Patrick Scott of the BBH Commodities & Logistics team recently spoke with Drew Lichter, vice president of corporate strategy and development at Mobius Risk Group, about the advantages of using financial instruments and market strategies to hedge against commodity price risk.
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 focuses on identifying and implementing physical and financial hedging and risk management solutions for its clients to maximize cash flow and minimize risk to achieve capital plans. Why should companies hedge, and what should they be thinking about?
Drew Lichter: Companies have a finite amount of capital, and it’s essential that this is invested in areas where they can maximize 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?
DL: 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 are a tool, not a strategy. 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?
DL: 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?
DL: 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 or 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.
How do you think about the tradeoffs between price risk vs. leverage risk?
DL: Leverage is a double-edged sword; it allows you to increase your return on equity, but on the flipside, it raises your odds of financial distress. Price risk has similar negative impacts, though without the increased returns, as unhedged price volatility creates earnings instability, which can inhibit a business’s ability to meet its cash flow needs. As a result, businesses that are able to successfully reduce their price risk often receive better terms from their lenders. This can mean more favorable rates, lower capital requirements and more leverage, which can lead to a lower cost of capital and additional capital to invest back into the business. When a company can reduce its exposure to price risk, it can support greater leverage resulting in higher returns with the same – and sometimes lower – overall risk profile.
Our basic philosophy at Mobius is that the same broad principles that apply to equity and debt portfolio management apply to business operations. An equity (Stock 1) that returns 12% per year with 5% volatility is, all else equal, better than an equity (Stock 2) that returns 12% with 10% volatility. Stock 1 gives you half the risk with the same returns, which means you could borrow money to double your expected return and still have the same risk as Stock 2. Alternatively, correctly managing price risk turns a company from Stock 2 to Stock 1 and moves it back onto the efficient frontier. If it sounds like Econ 101, that’s because it is. While people get caught on the quantitative modeling aspects of derivatives, from a strategic perspective risk management is all about the basics. When I was starting in commodities markets, a very successful mentor pulled me aside after a bad day and told me, “It’s easy to make money trading in commodities if you do the right things – it’s just not always easy to do the right things.” Through the years I’ve found this to be very true, and the irony of it is that the smartest and most successful people often have the most trouble following this principle.
How have you seen companies respond to recent commodity price volatility? How do your most sophisticated clients manage these risks, and what lessons can be learned from those who made the wrong decisions?
DL: Any time market prices are more volatile than what people are used to, the right answer is to keep calm, look at the fundamentals of your business and continue the same as you would if the price was moving $5 per day vs. $100 per day, though with a keen eye toward liquidity. Large price swings can tempt business owners and executives to change their decision-making process based on fear, greed or other emotional factors. Two examples would be liquidating hedges or making long-term fixed-priced sales to a customer with a history of not honoring commitments. Both decisions feel good in the moment but could put a company in harm’s way should prices start to decline.
During periods of extreme volatility, our most sophisticated clients use the environment as an opportunity to engage with their customers and suppliers and offer support, as their risk management expertise puts them in a unique position to service their supply chains. We have seen our clients reach out to provide options that will both de-risk themselves and their customers or suppliers and do it in a way that gets business done, generates goodwill and produces profits. These dynamic clients focus on utilizing their resources to make informed decisions that successfully manage risk and add value to their partners in a fast-moving market. Volatility leads to opportunity, provided you have the real-time information, analytics and expertise to capitalize on it.
For companies considering hedging, what factors would you suggest they evaluate?
DL: Every risk strategy is unique. The most effective process starts with identifying and quantifying the risks your business is taking today. Once identified, a company should determine whether or not it is being paid to take that risk. We have been focused on price risk, but the same framework could be applied to credit or operational risks as well. If there are risks you are not being paid to take, it is a matter of what it is going to cost the company to remove those risks. When the cost of risk mitigation is lower than the capital cost of self-insuring, action should be taken. When a company can reduce price risk, the result is a more stable business that allows its owner to deploy capital into growth projects or distribute to shareholders. While financial derivatives often seem complicated, for a company that faces commodity price volatility, a customized and well-understood hedging strategy is a win-win for business owners looking to reduce risk, stabilize their business and increase their long-term returns.
Drew, thank you for your time and insights.
Mobius Risk Group is an independent commodity advisory firm providing market guidance to producers, consumers and capital market participants needing timely and effective financial risk management support. Mobius leverages its proprietary technology, industry-leading analytics and deep market expertise to drive value across its clients’ organizations. Mobius was founded in 2002 and remains a privately owned company headquartered in Houston.