So You Want to Launch a Commodity Hedging Risk Management Program

For any one company, there are many types of financial risk – credit risk, market risk, operational risk, to name a few.

However, one type of risk that has emerged as a key issue in today’s global economy is commodity risk.

Commodity risk refers to the exposure to uncertainties of future income, caused by fluctuations in the prices of commodities. These can include price risk, quantity risk, cost risk, and political risk. Take, for example, natural gas. Between 1999-2003, prices skyrocketed from a low of $1.70/MMBtu to a high of $10.00/MMBtu only to drop back down to $2.00/MMBtu by 2003. Today in 2010, natural gas trades roughly in the $3-$4 range but not before it hit a high of $15/MMBtu in 2008.

The natural gas example illustrates the extreme level of volatility and unpredictability associated with commodities. Many people mistakenly believe that a good hedging program will generate cost savings. Instead, the primary purpose of a good hedging program is to eliminate a major source of uncertainty and volatility while enabling companies to strategically focus on items and issues within their control.

Take a large multi million dollar bakery and ask yourself how would this company differentiate itself from the competition. Generally, it is through unique and interesting products, solid marketing expertise, and efficient operations like distribution and purchasing. Indeed, most strategic plans focus on these key areas and plan accordingly.

When it comes to wheat futures trading though, it is little more of a stretch to believe that any one bakery could really have a competitive advantage in commodity trading. In fact, if a bakery was so adept at trading, one would have to wonder why operate a bakery at all. Close down the bakery and make a heck of a lot more money by trading the futures.

While wheat futures may be a critical cost component, companies have to recognize the difference between a controllable cost component and a non-controllable cost component. For the most part, manufacturers are price takers and do not control commodity prices which are set by the market at large. That does not mean that companies should just throw their hands up and give up. Rather they should strive to institute a risk management program that helps them control the uncontrollable. Hence the importance of a good hedging program.

This brings us to the first point about implementing a hedging program. Companies have to recognize their exposure to a particular commodity risk. Generally, if your profit and loss is subject to variability, based on what’s being bought in commodity markets, this is an important issue. You are at risk.

There is certainly no overarching hedging strategy. Every hedging program is different and needs to be evaluated based upon criteria unique to a particular corporation, its risk tolerance, and its respective industry. The risk appetite of an airline to jet fuel price volatility, for example, will not be the same as that of a bakery exposed to the volatility of wheat prices. However, what is most important is being able to understand what your exposure is, what drives the prices of the commodities, and then coming up with a specific strategy to address it. Luckily, there are a number of commodity risk management systems out there that make this process quite easy.

It should be noted that an effective hedging program does not attempt to eliminate all risk. Rather, it attempts to transform unacceptable risks into an acceptable form. The goal of any hedging program should be to help the corporation achieve the optimal risk profile that balances the benefits of protection against the costs of hedging.

Listed below are 5 steps to establishing an effective and tailored hedging program’s needs.

Step 1: Discover why you are hedging

The first thing that is necessary is a clear definition of the objectives of the hedge program. Senior management must provide the owner of the hedging program, with clear measures of success. An example could be to ensure the cost of fuel does not exceed 25% of revenues over the next year. Without clearly defined and quantifiable objectives, the outcomes from hedging cannot be accurately measured as successful or unsuccessful.

Step 2: Identify how much to hedge, and what to hedge with?

· Options

o Caps

o Floors

o Puts

o Calls

Two key considerations are 1) how much of the projected commodity exposure to hedge, allowing for a predetermined level of flexibility 2) which instruments and markets the company should hold. There are a wide variety of listed and over-the-country commodity instruments available for companies to employ. However, the fact is that most derivative solutions are constructed from two basic instruments: forwards and options, which comprise the following building blocs

· Forwards

o Swaps

o Futures

o FRAs

o Locks

Step 3: Execute the hedging strategy

Within executing the hedging strategy it is important, like all other financial activities, to implement a system of internal policies, procedures, and controls to ensure that it is used properly. The system often documented in a hedging policy, establishes names of managers authorized to enter into hedges, the managers who must approve trades etc.

Step 4: Ensure hedges are on track

It is important to revalue the trades, track the P&L, and monitor the risk, ensuring that the hedges remain effective versus the underlying exposure.

Step 5: Quantify the final outcome:

Once the hedge trades have settled, the next step is to net the realized cashflows from the derivative hedge trades against the physical commodity purchases or sales. This provides the net commodity cost to the business, and enables management and the board to evaluate whether the hedging program was a success versus the original corporate objectives.

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