Having too many unanswered questions may prevent a well-intentioned finance team from getting started with proactive commodity risk management. It is generally understood that fixed-price instruments can reduce risk, but knowledge levels drop markedly after that.

Many companies identify their largest commodity spends and use swaps to lock in prices or options to limit adverse price movements. Hedge ratios generally range from 50 percent to 80 percent. Hedge tenors generally range from three months to two years, with hedge ratios declining for the longer time frames. Companies clearly state in their disclosures that they are not speculating, but rather setting out to hedge in an effort to reduce price volatility. Few companies circle back to retrospectively assess the success of their hedging programs.

The most common questions companies ask before undertaking a commodity risk management program are:

• How are my inputs priced?
• How are my outputs priced?
• What is my competition doing?

A good place to start in calculating prices of inputs and outputs, as well as assessing the competitive landscape, is to call a meeting of all the affected parties—including procurement, operations, and the treasury team—and brainstorm a list of answers to each of the bulleted questions above. It's likely that no one person in a company understands every commodity risk the organization faces. However, once staffs from various functions assemble to discuss the company's commodity exposures, the top risks usually rise quickly to the surface. The assembled group should sidestep stumbling blocks such as a single bad quarter when an input price blew out but no one remembers how the change affected sales. The purpose is to identify key risks while eliminating outliers; usually the top few risks generate a consensus head nod from everyone at the table.

Once the group develops a list of commodity risk management priorities, the magnitude of each risk can be better quantified. Historical spending, budgets, and forecasts are potential starting points. If commodity spend is not a line item, then the numbers can come from a review of contracts. A sweeping generalization is that commodity prices often swing up or down by 20 percent in any given year. For example, $10 million in spending on a certain input last year may result in a spend this year of anywhere from $8 million to $12 million. If the quantified range in spend on a particular commodity is a big enough number to cause the organization concern, then that commodity deserves further consideration.

Goal Setting: Keep the End in Mind

The next step is setting goals that define how much commodity risk the company wants or doesn't want. The right goals drive appropriate action and aid in assessing progress, but many companies struggle at this crucial step. Common errors include failing to ensure that objectives are clear and selecting objectives that lead to unintended results. Hedging programs can reduce volatility but can't reduce prices paid.

Companies often set goals related to the amount of money they're spending on a hedging program (e.g., option premiums) or the amount of cash they would potentially have to post as collateral given a movement in rates of 1 standard deviation. More sophisticated goals can include targets around price points and hedge ratios—for example, maintaining a minimum of 20 percent of risk hedged for 12 months, increasing that amount to 40 percent if the price falls below a 90-day moving average, and increasing it to 80 percent if the price falls below a 180-day moving average.

Good goals typically revolve around a quantitative measure of risk. The quantitative measure establishes the initial amount of risk the company faces; adjusting inputs and outputs in the model helps decision-makers determine specific actions they can take to bring risk in line with their goals. The quantitative measure may be cash flow at risk (CFAR) or may focus on the difference between a +1 and a -1 standard deviation movement in commodity prices.

Quantitative measures are most accurate when the model simulates the hedging program dynamically through time. If a company plans to add hedge volume the second week of each month or when prices fall below a 90-day moving average, then the model will need to be complex enough to test these parameters. A static snapshot of the future or only using historical data can lead to suboptimal decisions. For example, a hedging program that avoids the pitfalls of the crash in fuel prices in 2008 will likely not protect a company adequately for the range of outcomes that are expected in the next two years.

There really isn't a list of best practices that span across business models and risk appetites. We find the best practice to be “focus on the numbers”—and in order for that approach to be meaningful, the company needs quantitative models that are good enough to provide meaningful numbers.

Taking Implementation Slowly

Companies often bite off more than they can chew when starting a commodity risk management program. Once a company has set its goals, it needs to revamp its hedging strategy to map out how it will accomplish those goals. But anyone heading in with a “rip off the Band-Aid” mentality needs to take a step back. Implementing a hedging strategy usually takes six to 12 months.

Rolling out the revamped hedging program may require the company to unwind the derivatives it currently holds while simultaneously purchasing new derivatives, perhaps at higher hedge ratios or with extended tenors. In our experience, the transition is best when completed over a predetermined time horizon with specific economic targets. Of course, the desired price points may not materialize, so the time constraint puts a backstop on too much wishful thinking.

When exiting hedges, a company needs to understand the nature and magnitude of its risk. For example, we worked with a company that was updating its program for managing risks around oil prices. As it transitioned from WTI swaps to heating oil swaps—to better match its actual exposures—the important metric for determining the optimal timing of the transition was the crack spread, not the absolute price of WTI or of heating oil. The crack spread tends to be mean-reverting and prices within a band. The company completed the transition at a point when the crack spread was below its 100-day moving average. As the crack spread tightened by more than $2 per barrel, the company saw a benefit of more than $2 million on its 1 million barrel transaction.

When adding commodity hedges, an organization is often rewarded for patience. A managed derivatives-accumulation strategy usually includes regular additions to the portfolio when commodity prices are typical, cessation of purchasing if prices rise, and an increase in purchases if prices drop below a predetermined level. For this reason, a hedging program designed to span a year can take three to six months to ramp up. A hedging program intended to span two years can take more than six months to establish. Of course, if prices drop below budgeted forecasts, programs can be put in place faster. Unfortunately, companies often realize they need a more robust hedging program only when commodity prices have already exceeded the budget.

The Importance of a Reinforced Routine

Each company moves according to an operational rhythm that arises out of its unique and often complicated set of circumstances. In some companies, a central treasury team handles commodity hedging for the entire diverse organization, whereas other companies give hedging responsibility to the business units that are on the front lines of dealing with the commodity exposures. Determining which works best for a particular organization requires an understanding of operations within that company, as well as the incentives for all the affected groups.

The centralized model often works best for companies with a strong central treasury group. Treasury should have access to forecasts from each business unit. The function's big-picture view enables it to see offsetting exposures among business units, as well as to identify potential correlations of risks. Many treasury groups are comfortable with interest rate and currency hedging in the financial markets, and these teams likely have the capacity to add financial derivatives for commodities to that lineup.

A common pitfall of centralized treasury hedging is that communication bottlenecks between the business units and the central group can lead to different teams acting at cross-purposes. For example, the procurement arm of a business unit might pay to lock in copper prices for the next 12 months, without realizing treasury has already collared the exposure. Another challenge is that business units might not be happy if the central treasury team passes on to them any gains or losses from hedges that they were not involved in securing (similar to taxation without representation).

Companies with a culture that focuses less on centralization and more on autonomy of its business units might prefer a segmented hedging approach. By giving commodity-hedging authority to individual business units, a company forgoes some efficiencies of the centralized approach, but it reaps other benefits by having each unit's risks managed by the individuals who are aligned with that specific unit's financials.

The Time to Start Is Before the Problem Gets Big

In risk management, as in personal fitness, inaction can make a situation even worse, especially when bad habits are already ingrained. Companies that decide to take action to maximize returns and minimize risks will likely have work to do. They will need to engage the appropriate stakeholders, set good goals based on statistical analysis, and then develop and maintain strategies that are congruent with the company's goals.

The time to start acting is when commodity risks are first identified and assessed, not once they've become much costlier problems. The old adage “let sleeping dogs lie” does not apply to the prevalent volatility in the commodity markets. As an example, the fuel markets rose 10 percent during the first quarter of 2012. The second quarter of that year experienced a 20 percent decline, followed by a 15 percent rise in the third quarter. An unhedged company had dramatic and unpredictable swings in cost of goods sold—but a company that responded with knee-jerk reaction and hedged after the first-quarter rise locked in higher costs for the remainder of the year. The company with a well-thought-out hedging strategy was able to smooth its fuel spend and plan accordingly.

From our experience, if a company cannot definitively answer the question of how a 20 percent increase or a 20 percent decrease in commodity prices would affect cash flow and quarterly earnings, then it would benefit from initiating or revamping its commodity hedging program. The good news is that others have paved the way, and no company has to tackle the project alone. Experts in commodity risk management can answer questions, or they can provide overall direction for a hedging program.

————————————–

Phil Weeber leads Chatham Financial's Commodity Risk Management Team, which advises corporations in various industries. Since joining Chatham in 2003, Phil has worked across asset classes advising clients with risk strategy, hedging implementation, and execution. Phil holds an MBA from Emory (Goizueta) University, a Masters in Environmental Engineering from the University of North Carolina, and a BS in Civil Engineering from the University of Michigan.

Bryant Lee is a director on Chatham's Commodity Risk Management Team, working with Chatham's hedge advisory group advising corporate clients on issues related to commodity price risk management, particularly focused on energy commodities. Bryant holds a Master's Degree in Energy & Environmental Policy form the University of Pennsylvania, a Master's Degree in Petroleum Engineering from the Institut Francais du Petrol, and a BS in Mechanical Engineering from the US Military Academy at West Point.