Large segments of the non-ferrous metals industry are blessed, risk-wise, by having their metal purchase and sale prices indexed to a hedging medium – LME, COMEX or Shanghai. In theory, these companies don’t ever have to face any price risk at all – price correlation between commercial prices and hedge prices is 100%, so hedged price risk should be zero. Real life, of course, is not as simple. Many parts of the metals industry are more like the energy and agricultural complexes where raw materials and product prices relate to commodity exchange prices, but not exactly, so here are a few thoughts on how you might deal with these kinds of problem beyond using the classic “perfect hedge”.
It is a truth universally acknowledged, that a metal price in possession of a daily reference, must be in want of an average. Or so it seems in the physical metals world. In the course of our adventures through the ecosphere of commercial contracts and pricing principles we see averages employed everywhere. And why not? They’re simple, easily applied and save administrative overload. And anyone who didn’t grow up under a rock knows exactly how to use them. Or maybe not. For in the world of business affairs it is practically certain that every concept properly applied will surely attract an indiscretion. We present four opportunities.
“We’re a conservative company – we don’t have commodity price risk here.” Hmmm…something smells…sound the alarm! Every commodities based company has price risk in one form or another. The chain of buying and selling, especially when coupled with a conversion process in between, is complicated. Yet this is a common claim we hear when we talk with metal-based businesses. Put through Google Management Translate this assertion converts more specifically to “we don’t really know about our risk and we don’t track it”. So would these same managers happily leave uncertainty in their own personal exposures (mortgage, car loan, health insurance, etc.)?
When the Lord gave us Hedging as the answer to the industrialist’s prayer to save him from risk, there was no promise made that we would be saved from thinking, or making market judgements. Commercial prices and their hedge instruments almost always leave some daylight between them, called basis risk. It’s a common challenge for most hedgers and caused by a derivative price that does not move in lock step with the price of the physical exposure being hedged. Not all risks are created equal however. Challenges to some can be opportunities to others and this risk, in our experience, presents such a contradiction for players in the physical world like processors and traders. If your business is wrestling with what to do about basis risk here are seven considerations that you should bear in mind.
A fast drive, a twisty road on a slippery day and a fogged up windshield do not make a good combination. In fact, it’s an outstanding way to generate an undesirable convergence between your car and a telephone pole. No intelligent driver would do it…would they? Yet when it comes to price risk this is exactly what many industrial commodity processors do and many times it takes a big price move (said telephone pole) for the company to realize that such a risk exists at all! Our clients will tell you that we perpetually expound on the criticality of creating visibility for this risk, it’s just like pressing the defog button. For companies that are really serious about doing this, we’ve rarely seen so powerful a weapon as a price risk dashboard.
They say it takes an oil tanker 2 kilometres to turn. That’s the distance between London’s St. Paul’s Cathedral and Tower Bridge or half the length of New York’s Central Park. With that kind of handling well implemented planning is critical to steer a ship. Executing business price risk management strategy has parallels. Fortunately for ships modern electronics do much of the work. Business managers face a complicated manual process however. What makes it worse is the necessary involvement of many people in several layers in numerous places that don’t understand how they matter. Crueler still is that risk means different things to each function and at each level. The peril of the “the broken telephone” ever hangs above like the sword of Damocles To avoid misunderstanding and inevitable disarray, risk planners use a simple communication framework to translate goals into results.
Plant engineers and commercial managers may be forgiven for thinking that learning about delta and gamma risk is one of those courses a busy person doesn’t have to take. Nonetheless you will be surprised to learn how much the unconscious granting and taking of options, particularly in a commodity price environment, can affect your profitability. When such optionality is incorporated into your commercial agreements it’s not always easy to diagnose. And if you’re on the wrong side of it, in just one bad day it can bolt untethered through the gate and morph into runaway losses. Negotiator beware, vigilance is essential.
“Isn’t our hedging supposed to solve this?” Each month-end, your stressed-out accountants sweat to explain your company’s volatile P/L and risk reconciliations that show the hedge results are failing to offset company exposures. No one can blame the futures brokers either – hedge transactions have been reconciled and were executed as specified. The problem must be somewhere else – possibly buried in the hedge targets or potentially in the reporting? The immediate task is to identify the glitches before bad information leads to faulty decisions.
This is an observation we often hear. People who make it believe it to be true but things are not always as they seem. What follows is a description of commodity price exposure in the stainless steel industry and the pitfalls of complacency – which could just as easily apply to your business, with the names changed.
You didn’t reel in that big client, you didn’t find budget savings of $100K and you didn’t bring the new plant in on target. In fact, as Price Risk Manager, you’re the very person that management really doesn’t want to hear about! As in Mission Impossible, “your mission, should you decide to accept it” is low profile – making financial results predictable and explainable. Should you fail, management will “disavow any knowledge of your actions”. So if you’re worried that your skilful work is heading you for career oblivion the good news is that purgatory need not hover above your head. There is plenty you can do to stay visible and appreciated and show you understand what impacts profits across the full spectrum of operations better most. Here are ten top tips to plunk your profile back on the fast track.
On May 11 1941, at the height of the London Blitz, Britons awoke to find the smoldering wreckage of the House of Commons. A high-explosive bomb followed by incendiaries had started a devastating fire. Later, as the wartime government debated what configuration should replace it, then Prime Minister Winston Churchill observed “We shape our buildings; thereafter they shape us”. That assertion stands true today and underscores the long term importance of getting “structure” right. Its applicability also extends to so many more of man’s designs, including those for the business world. Included in that fold are programs for Commodity Price Risk Management.
If you, a manager in an industrial metals company, are told that you have to understand how Futures Market Spreads work to do your job, you will probably think we are crazy. Not so, at least not if you are responsible for any function that is affected by metal costs and revenues. We can assure you that understanding spreads is just as important as understanding expansion coefficients, transportation rates, customer creditworthiness, or whatever else you need to know to do your job.
For producing, processing and trading firms in the commodity industry, price risk can be like a predator looking to exploit weakness. There is nothing that it likes better than corner-cutting assumptions, made by over-worked management, that inadvertently turn the businesses into prey. Over the years and across the continents, CRMA and CRCI have run into a wide assortment of such specimens and in some surprising places. Here, we’ve listed some of the most common ones we see. Some are pure lethargy and in the right circumstances some are lethal. Have a look-through and see if you recognize any of these animals living close to home.
A metals industry executive once asked me, after a presentation on the wonders of risk avoidance by hedging, – “Do you mean to say you go to all this effort just to break even?” I was taken aback, but the reality is that breaking-even is better than going bankrupt – and enhancing your bottom line is better still. Either way you don’t know how to justify “all this effort” unless you benchmark your performance. The CEO and CFO are entitled to see what they get in turn for funding the company’s risk management efforts. Here are ideas to get you started.
Corporate calamities, whether in operations or administration, can make striking headlines. “Lack of Control” is an oft cited cause and banner headlines decry how even the world’s largest and most respected companies can allow it to exist. It sends ripples of anxiety through global C-suites and shakes the confidence of investors and governments alike. Fortunately, there is no lack of information on the subject of control and its rudiments are well labelled and explained. Like any discipline however, commodity price risk management has its own spin on these elements. An exploration of a few of them is laid out here.
When it comes to Price Risk Management business executives don’t really know what to look for. We understand what metrics we need to describe production, sales, inventory and working capital – but what about concepts like net exposure, price mismatch and mark-to market valuation? How can we make them leap from the page? Where do they fit into the pecking order of numbers whose bottom line is P&L or Shareholder Equity? Here are ideas to get there.
All too frequently commodity-based producing and processing companies view the risk desk as a black box, difficult to understand and not to be interfered with. It is this very attitude that undermines risk activity itself. Effective price risk management, just like health and safety, must be visible. Here are key considerations.
Price risk management policy itself can be the source of a company’s price risk problems. It’s often here that the first major errors are made, which end up distorting price risk management program results. Left unresolved resulting problems could run a company off the track.
Sometimes the perspective of history only allows us to understand a trend or a cycle when it is almost over. Such is the case with the recent scandalous case of the aluminum ingot premium bubble and the related LME warehouse queues. Sometimes we can learn a lesson from history, sometimes not. We have been preaching the dangers of these warehouse manipulations for years now and are penning this blog in the hope that this is a case from which we can learn some valuable lessons.
Selecting a price risk advisor shouldn’t be done in haste. Advisors come from varied backgrounds and have different focuses but if price risk for a business emanates widely from deep within its workings, experts are needed. Research your options, think about the nature of your risk exposure and pick wisely.