Six Steps to Assess Your Exposure to Commodity Price Risk

Six_Steps_Commodity_Price_Risk

There are many reasons why you may be blinded to commodity price risk. The tyranny of the urgent, everyday demands on your time to just get your job done can serve as blinders, keeping you from recognizing the impact that globalization, changes in the marketplace, and industry developments can have on your bottom line. The fact is that stepping away from the everyday and taking a good, hard look at your procurement practices and the impact commodity price risk is having on your operations can often make the difference between hitting goals and falling short of expectations.

An honest and thorough look at your risk management practices can either reveal weaknesses in your strategy that can be addressed or serve as confirmation that you are on the right track.

One: Have you experienced commodity price volatility in the last 3 years that has had appreciable impact on earnings and cash flows?

Sharp price movements are the bane of corporate treasurers and CFOs, who must manage their company’s cash flow and deliver predictable earnings forecasts. A report by the U.S. Commodity Futures Trading Commission (CFTC) covering January 2012 through 2017 found that although the pace of these sharp movements is not increasing, they are affected by volatility and data releases. The report also noted that corn and silver had the highest price movement: more than 6% during the period. And more than half the observed contracts experienced price movements of 2% or greater.

Have your company’s balance sheet and earnings been affected by similar commodity price movements?
How did your company’s foreign exchange perform when the British Pound Sterling and Japanese Yen were hit with price movements of 3.26% and 2.66%, respectively, while domestic currency traders saw a price movement of just .91% during this period?
What impact on your company’s earnings and cash flow resulted from global energy prices plummeting 3.7%, fertilizers declining 13.1%, and precious metals rising 19.4% in November 2019, as reported by the World Bank?
What steps can your company take now to respond to a drop in natural gas prices by spring, predicted in a November 26, 2019 in The Wall Street Journal, following a nearly 40% decline from last year?

Many companies, while doing business, may have been exposed to the type of price volatility described above, and thus impacted had their earnings and cashflows. A properly designed and executed risk management strategy can minimize the effects of volatility in a wide variety of markets.

Two: Do you have strong understanding of key business areas that are affected by commodity price volatility?

Commodity purchasers recognize the obvious area that is affected by price volatility: the finance department, where prices have an impact on both sales revenue and on its operations that specifically affect the company’s supply/value chain. But what about consumer prices, inventory control, operating costs, expansion plans, and customer service?

Commodity prices directly shape the competitive marketplace, dictated to a significant degree by how much the consumer is willing to pay for end products. The company may absorb the price increase in the short term, but at some point, must raise consumer prices to maintain its profit margin.
Commodity price volatility affects inventory control. Consumers may respond to a price increase by choosing to forego purchasing the product, both negatively affecting revenue and leaving the company with excess inventory, forcing it to slash prices to avoid a total loss.
Commodity price volatility determines operating costs, which include cost of goods sold that directly drives a company’s profit margin.
A not-so-obvious area that may be swayed by commodity price volatility is corporate expansion plans: A company opening a new location, for example, will pay more for building materials if the price of lumber rises.
A company’s customer service department may feel the impact of higher commodity prices, as more training resources (and longer telephone response times) may be needed to respond to customer questions and assuage concerns over higher prices for the goods and services they purchase.

A hedging strategy to counteract commodity price volatility will help maintain consistent revenue forecasts, forecast accurate operating costs and profit margins, execute cost-efficient expansion plans, and deliver premium-quality customer service.

Three: Do you have clear business objectives (path) to procure commodities and related hedging?

Avoiding supply chain purchasing problems generally comes down to good planning, which is even more critical when commodity prices are in flux.

Do you purchase steel-based components in bulk, when prices are lower, to help protect against future price fluctuations?
Do you structure contracts with suppliers to have a sliding scale for prices?
Do you build in a premium for parts used in the product in case commodity prices spike during the manufacturing and delivery period?
What steps can you take to assess the effects that changing energy prices will have on other components of the manufacturing process, such as shipping?
Can you purchase and store gas and oil stocks to prepare for rising energy costs, factoring in the cost of storage into the equation?

A hedging strategy is the overarching solution to procuring the materials you need to protect your company’s supply chain against volatile commodity prices.

Four: Do you have tools in place to monitor commodity risks and report relevant information to management?

Commodity price risk management falls under the umbrella of a company’s treasury management and is further delineated by financial risk (interest rate changes and foreign currency fluctuations) and supply/ value-chain risk (assures adequate liquidity in the procurement process). Companies use various tools to navigate these risks. Are these metrics and solutions in your toolbox?

Financial risk

Risk appetite assesses the type and amount of risk a company is willing to assume.
Risk management strategy builds on risk appetite and maps a plan for the company to achieve its goals.
Risk management governance is management’s policies and guidelines established to provide oversight.
Risk operating model establishes the processes a company needs to execute its strategy, and encompasses personnel, controls, compliance, and information reporting.

Supply/Value Chain

Derivative instruments can be used to protect the company and their supply/value chain from commodity price fluctuations by hedging. Hedging establishes an equal and opposite position relative to the cash market so that volatility’s impact on margins can be minimized. They are called derivatives because they derive their value from underlying commodities like bushels of wheat, bars of gold, currencies, and equities. They are agreements to buy or sell a commodity or financial instrument for a specific price at a specified time and can be settled either with cash or delivery of the commodity. To secure a firm’s supply chain, these instruments can be used to:

Fix prices with a supplier
Hedge location, product quality, and calendar risks
Protect a firm’s commodity investment while in storage or transit
Ensure consistent and reliable supply

A properly designed hedging strategy not only protects your company from the financial consequences of commodity volatility but also provides management with vital decision-making information.

Five: Does your technology provide sufficient and timely access to data needed to measure and manage risk?

Companies face challenges in measuring and managing risk as they assess demand to determine price risk and monitor financial exposure. Industry consolidation often results in complex information technology platforms that make it difficult to extract needed reporting information.

Do you have a central trading desk, rather than legacy IT systems, to serve your company’s business units? A central hub aggregates input from the company’s various locations to give a comprehensive view of its risk exposure.
Does your technology platform include multi-entity access, multi-currency functionality, and multi-GAAP software? Does it link your company’s end products to raw materials, offer real-time prices, and manage commodities, foreign exchange, and interest rates on one platform?
Are you familiar with how blockchain technology is emerging as a tool for disrupting the verification process by making it more reliable and alleviating instances of fraud? Rather than relying on a cumbersome, manual, paper-based system to ensure that counterparties receive the cargo they ordered, blockchain technology can accurately track cargo on a secure, unchangeable digital platform. Examples of fraud that blockchain could thwart:
- High-tech copiers duplicate a bill of lading and add fake information, such as additional shipments, to obtain bank loans
- Invoice spoofing that intercepts invoices and then changes the bank account for payments
- Duplicating warehouse certificates to pledge the cargo as collateral multiple times

A centralized technology system with state-of-the-art functionality can provide accurate information and protect your company against fraud.

Six: Do you have tools in place to measure and report your specific exposure to commodity prices?

Meeting your company’s commodity price challenges depends on having the correct mix of skills, technology, and market data. It begins with visibility into commodity risk exposure.

Do your company’s risk assumption models extend to customers, suppliers, and third-party entities?
How does your company blend commodity management, strategic sourcing, and supplier management?
Does your company consider demand aggregation at all levels of the supply chain?
Does your company’s management understand not only the benefits of hedging but also the cost incurred when prices fall?
Does your company’s procurement department have the right people in place to execute hedging and trading?
Is your company prepared to make the investment required to build accurate forecast models and develop market perspectives?

StoneX Group Inc. (formerly INTL FCStone Inc.) provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of INTL FCStone Markets, LLC (IFM), a member of the National Futures Association (NFA) and provisionally registered with the U.S. Commodity Futures Trading Commission (CFTC) as a swap dealer. IFM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of IFM. INTL FCStone Financial Inc. (IFCF) is a member of FINRA/NFA/SIPC and registered with the MSRB. IFCF is registered with the U.S. Securities and Exchange Commission (SEC) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Advisor. References to securities trading are made on behalf of the BD Division of IFCF and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of IFCF. INTL FCStone Ltd is registered in England and Wales, Company No. 5616586, authorized and regulated by the Financial Conduct Authority. Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the INTL FCStone group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of INTL FCStone Inc.