Taking Cover. Hedge, to cope with commodity swings

Oil, gas and non-ferrous metals are currently undergoing their biggest price correction since the recession of 2008. Economic volatility has shaken up the commodities market.

China’s uncertain economic situation is likely to loom large over the metals sector in 2015.

Recently, the Thompson Reuters Core Commodity index hit its lowest point since April 2003. Effectively, the market has erased all gains of the decade-long commodities “super-cycle”{+.}

Volatility has not spared the agricultural markets either, with corn showing volatility of over 24 per cent in 2014 and coffee volatility at the end of 2014 increasing to 50 per cent.

This is a tectonic shift in the world of commodities — where relying on fundamentals of physical supply, demand and inventory positions alone cannot explain the extent of volatility.

Today, commodities are treated more like an asset class and have become an integral financial investment in investor portfolios.

The growing number of financial investors participating in commodity futures also transmits the risk characteristics, expected returns and volatilities of the equity markets into the commodities markets.

As seen from the table, price volatility in commodities is severe enough to impact the operating margin of companies involved in the commodities chain.

To be sure, companies have started taking steps to align or transfer the price risk existing in their supply chain back to suppliers, or customers. Paper markets are not the first choice to mitigate such risks.

Natural hedges Typically, companies resorted to techniques such as creating a natural hedge within their value chain, instead of hedging their exposure, which can be expensive. They usually employ certain tools to manage commodity volatility. Firms align price-ins of their inputs with price-outs on their products, thereby naturally offsetting price risk.

Production processes and volumes are controlled to ensure that product prices are in line with desired profitability levels.

Trade and payment terms are modified to ensure alignment between payables and receivables. Exposure on purchase and sales are aligned to ensure an optimal mix of spot and average-priced contracts.

Companies also opt for domestic markets instead of international ones, to reduce currency risk.

Having said this, some firms are now actively looking to the futures markets to manage commodity price volatility too. Usually, manufacturers or producers take positions in commodity futures contracts to hedge against downside risk in the physical delivery of commodities.

They ensure low costs by using instruments such as swaps and futures to lock in a fixed proportion of their annual input requirements.

Trading position Then there are firms which take a trading position and tend to rack up profits in periods of high volatility. Currently, as seen above, price swings for crude oil and other commodities are providing the best trading conditions since 2009-2010.

Such trading organisations have a fundamental view of the market based on their knowledge of physical markets. They have mature trading and risk management systems.

They typically use exotic instruments with stop-loss mechanisms to minimise their downside and retain the upside, by paying a higher cost. Gone are the days when companies could adopt a wait-and-watch approach to deal with commodity price volatility.

Today, the markets, shareholders and the Street, all demand explanations and performance insights on a company’s risk management systems and hedging programmes.

Managements need to be extremely watchful to ensure that when taking exposures, margins are frequently reviewed and a risk management framework is in place.

Sophisticated capabilities Companies exposed to input fluctuations need to develop sophisticated hedging capabilities, analyse the components that can affect their margin, and look at a range of scenarios to reduce the impact of price volatilities on their bottom line.

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