The Right Commodity Hedging Strategy for your Company
How CFOs fortify their companies with tailored hedging strategies before the unexpected happens
Among the risk management priorities CFOs and Treasurers oversee, a commodity hedging strategy is sometimes the least proactively managed. You wouldn’t allow insurance policies to lapse, leaving the company exposed to risk of significant financial loss. It is equally critical to ensure unexpected commodity price changes don’t cause an unacceptable impact on profit margins. A robust and tailored commodity hedging strategy aims to protect your company from unacceptable swings in profitability.
Like all risk management endeavors an effective commodity hedging strategy has a few key characteristics. Clearly it must be tailored to your company. Developing it requires analysis to uncover how exposed your company is, or isn’t, to commodity price risk. It requires defining what are tolerable outcomes, and what is not acceptable. Determining what commodities require hedging and formulating an execution plan is critical to ensure unacceptable risks are eliminated. Equally, it’s key that the right stakeholders have understood the commodity price risks your company faces, and support the strategy to accept or mitigate them.
Just like interest rate hedging and other risk management activities, commodity risk mitigation is best done before you need it. So, how do you fortify your company before the inevitable “unexpected” move in commodity prices comes? Here is a practical guide to help inform your analysis about commodity price risk and likewise, how to address it.
Step 1 – Analyze commodity price exposures and quantify the risk
The purpose of this step is to really quantify the impact of potential commodity price movements could have on your business. To do this, you start by identifying all material commodity spending, commodity inventory, and commodity sales. To ensure you’re getting the clearest picture it is often best to involve colleagues in operations and purchasing. Why? Purchases of diesel fuel for a fleet may be easy to see in your accounting system. Conversely, other commodity spends may be less visible. For example purchases of components from a supplier, where the price of the components is based upon say copper contained in them. This step is very important. Commodity price exposures that aren’t identified, can’t be analyzed and potentially mitigated.
As you identify commodity exposures, record both the unit volumes and the dollar values. For example, if your company uses silver to manufacture product, how many oz did you buy each month.
Take note of any seasonal variations in volumes and inventory levels of each commodity.
Evaluate if you have any pricing offsets. For example, are commodity purchases simultaneously offset with sales to your customers? Are you able to update the prices you sell to customers based on commodity price moves, or must you absorb them? The objective is to determine your net exposure to each commodity.
How much risk is that?
Having quantified commodity consumption or inventory, it is time to evaluate the impact of potential price moves.
For each of the commodities, look at historical high and low price ranges. Ensure that you review data over a sufficient period of time, including different business cycles. Consider how much higher or lower the price of these commodities might move. Analyze the impact, in dollars, on your business if the commodity prices did move in these ranges.
Now evaluate this impact in the context of your business’s profit margins. If the prices moved as calculated above, would the impact on your profit margins be meaningful? Is there a point at which a price move for any of the commodities analyzed would have unacceptable consequences?
Step 2 – Consider the alternatives and construct your commodity hedging strategy
If your analysis indicated that certain commodity price moves could generate unacceptable or undesirable outcomes, build your hedging strategy.
A sound hedging strategy
A sound hedging policy begins with establishing parameters for what is an acceptable amount of risk. These parameters should tie to the tolerance you have for prices to move against your company. They should also be tailored to whether the commodity is consumed or held in inventory. Parameters can also be set for when hedging will be executed. To illustrate, a company’s policy might establish parameters like:
For commodities that are consumed as part of operations
- The company will ensure it has hedged a minimum of 50% and a maximum of 85% of its expected diesel fuel consumption for the next 12 months
- Should the copper price fall 20% or more below its budgeted price, the company will hedge 75% of its expected consumption for the remainder of the fiscal year
For commodities that are held in inventory
- The company will ensure that at all times its net unpriced gold inventory will be hedged to within a tolerance of 100 oz
- The company may have a maximum unhedged inventory position of 100,000 pounds green coffee
From here you start crafting your hedging strategy so it is in line with the parameters you established. This is about matching, to the largest extent possible, the hedging instrument with the specific commodity.
Futures vs. forwards for commodity hedging
Depending on the size of your business and hedging needs, you may have several different alternatives available to you in how to execute. Your bank may offer commodity swaps and other derivatives like caps and collars. Alternatively, you can access futures and futures options markets through a provider like Kilo Futures. Both of these alternatives have benefits and drawbacks. Here are the key differences you will want to consider.
Futures are standardized contracts traded on a regulated exchange. Settlement takes place through a clearinghouse. In contrast, swaps are privately negotiated, bilateral contracts between two parties. This usually means a company and its bank. A noted benefit of swaps is the ability to tailor the specific terms like location and commodity form.
Pricing and execution
In terms of pricing and execution, using futures a company enters a hedge by buying or selling futures on the exchange. The market prices for the futures are transparent. You can observe futures prices in real time. The company pays a commission to the futures broker, which should be both modest relative to the notional value of the hedge and fully disclosed in advance of execution.
In contrast, with swaps the bank providing the swap acts as a principal and is the company’s counterparty to the swap. This creates the potential for misaligned incentives between the bank and company. The bank earns a profit on the trade by marking up the swap price to the customer over its cost to hedge itself in the futures market. The bank is motivated to widen this markup, as it is principal in the trade. Consequently, the company’s costs increase. The bank does not typically disclose the extent of this markup.
A level playing field
Another key difference is counterparty risk and margin requirements. When using futures, counterparty risk is mitigated. This is because a clearinghouse stands between buyers and sellers on the exchange. All users of the exchange post margin. Consequently any user of the exchange, from the largest and highest rated banks to smaller commercial enterprises can execute at the market price. In contrast, using futures there is no counterparty markup. Broker commissions, and fees for clearinghouse, NFA, and the exchange do apply.
With swaps, both the company and the bank are exposed to each other’s risk of performance under the swap. For mid-market companies, this can sometimes mean that a bank is either unwilling to enter a swap. Alternatively, the bank will price it higher to account for the company’s perceived credit risk. The bank may also require the company to post cash or securities as margin.
Speak with the experts
Additionally, we suggest that you talk with your CPA firm for guidance on accounting treatment. Accounting treatment likely shouldn’t drive your strategy, but it is best to have a clear understanding on this aspect before executing.
At this stage you collect detailed information on the swaps or futures market instruments most germane to your needs. We suggest you start by speaking with your bank &/or a reputable futures market professional. The available futures hedging alternatives are straightforward, even if they are somewhat unfamiliar or confusing at first. Comparing the execution prices of commodity swaps and futures market execution will help you clarify your path forward. Here at Kilo Futures, we would be grateful for the opportunity to explore this with you.
Step 3 – document your plan and get buy-in from stakeholders
A great commodity hedging strategy is simple, flexible, and brief. It should lay out the highlights of the analysis you completed in the steps above. It should also detail the key components of the plan, which should include:
- Establishing parameters for specific commodity exposures
- Which counterparties or futures contracts are acceptable for the company to deal with
- The horizon over which you will hedge
- An acknowledgement of the purpose of hedging (limit risk, not profit), and of the possibility that the hedge may result in an outcome where the company could have obtained better pricing if it had not hedged
- Who in the company is responsible for executing hedges and monitoring that as the business evolves it stays within the established parameters
- Who will review the commodity hedging policy and when
Determine who the key stakeholders are that need to be involved in approving and implementing the plan. Communicate your plan and seek buy-in or approval as appropriate. This isn’t a “CYA” exercise. The purpose is to ensure everyone understands and supports the strategy. Most importantly, it enforces rigor around hedging decisions and reduces the very human tendency to try to time markets. Critically, it helps avoid the very dangerous “I’ll hedge when rates drop” approach.
Step 4 – set-up, document, and execute
This step is more mechanical than analytical. There are some real differences in establishing a swap relationship compared to opening a hedging account with a futures provider. The agreements used to establish a futures trading relationship are relatively straightforward and standardized. The entire process of opening and documenting the account can take as little as a few days.
For swaps or other bank provided derivatives, the process can be a bit more involved. It often requires the bank to undertake a credit review process if you haven’t already established derivative lines with them. The governing document for swaps is typically the ISDA master agreement. Negotiating these documents can be time consuming and costly. Consequently, banks may only be willing to negotiate an ISDA with companies where the size of the swaps &/or the pricing provides sufficient profit incentive to the bank to justify the cost. Some banks do offer abbreviated, standardized documents which can speed up the process.
Executing your commodity hedge should be a straightforward and quick process. You can do this by speaking with your bank’s derivatives representative or you futures professional. Here at Kilo Futures, in addition to your futures representative, you will also have access to an electronic portal. The portal allows you to execute hedges, see live market prices, and see real time mark-to-market information on your positions.
Step 5 – monitor, review and adjust
Monitoring and adjusting your exposures to align with your commodity hedging strategy should occur periodically.
Hedges relating to inventory may need to be adjusted dynamically as inventory levels fluctuate. This hedging activity is often handled by business line staff in operations or purchasing. However, some companies prefer to have treasury staff execute all hedging. The dynamic inventory hedging should be executed in accordance with the company’s commodity hedging strategy.
For hedges relating to commodity spends, many companies review this along with their annual or quarterly budgeting process. Similarly, a review should also occur when your company has events like acquisitions or enters new business lines. These hedges are usually executed by the treasury team. A more frequent review of hedges (e.g. weekly or monthly) should occur under certain conditions. For example, when commodity price exposure is large relative to company profit margins. Equally it should be undertaken where the commodity is particularly volatile.
At least annually it is helpful to analyze how the hedging policy performed. Conducting this review in parallel with the budgeting process for the next fiscal year can help reinforce rigor. Determine if hedging was executed as prescribed by the commodity hedging policy, and if not, why. This can also be a good time to make any updates to the policy based on what you learned from the review.
We hope you’ve found this guide a practical and useful tool to help you evaluate and manage commodity price risk at your company. Please let us know if you have any suggestions on how we can improve it. If you would find it helpful to talk through your specific situation and explore the various commodity hedging tools available to companies like yours, please contact us. We would be grateful for the chance to help.