This is a volatile time for global commodity prices and an important time for companies to discuss and understand the sources of risk in their business. Hedging has long been a way for commodity producers, traders, processors, and end users to mitigate the risks of price fluctuations and minimize earnings volatility.
Mobius Risk Group is a risk technology and advisory firm that focuses on identifying and implementing physical and financial hedging and risk management solutions for its clients to optimize cash flow and risk to achieve capital plans. Why should companies hedge, and what should they be thinking about?
Companies have a finite amount of capital, and it’s essential that this is invested in areas where they can optimize risk-adjusted returns. While there are some exceptions, we find that most companies, regardless of where they sit in the supply chain, are not paid to take on price risk.
Taking on incremental risk without incremental returns is inherently harmful because it both jeopardizes a firm’s balance sheet and prevents it from investing in other areas that could grow the business, such as acquisitions, growth capital expenditures, or research and development. Basically, hedging lowers the risk of financial distress, optimizes risk-adjusted returns on capital, and allows for strategic, operational, and commercial focus on core capabilities.
Can you expand on how a company can hedge either financially or contractually by matching purchases and sales contracts?
When we use the term “hedge,” what we really mean is identifying and quantifying a company’s exposure to the price of a commodity and then finding a way to reduce that risk. This can be done through physical agreements and contractual structures, or by using derivatives contracts.
An agreement to purchase a physical commodity at a fixed price hedges delivery risk and price risk, an agreement to purchase a physical commodity at a floating price hedges only delivery risk, and a fixed price derivative contract hedges only price risk. These contract types can be combined in numerous ways to meet a company’s purchasing and risk management needs. As an example, an agreement to buy a physical commodity linked to an indexed-based price (that is, a floating price) plus a fixed-for-float swap contract replicates a fixed price purchasing agreement.
Financial derivatives such as futures and options are a tool, not a strategy. We focus heavily on strategy and help our clients to implement these. Physical agreements are great when they come naturally, but you never want to force contractual terms on your supply chain or customers. Financial derivatives enable you to buy how your suppliers want to sell and sell how your customers want to buy. On an incremental basis, this flexibility should allow you to buy a little cheaper and sell a little more expensively.
That’s interesting. What should these strategies cost?
When we talk about cost, it’s important to view price and cost independently. Price represents the current fair value of an asset, while cost is the spread to value that a company pays to execute. Best practice hedge programs should focus on minimizing spreads paid while recognizing that liquidity has a cost, as well as look to pass on or share those costs where possible as a company grows in sophistication and scale.
Most of us at Mobius have backgrounds as traders at banks or merchants, and one common misconception many people have about these roles is that traders are actively looking to be risk takers. While this can be true at times, the vast majority of the time institutional traders are looking to be paid to take on a counterparty’s risk and then hedge this risk as efficiently as possible. Managing a corporate risk position is no different – you’re just doing it with internal exposure rather than exposure that was transferred.
While hedging allows a company to mitigate price risk, are there other challenges or risks a hedging strategy could introduce to a company?
When we analyze price risk, we look at it from a couple of perspectives. The first is the actual economic risk or risk to your profit and loss statement. This analysis focuses on how much money your company might lose if the price of steel or another raw material starts to increase or decrease significantly. The impact of higher or lower prices on a company’s profitability can be felt immediately or over a full business cycle as higher-priced goods are delivered or processed and sold to customers.
The second is the cash flow impact of price movements. For companies that hedge using financial derivatives, this includes potential margin exposure, as it can introduce short-term liquidity risk. Exchange-traded derivatives are marked to market daily, and if the market has moved against the position, margin capital must be posted.
For example, if a company maintains a short futures position to hedge its inventory, an increase in the price of the commodity would result in a margin call payment to the futures exchange. While this doesn’t result in an economic loss, there is a timing mismatch to cash flows, as the higher value inventory might not be monetized for several months. There are a number of routes a company can pursue to protect itself against margin-based liquidity constraints, including arranging a commodity trade finance line of credit that adjusts to price movements in real time, using options structures, and executing physical contracts with suppliers and customers that have embedded risk management solutions.
On the last point, while hedging physically with suppliers and customers can remove margining risk, it introduces counterparty performance risk. One of the most important risk management rules is for a company to conduct business with trustworthy counterparties. If a company reduces price risk by matching its purchase and sales contracts, it could experience losses if a supplier or customer fails to meet its obligations in a volatile price environment.
If, for instance, a customer was to default on a contract in a declining price environment in search of a better price, the company may be forced to sell the material at a lower cost. While this failure to perform could result from a credit event, it can also result from a large customer using leverage to renegotiate. For example, the customer might agree to honor its contract but threaten that you will lose the account if you don’t renegotiate.
The importance of managing liquidity and counterparty risk is essential for companies to remain healthy and able to pursue new business opportunities.