Commodity Risk Management in a Treasury Framework
To begin this article, let us distinguish between two different approaches to viewing commodity risk: core and non-core risk. Many corporates will already have an excellent grasp of their commodity exposures and related hedging, particularly when the commodity in question is a core risk to the business, such as base metal exposures for a mining company, or agricultural commodity exposures in the food or beverage industry. These core risks require a different decision framework and normally form part of the global business strategy around procurement or sales of primary inputs/outputs, which are designed to add value for the shareholder.
On the other hand non-core commodity risks, such as the cost of plastic packaging used for most retail products, are secondary to the primary function of the business and therefore can be treated as market risks in the traditional treasury sense and hedged appropriately.
Historically, some of these non-core commodity risks were largely ignored, directly affecting the cost of sales or alternatively the commodity risk was passed on to the supplier with the use of fixed-rate contracts whereby the supplier would charge an excessive margin for accepting this risk. Due to low volatility – together with other negative issues such as accounting regulation, complexity of commodity products, and the lack of systems to implement an accurate commodity risk management policy – these were acceptable practices. However with improvements to these issues (addressed below) a more efficient approach could be to bring this risk back under treasury management, treat it as a market risk, and include it in a holistic risk management approach.
Accounting Standards Open the Doors
Accounting regulation in the past has been a relevant factor in the decision to not hedge these risks, as previously under international accounting standards (IAS) hedge accounting could not be applied in most cases to the derivatives used to hedge the commodity exposures. This created the potential for large temporary profit and loss (P&L) impact while marking the fair value of the derivatives to balance sheet, which inevitably defeated the purpose of hedging the exposures as they could actually increase the volatility in the profit.
Accounting standards are now opening the doors to commodity hedging through updates to hedge accounting. In September 2012, the International Accounting Standards Board (IASB) released a draft version of the hedge accounting requirements to be added to International Financial Reporting Standards (IFRS) 9. Under this draft, the commodity portion of a firm commitment or forecasted exposure may be assigned as a hedged item into a hedge relationship as long as the risk is identifiable and measureable, allowing the entity to manage their risk position without unnecessary impact to the P&L. With the potential P&L impact no longer an issue, the next question is how to identify, measure and manage the risks.
Commodity Hedging Instruments
Over the years derivative instrument complexity has steadily increased, brought about by demand for increasingly unique risks being experienced by different companies. These products can be divided into two different groups, the exchanged traded derivatives (ETDs), and the over-the-counter (OTC) market.
There are distinct advantages and disadvantages between these groups of instruments, for example the ETDs enjoy high liquidity and price transparency, and also a reduction in counterparty risk as a result of central clearing and margining, while OTC derivatives have the advantage of being bespoke instruments that can be designed to fully hedge economic positions, with flexible collateralisation schemes – as opposed to cash collateral for ETDs – and which fit in with a company’s existing systems and processes. As opposed to foreign exchange (FX) hedging, where OTC contracts are used almost exclusively, both OTC and ETD markets need to be fully considered with regard to commodity hedging, specifically with respect to working capital requirements for margin calls and liquidity in the markets.
Complexity and ‘Basis Risk’
In addition to the products used, another aspect of commodity risk to be considered is the ‘basis risk’ component. Investopedia defines basis risk as “the risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.”
This is particularly prevalent with ETDs due to the high standardisation of products, where the maturity dates of the contract may not match exactly the date in which we expect the exposure to occur. Additional basis risk is found when, for example, jet fuel prices are hedged with crude oil or where a particular alloy is hedged with the component metals. In these cases, the exposure may not fluctuate in exactly the same manner as the derivatives purchased to hedge them.
Other differences that must be considered and understood are the complexity in pricing and valuations, such as cost of carry when evaluating the price of a forward/futures contract, and the potential pitfall of an unwanted ‘delivery’.
Requirements for a Comprehensive Strategy
What the article has discussed so far points towards the need for a comprehensive risk management tool that has the ability to identify, measure and record the exposures, (both firm commitments and forecasted), register trades, and accurately calculate mark-to-market valuation allowing continuous risk management and dynamic adaptation to market changes through up-to-date and live access to the entity’s net commodity exposure.
Fortunately, there has been substantial investment in this space from multiple technology vendors, with products that can provide all the essentials listed above, opening the opportunity for a comprehensive IT-supported commodity risk management policy.
Why Treasury should Champion Commodity Risk Management
With the developments and progress in the commodity risk management arena, organisations should review their non-core commodity risks to evaluate the potential benefits of risk reduction and cost saving that could be achieved by implementing a framework to effectively manage these commodity risks.
The treasury function has established structures and policies that closely tie in with this commodity risk perspective, as they are already
responsible for monitoring and hedging an organisation’s FX and interest rate risk. Treasury can leverage these policies to easily gain a centralised view of the complete economic exposure, taking advantage of economies of scale and natural hedging opportunities.
With this in mind, the modern treasury function is well positioned to manage these commodity risks and champion the potential benefits while serving as the risk management centre of an organisation, creating a holistic risk management approach.