Managing Commodities Risk to Add Value
Is volatility in commodity pricing an element of business that is simply accepted, or can treasury leverage its understanding of related mitigation processes and financial tools to add value? TMI asked a trio of experts for their insight.
There is no doubt that commodity pricing is in a period of turmoil. Almost every business is exposed to unsavoury shifts, to a greater or lesser extent. But while some companies may have felt less direct impact than others, failure to efficiently manage a volatile cost base – that is, not simply passing increases on to customers – is neither good for financials nor reputation.
While commodity prices are generally below the peaks seen two years ago, the relative calming of markets today still sees some prices above pre-Covid levels. And the current wave of global instability suggests it will not take too much effort to throw the markets into disarray once again. Add in the urgent need for more investment to facilitate the switch to sustainable supplies of many commodities and it seems price stability is not something that should be counted on anytime soon.
With so many different commodities markets around the world – loosely divided between soft (such as agricultural products or livestock) and hard (typically natural resources that are mined or extracted) – risk mitigation is arguably more complex than for FX or interest rates.
Pay attention
Certain industries on the consumer side will always be heavily exposed to commodities, and many have historically tried to manage pricing risk as well as supply chain risks – transportation, food and consumer packaged goods (CPGs), for example. But Chatham Financial’s 2024 State of Financial Risk Management Report suggests engagement within other sectors has perhaps been less focused than it could be.
Of course, interest rate (IR) risk is very firmly in the domain of the treasurer and CFO, notes Amol Dhargalkar, Chairman and Managing Partner, Chatham Financial. “Rarely is anyone else in the organisation putting debt onto the balance sheet.” Similarly, FX risk is mostly handled within treasury, but different business units may have different supplier or customer contracts with their own FX elements embedded, making it a “more complex team sport to manage”, he comments. “But in this respect, commodities are a whole different ball game.”
The connection between the physical and the financial in commodities is extremely important; it’s the only financial market where a tangible product is central to the deal. Whether pricing risk is part of the end-product manufacturing process or a general business cost (fuel for heating or running vehicles, for example) or both, that physical/financial connection often has organisation-wide reach. Indeed, it can create multiple location spreads, forced by considerations such as transportation, delivery timing, and storage of those commodities.
Not only could there be different business units approaching commodities trade from either a supplier or buyer angle, but there will also be a procurement and production perspective, often supported by the COO. This will be driven by an understanding of the physical need for commodities, particularly on the manufacturing side.
Conversely, notes Dhargalkar, treasury’s understanding is driven by the financial opportunities that are available to mitigate that risk. “And in most organisations, never the twain shall meet.” Indeed, he adds, “it takes an incredible amount of energy, and executive sponsorship, to bring all parties together to the table”.
It’s human nature to try to control only that which is controllable. In this context, it’s easier to control FX and IR risk. But commodities risk management is arguably more challenging, and for many businesses, this means a more reactive effort, notes Dhargalkar. “When commodity prices shoot up, and board members, CEOs, and CFOs are forced to answer questions, suddenly their minds are focused on it.”
Naturally, different industries occupy different parts of the commodities risk spectrum. A commodities producer (such as a utility or mining firm) must always be thinking about how to manage the risk. But the closer a business is to the consumer end of the commodity spectrum, despite obvious exposures in some cases, the more decentralised, or regional, the approach to that risk tends to be, says Dhargalkar, adding that this is “highly correlated with that reactive orientation”.
It’s evident to him that the degree to which companies can manage commodities risk often comes down not only to how much effort has been invested in understanding and defining the nature of this risk but also in creating the best structure and team environment to develop and execute a plan.
Right tools for the job
And as far as those plans go, there are two sets of solutions that can be deployed to mitigate commodities pricing risk: technological and financial.
On the financial side, the simplest way to mitigate risk is to ‘lock in’ or fix prices using long-term procurement contracts. Others may use financial market solutions, typically hedging. Commodity hedging is fundamentally similar to currency hedging, in that the aim is to balance the price risk on the underlying exposure (a commodity rather than a currency) with a financial instrument that responds to market prices in the opposite way to increase predictability and reduce volatility.
Over the counter (OTC) contracts are tailor-made by banks and traders to fit the client’s needs, but at a premium. Otherwise, familiar hedging choices include futures, swaps, options, forwards, and collars.
But not all commodities markets are developed for option products, notes Dhargalkar. And although some commodities are easily hedged with standard products, especially futures contracts, many commodities do not have liquid markets where they can be easily or cheaply hedged. “Someone, somewhere, will always make a price,” he comments, “but liquidity for hedging Brent Crude, for example, versus liquidity for hedging resin, is a world apart.”
On the technology side, large commodities producers will almost certainly use an advanced system, whether in-house or third-party built, to manage the full range of operational risk, from physical to financial. But for companies not directly engaged in production, the level of refinement required to manage exposure has not always been in evidence.
The adoption of sophisticated risk solutions is often dictated by company structure and the prevailing mindset, notes André Jäger, Senior Vice President, Product Management, ION Commodities. Viewing commodities as a procurement issue rather than a financial hedging issue may see a firm managing the budget and optimising costs, rather than treating it as trading activity, he notes.
“Risk solutions can be used to balance demand and supply positions, with a trading function sitting in the middle, buying and selling. Here, depending on how risk averse the firm is, it may take a bigger open position than others. But we struggle to find this mindset in many CPG or food companies. I think that has slightly hindered their progress, but the picture began changing with recent ultra-high commodity prices and increased volatility.”
An airline that did not hedge at all during Covid would have benefited, saving significant sums on hedge costs on fuel that it suddenly could not use. “But that is more luck than judgment,” comments Jäger. “Over the longer term, in more standard market conditions, there is more value in managing risk with a trading mindset versus a cost-base procurement mindset.”
While there are many companies taking the procurement path, Jäger cites successes in the airline and CPG industries using commodity trading (and energy trading) and risk management solutions closely tied to, and owned by, treasury. This capability is relatively recent though.
Earlier commodity trading and risk management (CTRM) and energy trading and risk management (ETRM) systems lacked treasury functionality, and while many TMSs have been able to handle financial commodity trading, they often lack commodity-specific functionality on the physical side of the trade. ERPs also tend to be more procurement-focused, with limited risk functionality. ION, he explains, has been able to bring TMS capabilities to bear on its CTRM/ETRM offerings “to provide an integrated view across those different activities”.
The difference between the sophisticated solutions and the most basic (often Excel) can be stark. Indeed, Excel has a number of deficiencies when trying to share and respond to the same information across a business, notes Chatham Financial’s Dhargalkar.
“While commodities may not be the most significant risk on a company’s agenda, it is often the most volatile, so we always advise clients to at least implement an ‘in case of emergency, break glass’, plan,” he says. “The goal here is to discover and evaluate the most appropriate technology, and then be willing to pay the running costs because, like most insurances, no one likes paying the premium but everyone values it when it’s needed.”
But, warns Jäger, building an effective solution depends on business structure. Centralised is easier to extract value from the investment than regional, and ownership of the risk by treasury is preferred over procurement, as it places its management in the hands of financial experts. But it may require a push against the status quo for an ‘outside’ function such as treasury to take on a trading view of what’s happening in the raw materials side, he warns.
Stronger together
If the business can organise itself to co-ordinate this on a larger scale, through technology, people, processes, and policy, it will find more synergies, suggests Jäger. “On the commodities side, there may be FX and IR components, for example, where there are natural correlations with how pricing is moving. If you are in a position to measure that, you can then focus on how best to hedge these risk component combinations.”
Unless a company was lucky with its positions (as per the airlines not hedging fuel during the pandemic) most will have seen a negative impact from recent commodity pricing volatility, comments Jäger. “But now they will almost certainly have the right level of awareness that it can hurt the business and should be motivated to do something about it.”
Treasury now has an opportunity to add value. This is about creating a clear view into the company’s exposures and working with other functions to manage them. Operating treasury and commodity risk management as separate activities is neither efficient nor effective.
But while utilities meet supply and demand, and are set up to trade beyond that on the markets to optimise their standing, most companies would be averse to trading raw materials to balance their positions.
It’s therefore not only important to have clear guidance or policy around risk-taking, to minimise commodity costs and exposures but also an additional level of monitoring. This will involve effort in terms of specific policy amendments around the limits of trading, including hedging limits, with due consideration for market and credit risk. It will also need a view of open exposures, the ability to run scenarios, and to visualise what is in the commodity portfolio.
This suggests a change in thinking may be needed to achieve value optimisation versus simple procurement of what is needed for production, insists Jäger. The motivation is simple: businesses are valued, from a stock perspective, on consistent earnings; high variability is unattractive to investors. Companies cannot change prices to customers in the way commodities prices fluctuate, so managing the input side is the best way forward.
Of course, it requires the wherewithal to effectively execute an optimisation programme. It also demands the ability to articulate to investors and other key stakeholders what that plan is, and the results it is intended to achieve, to instil within them the confidence that commodity risk is being effectively mitigated.
“And anyone who has tried this will know that commodities risk management is far more complex than IR or FX risk management,” states Dhargalkar. “It is a very different game, requiring a different set of skills to be successful.” And now, he points out: “CFOs are clamouring for someone to raise their hand and say, ‘Give me the ball.’ This presents an ideal opportunity for treasurers to step up, and lead or work alongside a team that can steer the company to a better place.”
A treasury risk manager’s perspective
For treasurers seeking to manage commodities pricing risk, developing a robust approach is clearly easier said than done. But for Vincenzo Masile, Senior Treasury Operations Analyst, Interim, Philips Healthcare, there is real value in getting it right.
From his own experience, he knows that while hedging and technology deployments can introduce their own additional complexities, ad hoc use of collaterals (for example, export credit insurance or LCs) may also be needed to support the position of the business. The inherent complexity of the task will thus almost certainly require treasury to seek input from multiple stakeholders if it is to deliver real value to the business in this context.
Masile worked for seven years as a trade and credit risk analyst at ADM Cocoa, a business now owned by Singapore-based commodities firm Olam International. As one of the largest agricultural processors and ingredient providers in the world, ADM has a huge exposure to the US$26.7bn global cocoa market.
For its supply of cocoa beans from West Africa – mainly Ivory Coast and Ghana – ADM mostly used trade finance instruments, notably LCs and export credit insurance, to cover shipments that are usually measured in millions of US dollars or euros. To ensure optimal use of these instruments, as part of his risk remit, Masile was keen to form business partnerships from his Netherlands base with the firm’s trading desk, shipping, logistics, and customer services teams, as well as industry agents and customers.
Weighing up the options
In the current volatile trading environment, Masile says it is important to mitigate both current and future risks. This is especially true for seasonal commodities such as cocoa, where the additional threat of climate change is disrupting harvests and, therefore, market prices.
But this volatile environment makes it difficult to forecast pricing with any degree of confidence, amplifying any marginal risk. For Masile, a blend of hedging and collaterals is needed to mitigate such losses. But there is more to it than that.
Software that can capture trade finance instruments digitally, and generate dashboard-style visualisations of risk, is appealing, he notes. But ultimately the process still requires a judgment call. “And at the end of the day, it depends on how much the corporate buyer is prepared to lose in any given trade as to how it manages it.”
LCs have long been used when trading with higher-risk counterparties, and these can be deployed ad hoc or as revolving instruments. With shipping rates now unpredictable, and costs rising for trade instruments, Masile says buyers must now be considering the location of the source every time when making a choice. “Current activities off the coast of Yemen present a huge risk for goods carried from China to Europe, for example,” he explains. “In this case, using a revolving LC makes no sense because the journey of the cargo is so long that there is no way of knowing what will happen during that time.”
To steer the risk mitigation process in the most appropriate direction, analysis of historical trends can provide a useful pricing indicator. Before offering his views on the value of technology in this context, Masile reiterates the challenge posed by current market uncertainties, referring again to the need for every business to know how much risk is too much risk. “There is no clear-cut answer. With some companies able to absorb a greater percentage of loss in their margins than others, approaches to mitigating pricing risk can never be one-size-fits-all,” he notes.
Returning to the technology topic, Masile believes that it has a role to play in assisting the mitigation of commodities pricing risk. “Again, it depends on the scenarios being considered, but, absolutely, technology can be used to cast more light on outcomes.”
Trusted external sources of information – banks and other third-party providers – can also be useful and should be explored, he continues. Indeed, in his role as Cash and Treasury Operations Manager at European healthcare services provider Affidea, he was in receipt of daily commodities and FX updates from one of the firm’s major banks. From these updates, five scenarios were generated, from low to high risk, enabling him to determine the right mitigant.
Above and beyond
For treasury to add value to commodities pricing management, the business must unbridle the function from outdated views. “Too often treasury is seen as another accounts department, dealing only with numbers. Today, treasury should also be seen as a business enabler,” he states.
At ADM, every Monday Masile attended meetings with the traders to review credit limits. “ADM supplies some of the biggest buyers in the market, and I had visibility across the entire future pipeline. That enabled me to advise, some time in advance, on elements of pricing risk they had not considered, such as the cost of LCs, and whether or not these could be consolidated to earn a discount.” These meetings also enabled ADM’s traders to be party to views emanating from treasury’s banking partners.
While acting as interim Senior Treasury Associate at ACT Commodities Group, a global energy transition business, Masile was similarly afforded timely visibility of all related costs. However, he knows that in other firms treasury is not invited to meetings and is therefore unable to exert positive influence on trading activities, especially if it is seen only as a last resort when trade risk is increasing.
“Every company wants to be more profitable, and there are different ways to save money and optimise the available tools. But when you seek treasury’s advice at the last minute, those options are limited. But by that same measure, treasury may have to be proactive, inserting itself into the process as early as possible if it is to add value.”
The bottom line is that treasurers are able to add value if they’re prepared to engage in effective communication with internal and external partners, to explore technology options, and approach the impact of risk creatively. “We need to be positive but we still have to be realistic,” advises Masile.
Asking timely questions of colleagues and partners, and using this as a prelude to formulating commodity pricing risk contingencies, gives the business options, he comments. “It also demonstrates treasury’s true value in this process.”
