Time to Consider Hedging Commodity Price Risks?

Given the continued negative impact of commodity price volatility on their results, companies are increasingly hedging to lower their costs.
Talib DhanjiJune 16, 2015

Commodity price volatility is not a new concept for CFOs, who recently have had to deal with extreme cost fluctuations for raw materials.

Talib Dhanji

Talib Dhanji

Corporations, especially those with indirect exposure to commodity risk, have historically taken a passive approach. Using such an approach, companies have tended to categorize unfavorable price movements as a cost of doing business and either pass the cost increases through to the consumer or absorb them.

But given the continued negative impact of commodity price volatility on their results, companies are increasingly using hedging programs to lower costs, improve cash flow predictability, and enhance stability to their operations and financial results.

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Dramatic Price Swings

Lately, commodity markets have experienced dramatic price swings, making the paradigm of passive management unpalatable. Contributing factors such as geopolitical unrest, emerging technologies, government policies, and erratic weather patterns have played a major role in increased commodity volatility. For example, natural gas and cotton spot prices have shown about a four standard deviation move in the last ten years (only a 0.0005% probability in a normal distribution). (For the analysis of historical volatility for the purposes of this article, I use historical price data for the period of January 1, 2005 to May 20, 2015 to evaluate the following: NYMEX Natural Gas Futures; ICE Sugar No. 11 Futures; CBOT Corn Futures; and ICE Cotton No. 2 Futures.)

Opinion_Bug7Agricultural markets, which had been relatively stable, are now tending to behave more erratically – corn volatility decoupled from other major agricultural products late in 2013, with volatility increasing about 172.1%. Sugar volatility followed suit at the end of 2014 by increasing approximately 233.8%.

Commodities with prices that traditionally operated in unison as classes are currently operating more independently, thereby requiring increased proactive management.

Given the historic level of volatility and price fluctuation, management of commodity price risk is a top concern for executives and boards of directors. In the recent EY Global Capital Confidence Barometer, a global survey of over 1,600 executives across 18 sectors, 35% of respondents believed increased volatility in commodities and currencies is the greatest economic risk to their businesses over the next six to 12 months.

The Right Baseline

The primary objective of commodity hedging for corporate end users is to minimize price risk and earnings volatility, stabilize procurement costs, and get the best margins.

In certain industries, like consumer staples, where fierce competition exists, companies are typically unable to pass on rising commodity prices to customers over the short term – and without a hedging program, they may see margins decline.

Despite such challenges, many companies remain skeptical about using hedging programs because frequent misperceptions, which have ranged from “hedging is too difficult” and “derivatives will cause unforeseen losses,” to “it takes an army of accountants to achieve hedge accounting.”

In reality, examples exist in most industries in which cost-effective hedging programs were implemented to help reduce commodity-driven earnings volatility to a manageable level.

The first step for a company about to embark on a hedging program is to identify and prioritize its strategic goals. Historically, companies have relied on varying hedging strategies, ranging from static programs that lock in prices for a fixed volume to active hedging programs that anticipate trends in price movements.

The relevance of each strategy is dependent on the overall business objectives, financial goals, and risk appetite of the enterprise. Here are some typical company approaches to hedging program strategies:

  • The “price fixer” wants protection against rising prices, at relatively low cost, using instruments such as swaps and futures to lock in a fixed proportion of input requirements. While there’s little opportunity to gain from decreases in commodity prices, the arrangement does offer price certainty – a valuable feature if the concern is over the volatility of input costs.
  • The “opportunistic hedger” hedges a portion of the input exposure, but with more active management of positions and use of more complex techniques such as calls, puts, collars, and spreads, in an effort to extract additional margin based on market volatility. This approach, however, comes with a higher cost and potential risk exposure.
  • The “active hedger” exercises more flexibility in price exposure, with a higher likelihood of large gains or losses from the hedges depending on the hedger’s view of the market. This strategy may include speculative positions that require daily monitoring using a well-defined framework of controls. Companies that have a fundamental view of the market stemming from their leading roles in physical sourcing and relatively mature trading and risk management systems and processes tend to adopt this approach.

Besides determining the objectives and risk tolerance for a hedging program, companies must understand that ownership and infrastructure needs involving people, processes, and technology will differ depending on the company’s organizational structure and on the roles, responsibilities, and skill sets of resources.

Commodity price volatility is here to stay, and its will continue to drive earnings and cash flow variability unless managed appropriately. The EY Global Capital Confidence Barometer also highlighted that 31% of respondents have seen the change in commodity prices elevated in prominence on the agenda for their companies’ boards of directors.

In addition, shareholders continue to demand explanations of volatility, the objectives and effectiveness of hedging activities, or a rationale for why a program was not used. Hence, the days of “let’s wait and see what happens” are history.

Talib Dhanji is Ernst & Young’s Financial Accounting Advisory Services’ ‎Commodities Markets Leader.

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