In our previous blogs on strategic hedging we talked about the key goals of long term optimization of outcomes, through trade-offs, which brings out the value-for-money of options as risk management tools for end-consumers and producers, rather than the sheer precision of futures and forwards which is more prized by offset hedgers of pass-through commodity processing businesses. The choice of weapons in the options armory, an ongoing process of changing choices, is more complex than simple offsets, and harder to explain to colleagues and shareholders. We offer here a few guidelines for success – and survival – to those strategic hedge practitioners who are in the front lines of, in this example, an end-consumer of aluminium.

“Get your things and report to the mailroom!” In parts of the metals industry the mere mention of strategic hedging can have career limiting effects. Yet price risks that require a discretionary approach to hedging are so common and impactful. Almost every major class of metals business is shaken by the financial volatility they cause, whether it be producers with price risk on sales of future production, processors with risk on permanent inventory and sales of metal gains or consumers with risks on future raw material purchase prices. Yet for strategic hedging, the specter of legendary past disasters looms above like some radioactive miasma, prompting many managers to adopt the ostrich position. Ignored are the successes that exist and with enough frequency that they are no accident, particularly among consumers. Our ostriches could in fact be looking at disasters upside down. Far from portending certain doom, past calamities hold valuable lessons on must-avoid practices for good hedge process design.

There was a time, not so long ago, that metal producers saw textbook opportunities to lock in forward revenue with strategic sell hedge programs. And it was a good move, until China’s huge and unexpected expansion turned the hedges into disasters. Strategic hedging almost became extinct. Not so for consumers however, some of who laid on strategic buy hedge programs that have since served as role models for their industries. Since then, from both perspectives, lessons have been learned and mistakes have been avoided and that has lead to financial outcomes that have, in the most part, been optimized.

One man’s inventory is not another’s, but If metal price volatility has weaponized your inventory so that its value swings lay waste to your financial results, then it’s a problem you need to get a grip on. Many metal processing businesses face this exact issue but find that quantifying the price exposure it contains is trickier than assumed. Production people measure metal inventory by tangible presence, accountants deem it to be what’s under operational control but risk managers must know volumes based on pricing events (Stock-At-Risk SAR). Rarely if ever are the three equal either; in fact they can be significantly different. We’ve seen operations with enough physical and accounting inventories to make an asset manager cringe, but when it came to SAR, they were inventory negative. Strange but true, and the reverse is just as possible.

You know what they say are the three most important factors for successful property owning – well it is the same with hedging metal units in inventory, or, more correctly, Stock-At-Risk – not location but optimization. Transactional, Cash Flow Hedging should be relatively straightforward so that while the expression “Perfect Hedge” is not always practically possible, it is the right way to aim. Not so for hedging Stock-At-Risk. Neither automatic execution nor perfection is possible. The use of informed disciplined management judgement is the key ingredient and the goal is to be able to say after five years that the overall financial outcome has been significantly better than doing nothing.

Inventory hedging is the orphan of the commodity price risk management business. The source of more diametrically opposed opinions and different practices than any other topic, it makes us wonder where to begin. At the beginning, of course, but hold onto your hats it is a twisting and rather long ride! We will be following up with a second blog on the more nitty-gritty issues of, variable quotational periods, hedge roll-overs, use of discretion and accounting treatment, so watch this space.

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.