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Good Structure: The Key to Shaping Price Risk Management Performance

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 (CPRM).

So what is structure when it comes to price risk management? It’s the use of principles and the configuration required to distill price risk from the confusion caused by a myriad of business activities. Its purpose is to provide a platform for the creation of effective offsets and a reporting process that yields explainable outcomes, which can be especially difficult for processors. In price risk management, decisions on structure are fundamental and can mean the difference between clarity and confusion.

As no two businesses are exactly the same, often program architecture deviates business to business. An early structural decision can be where it’s done, a “centralized vs local” decision. Over the years we’ve worked at both extremes, with configurations designed to match the size and nature of the business and the goals set out by management. In the local extreme, CPRM programs run at the individual operation level and meet the needs of companies with cultures that promote strongly independent operations. One rationale is that CPRM programs depend on dynamic communication with commercial, production and accounting functions. If these functions are themselves localized, then so should CPRM. Arguably however, this configuration comes with a high inefficiency cost as multiple systems and duplication of risk functions is required.

Other companies, through their quest for lower costs have centralized commercial and commercial accounting functions and have followed with centralized CPRM. This is especially good for businesses with larger market footprints and facing increasing challenges posed by credit and cash management. Developments from the regulatory and control worlds also lean toward this structure. This style of organization places higher demands on communication and systems however and this is serious. On more than one occasion we’ve seen anomalous events lead to unreported exposures, leaving unwelcome and unprofitable surprises in their wake. Depending on the complexity and irregularity of activities, risk management staff may still be required closer to ground at operations.

Virtually every commodity processing enterprise, whether it’s a smelter, a refiner or a fabricator is in fact a trading engine surrounding a manufacturing engine. How so? At the core commodities are converted from raw input to a next stage of utility – obviously the manufacturer part. But to allow this to happen – to generate the cash and margins necessary to operate the complicated equipment – there is a buyer and a seller simultaneously at work. Just like a trader they are working to capture value added margin through the activity at both ends. Also like a trader, price timing and quantity mismatches between the two may be involved, creating pricing exposures that require recognition and expertise to manage. The next level of structure is the alignment of the CPRM program to the measurement of the functions creating risk.

The underlying issue is simple. Why should the financial impact of early or late pricing by suppliers or customers, or deliberate mismatches in buy/sell timings be reflected in the financial results for production? Without separation, the resulting jumble renders the financial results useless for performance measurement of both manufacturer and trader and will lead management to draw wrong conclusions. A common way of accomplishing this separation is to have parallel risk reporting streams, with results converging at a centralized point. A good system can manage this easily. If done right, the value added derived from both activities will be transparent.

The final structural element is the isolation of the separate pricing risks themselves. Often the same commercial transaction may contain more than one embedded price risk. An obvious example is commodity price and currency – where a transaction involves a commodity price that is referenced in USD but quoted by/to a third party in another currency. Escalators and de-escalators in certain concentrate contracts offer another example. Situations where commodity inputs are bought on one price reference and sold on anther, for instance LME vs COMEX (e.g. copper), serve as a third example. All are slightly different and need unique management. Transaction by transaction these risks can be small, but when added up over the many deals in a reporting period, failure to segregate risks properly and act on them can easily mean the difference between a profit and a loss.

When considering the creation of a processor price risk management program, early stage decisions around creating the right structure rank highly. Just like a building’s architecture shaping the activities of people in it, structure in price risk management will shape a company’s ability and appetite to take risks. More than a few companies we’ve worked with have fought through years of trial and error to develop the right structures for their programs but you don’t have to. Experienced advice is available from the outset and will save you headaches and time.

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