Control Considerations for Price Risk Management

Corporate calamities, whether in operations or administration, can make striking headlines. A perverse interest in public scandal and the natural appetite for internal rivalry means mishaps get a great deal of attention and cause serious embarrassment for the business, or the executives involved. “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.

Many aspects of a successful business rely on good internal control and Commodities Price Risk Management is one of them, especially as it so dependent on tight business wide co-ordination. We’ve said before that without coordinated and controlled oversight, a discrepancy unchecked in one department often leads to an expensive loss in another leaving those responsible for explanations with no answers. 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.

Knowing Your Risks: Knowing the commodity price risk faced by your commodity business is the first place control starts. On the surface the definition may seem straightforward but you should ask around. They say ask four experts and you will get five answers and in the same vein, you too will likely find different departments will have more definitions of price risk than you think, depending on their own perceptions. Not all will be right however so to ensure a focused operation it is important that the ones that are should be widely agreed and understood. That common definition will be needed in order to build the model that translates business flow into one reflecting true pricing flow and calculates risk. Timing and accuracy of inputs and appropriate action are other essential elements of control here. The lack of any of these factors will render the model unusable as a measure of performance.

Interrelationships between price risks and other business risks must be accounted for too. Price risk models tend to assume a steady state but the bigger picture can sometimes creep in and blindside the unwary. Such risks include:

• Credit risk that will influence your ability to price out business as planned
• Production risks that can force changes to shipping and inventory projections
• Liquidity risk that can disrupt execution of physical or derivative transactions
• Cash flow risks imposed by volatile markets that may impact margins and hedge allowances

Having contingencies for unexpected events listed above mapped out can help avoid knee-jerk decisions and improve control.

Oversight: Control requires management oversight from boardroom to basement. As we’ve said in other blogs, good supervision for commodity businesses needs solid comprehension of price risks by senior management and the board. Without it, how they can design policy, set constructive targets and limits and lead the creation of an effective risk culture? Senior managers generally have more than their fair share of priorities however so supervision of ongoing price risk complexity is often assigned to the Risk Committee. Aside from including the Risk Manager, its composition should include decision makers from other departments such as finance and accounting, credit, commercial and even production. It should also report to “C suite” management and report prior to executive committee meetings. It will discuss and approve day-to-day risk problems, opportunities and strategy, and for large issues will issue recommendations to the EXCO. It can also assist in determining meaningful limits, as it is a valuable forum to explore how activities of the commercial activity and the risk desk interrelate. Finally, the cross pollination it provides creates an alignment the will reduce internal squabbling when market circumstances require fast action. If your risk committee is just being implemented consider including an experienced independent advisor to provide perspective on roles and decisions and to tease out and address pre-existing sacred cows that may prevent effective operation over the long run.

Managing Actively: Our blogs often speak of the big picture demanded by commodity price risk management. Control however demands a grasp of the many small functions that make risk programs work. Required controls are not limited to the risk desk – they must extend to production, who have to do the double checks to ensure inventories and throughputs are reported accurately, to sales and purchasing, with limits placed on exotic pricing terms, and even to logistics who must promptly report shipping movements that activate pricing triggers or occasional inventories left at the port. Like an ant colony, business success relies on the coordinated and repeated actions of many people. In business however a lack of thoughtful procedure and system design and having to firefight other priorities invites a breakdown of control activities potentially laying the organization open to unwanted exposures.

Other critical control elements are segregation of duties, double checks and sign offs and good availability and flow of operational data. A good system goes a long way to make these happen. It can ensure segregation of conflicting administrative duties. With proper connections it can facilitate information flow between commercial and risk departments so that pricing offsets are not missed. System generated control reports give line and middle management assurance that control tasks have been performed and that control metrics are falling within allowed tolerance. Finally it can help ensure that results are making it upward, past filters that middle management may want to impose, ensuring situational awareness by senior management. A proper system ensures control far beyond that an Excel environment and it’s hardly surprising that auditors complain when it’s lacking.

Observing and Correcting: When we read about control for business it’s usually the prevention of major fraud that gets top billing. Fighting fraud is the “sexy” side of control but the reality is that the payback for time and money invested in control will come from the prevention of consequences derived from commonplace error – many thousands of small frequent slips can more than equal one big but rare one. Even the best-designed processes have errors creep in and sometimes in ways that seem amazingly creative. The existence of an Exception Reporting system, that recognizes the problem, lays out the root causes underlying it (frequently there are more than one) and follows up on corrective actions taken, is essential. The risk committee and senior management should review results. Corrections and preventative actions may be required in more than one department. In the absence of an internal audit function, the risk committee can follow up with the assessment of corrective actions taken.

As a parting shot, in our experience with price risk management programs, not every business is equal in managing control issues and the differentiator is company culture. The best cultures treat issues that arise as opportunities to improve and encourage staff to report and help correct them. The worst look for fault and publicly castigate employees for errors. By doing so, they risk turning small matters into nightmare monsters in the closet. Witch-hunts and employee humiliation are a sure-fire way to drive errors underground and amplify simple error into fraud.

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