Now we have survived the summer heatwave, take a fresh look at your exposure to commodity price risk and how to manage it

30 August 2018

We are speaking with many companies concerned about their commodity price risk - what it means for their business and crucially how they can manage it. For many their ability to manage this exposure is a key source of commercial and competitive advantage, and for some, it may be crucial to the viability of the business in the longer term.  

Over the past 12 months we have seen volatility and uncertainty in energy and other commodity markets off the back of macro-economic and geopolitical factors. Prices for metals such as copper, and agri-products such as soybeans falling in recent months due to fears of a trade war and the resultant impact on international trade. Whilst volatility may be welcome news for traders, for many producers, manufacturers, the transport and aviation sectors, as well as retail, price volatility and uncertainty are a cause for concern.

So where do you start?  We have set out below two key questions we believe you should consider as you start to think about managing commodity price risk in a more strategic manner:

  1.  What is your exposure and what is your risk appetite?  

Understanding exposure can be particularly challenging. It is important to consider both your purchases and sales contracts, as if both are similarly indexed or you have the ability to pass on price rises, your overall exposure may be mitigated.  It is also important to analyse contracts that may not obviously be linked to a headline commodity, as proxy-hedges (i.e. hedges in a closely correlated commodity) may provide a sufficient degree of protection and be more readily available.  For example, in the petchem sector whilst there may not be suitable hedging instruments in all chemicals/intermediates/ polymers, we help clients to look back up through the refining process for potential commodities which are closely correlated in price and which have more liquid hedging instruments available.

Analysing the exposure, understanding its complexity, determining the impact on your business as well as determining your tolerance of that risk is critical if you are to manage price risk effectively.

  1.  How do you want to manage the risk?

Determining the appropriate risk model for your business is another important early consideration.  There is no right answer, so we have developed a maturity ladder with four key levels to help companies think about both their current and desired future operating model;

  1. Federated risk management: a traditional procurement or sales model with a focus on risk transference and avoidance to third parties; often at a divisional level
  2. Enterprise risk management: developing on the federated model by employing risk mitigation (including hedging) in a more centralised approach
  3. Best margin risk management: taking the enterprise model further by seeking to further enhance margins through risk leverage by trading around areas of comparative advantage
  4. Trading risk management: becoming a trader  by also seeking profit from trading in its own right instead of through margin enhancement alone

We are seeing many businesses with material commodity exposures seek to move up this maturity ladder. Even those with a limited risk appetite can progress to an enterprise approach, with many in the energy sector in particular operating a best margin risk management approach and some have developed sophisticated trading operations.  However, not all businesses will want or need to move to levels three and four.

Change has significant consequences in its requirement for appropriate people, systems, governance, reporting structures and controls. It also implies organisational change and much internal and external stakeholder change management. We believe no matter where you are on the ladder, such transformation should not be taken lightly.

To help you start your journey, we recommend you spend some time developing a feasibility study to outline the solution that is right for you. This should draw on a combination of the best internal and external expertise so that you consider appropriate good practice, peer experience, market opportunities and business requirements.

Such a study might include;

  • An assessment of your exposure to commodity price risk
  • Consideration of the appropriate hedging and non-hedging options for you to manage that exposure
  • The development of a strategic proposal for consideration by your Board including your required operating model, the benefits/costs of change and an implementation plan

In our next blog, we consider the key implementation challenges faced by companies based on our experience of working with clients on this change journey at all levels of maturity.

Jonathan Rose

Jonathan Rose | Director, Commodity Risk Management
Profile | Email | +44 (0) 7595 850 848

More articles by Jonathan Rose

Nikita Shenfeldt

Nikita Shenfeldt | Senior Associate, Treasury and Commodity Management
Profile | Email | +44 (0)7913 163728

More articles by Nikita Shenfeldt

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