VideoOn the Chicago Mercantile Exchange early this summer, the price of block cheddar cheese was up 79 percent from a year earlier. In central Illinois, No. 2 yellow corn was up 68 percent from a year ago. And down in Texas, natural gas at the Henry Hub was up 15 percent from a year earlier and a dramatic 63 percent from its 52-week low.
Those are volatile pricing trends for corporate purchasing agents to manage. Increasingly, however, they don't have to — at least not alone. Instead, companies are asking their treasury departments to export to their commodity-buying operations the same risk-management expertise they have long exercised in foreign-exchange and interest-rate markets.
"Treasury [managers] have gained a lot of knowledge in providing risk-management execution in those other areas," says Robert J. Baldoni, leader of the global treasury advisory service for Big Four accounting firm Ernst & Young. "They're the keepers of the tools and strategies. It is a natural progression for them to be moving down the risk spectrum to what is, at many companies, the next major risk."
Darrell Thomas, assistant treasurer for capital markets at $35.1 billion beverage and foods company PepsiCo Inc., says he and his staff began working with his company's global procurement and accounting teams about three years ago to better manage the company's exposure to commodity risk. A big buyer of corn sweeteners, flour, potatoes, sugar, wheat, and other food staples, PepsiCo also consumes vast quantities of natural gas and fuel to produce and deliver its products. In addition to relying on productivity initiatives and global purchasing programs to manage the price risk, it also uses derivatives contracts.
By getting involved in protecting the company against commodity-price risk, Thomas says, treasury also provides senior executives with better visibility into PepsiCo's hedging program.
Thorny Hedges
Better visibility into any sort of financing activity has itself become a prized commodity since the Sarbanes-Oxley Act of 2002 began requiring public-company CEOs and CFOs to formally sign off on the accuracy of financial statements. It is especially important for hedging transactions, because hedge accounting can be treacherous. In 2001, the Financial Accounting Standards Board began requiring companies to mark their derivatives contracts to market, with gains or losses flowing through the income statement, except under very tightly prescribed circumstances in which the contracts qualify as hedges rather than speculative transactions.
Plenty of companies have had problems hewing to the new derivatives accounting standard, commonly known as FAS 133 (see "Lost in the Maze," May 2006). The consequences can be harsh. If a company's hedge accounting fails to pass muster, the company must restate its financial results in both current and, where applicable, prior earnings periods to reflect mark-to-market accounting. And hedge accounting can be surprisingly easy to mess up, especially with commodities hedges.
Say you're importing wheat from Mexico and paying your Mexican supplier in dollars under a contract that requires you to pay a kicker if the peso rises by 5 percent or more against the dollar. "That's a common practice among purchasing people, who don't like sourcing in local currency and don't know how to manage currency risk very well," says a Fortune 50 treasury executive who asked not to be identified. Unfortunately, he adds, that price kicker could be considered an embedded currency option under FAS 133, which would require mark-to-market treatment. Examples like that, he says, show why companies would be foolish not to get treasury involved in managing their commodity risks.
"Hedge accounting for commodities is ugly, and almost always beyond the ability of the purchasing department," agrees consultant Jeff Wallace, managing partner of Greenwich Treasury Advisors LLC.
Burgers and Chips
The point, of course, is not to disparage procurement specialists. "These folks have generally done a good job," Baldoni says. "But while price is an issue for them, physical delivery is a bigger issue." That doesn't help the growing ranks of companies, he says, that are unwilling to withstand the stress of earnings volatility and are increasingly interested in finding ways to lock in their costs.
Nor does it help those who find rising commodity prices eating into their margins. When Moody's Investors Service lowered ratings on fast-food restaurateur Wendy's International Inc. and its securities in June, it cited, among other things, commodity cost pressures. In its latest annual 10-K filing with the Securities & Exchange Commission, Wendy's says it has not used financial instruments to hedge commodity prices, relying instead on purchasing and pricing contract techniques such as setting fixed prices with suppliers, generally for a year in advance; buying forward (setting future pricing in advance); and using unit pricing based on an average of commodity prices over time.
Tom Linton, vice president and chief procurement officer for Freescale Semiconductor Inc., a $6.4 billion chip maker that was recently taken private, says his colleagues in treasury get involved in helping manage that company's exposure to price risk for some commodities, such as the silver and gold it uses on its circuit boards. "We are applying to commodities some of the risk-management techniques that treasury developed for other areas," Linton says. "The reason is predictability."
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