Breaking Down Barriers to Manage Commodity Risk
Treasurers are contending with increased commodity risk. Price volatility has brought a shift to shorter-term contracts. Suppliers are reluctant to enter into long-term agreements, because a jump in prices could let them reap bigger profits on commodities and depressed prices means greater losses if they are locked into a longer contract. Where corporates would once sign a five-year agreement with an important supplier to receive their critical raw materials, they are now faced with a maximum of only 12-month or even six-month contracts. While this brings flexibility, it also increases risk on a number of fronts: counterparty, credit, volume and operational.
Increasing market complexity, largely driven by the growth in the financial trading of commodities and the explosion in popularity of exchange-traded funds (ETFs), has created something of a perfect storm of risk for corporates. With commodity markets now a source of investment, volatility is no longer a simple, relatively predictable result of supply and demand imbalance, but instead is affected by macroeconomic factors like never before. Take Chinese economic announcements, for example. These have a significant impact on the price of copper, so for a cable company this introduces a further layer of complexity to its risk management.
The Swiss franc’s (CHF) de-pegging from the euro (EUR) last January illustrated the vulnerabilities that many companies face in having to deal in a variety of currencies. The inability of investors to move quickly enough away from the CHF created large losses. While such a dramatic a move in currency valuations might be rare, the nature of international trade means that corporate treasurers find themselves holding many types of currencies. Chief financial officers (CFOs) need to be able to oversee these holdings in a way that allows them to be nimble enough not to take losses, but also ready to make procurement purchases from a panoply of nations.
Typically, these two risks are managed very separately, due to the historical division of treasury and procurement functions. The upshot is that while treasuries will often manage currency risk through financial hedges and similar vehicles, they have little-to-no visibility of commodity price risks across the business. Meanwhile, procurement divisions typically manage physical commodity exposure – if at all – in an unsophisticated way; for instance by locking suppliers into a price for a fixed period when it seems low, and via blunt, antiquated systems (often the manual use of spreadsheets).
An Era of Volatility
This risk was manageable when commodity price volatility was relatively low. However, times have changed. Over the past decade international commodity markets have entered a new era of high volatility. Recent sharp movements in the price of Brent crude oil provide an illustration. After peaking at US$115 per barrel in June 2014 rising supplies sent the price into a nosedive; at one point it slumped by over 50% to a low of US$45 a barrel in January of this year. News indicating a pullback in drilling and investment – along with supply disruptions in oil-producing countries – has since triggered a modest rebound to above the US$60-per-barrel mark. However, the International Energy Agency (IEA) has warned that this degree of volatility isn’t unlikely to diminish in the near term.
This only goes to highlight the absurdity of a situation where corporate treasuries are routinely hedging for currency risk, but ignoring commodity price risk. Many companies with exposure to raw materials may be greatly affected by these dramatic swings in the price of crude and will not have hedges in place to protect themselves. Yet because interest rate risk has historically been a core function of corporate treasury groups, many will have hedged short-term rates even though three-month London Interbank Offered Rates (LIBOR) have been well below one per cent for some time. This is not to say such hedging isn’t important; rather that commodity risk needs to become just as much of a priority for treasuries as their traditional areas of responsibility.
Forward-thinking CFOs are achieving this more intelligent approach to hedging by breaking down the barriers between treasury and procurement, integrating the two in such a way that the company is able to have a single view of risk across a company’s balance sheet.
Done properly, this allows businesses to make far smarter procurement decisions, far more quickly, and in response to market fluctuations. It also promotes the use of sophisticated analysis and financial commodity hedging, should this be warranted. For a business previously reliant on spreadsheets, it pays dividends in terms of man-hours and reduced operational risk and lower error rates. All of which translates directly into an improved bottom line.
No company will ever engineer risk out of the equation entirely. Yet by breaking down divisions between treasury and procurement functions and learning to merge risk management, CFOs can be on the winning side of the battle against risk.