluation, then the software is most likely lacking in flow and inventory theory.
  5. Can the system handle regulatory requirements such as accounting treatments for various regulatory zones? They have to understand the treatments but also need a rules engine that will allow you to apply rules on the fly. Don’t forget all the control and attestation requirements for SOX and other regulatory agencies.
  6. Can the system tell you where you are right now, look into the future and tell you where you are going to go off track? Look for event-based controls such as variance reporting in the dashboards and real time valuation.
  7. Can you map your process? Most systems are starting to build process mapping components into their functionality that will allow you to set up a process flow. It’s the degree of controls, security and results that you are looking for. The current state of the art is to build process flows that populate tasks including timed exception reporting in a ‘my dashboard’ functionality.
  8. Do you audit? Can you tip toe from one end of the system to another easily? You’d be surprised how few systems can actually take you from a general ledger (GL) posting to the underlying transactions or contract without some sort of leap from one module to another. Full suite integration is still on the drawing board for most software companies but not all.
  9. Does the system have processing rules? One of the greatest control mechanisms in new systems is the transaction event based processing rule that allows you to do almost anything, in complete security to any transaction during any point of its life cycle under full audit and control. There are no limits to the power of this functionality but good luck finding it. In most software companies it’s still on the board.
  10. Can they really see the future? Is the company led by a visionary or an accountant? You want to hear words like Java and open source and hyper-threading and multi-tier. Choosing the right commodity management software is complex and difficult. So let me provide the most valuable piece of advice I can give. Does the software vendor listen to you or are they trying to tell you what you need? Run as fast and as far away from the latter as you possibly can.

17 views

Related reading