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Hedging Inventory Part Three – How Much Risk do you Really Have?

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.

Why is it important to know SAR? Well, just as you don’t want to pay for metal you never receive, if you have a pile of metal that you need to hedge, you don’t want to hedge the parts that aren’t exposed to price volatility – that’s not hedging. The model behind calculating SAR is simple enough. It starts with physical inventory at a point in time, generally a month end, and then adds “priced-in” material physically not present and subtracts “priced-out” material that is physically present, adjusted for “payability” (if that’s a factor in your industry). In an ideal world you should then have a start point to begin your risk mitigation from, and for simple operations that is possible. But…the devil is always in the details. For the majority of processing operations that face material heterogeneity, bulk handling, comingling, material transformation, processing losses and partial input payment (i.e. payability), it is only the first in a chain of steps.

Once you’ve constructed your first SAR, the next step is to do it all over again – if you did it the first time for end-May, do it again for end-June. Then see if the difference aligns with the ins and outs between the two periods as calculated by your commercial numbers, adjusted for time of pricing, (something your commercial systems will need to be able to produce both for past and future periods). It probably won’t – and you’ll see this more clearly with the more periods you analyze. What’s exposed are two sets of issues:

  • Poor tracking. It is not unusual that materials outside the plant are missed by physical systems as they monitor materials that have hit accounting triggers. Inbound raw materials stuck at portside, offsite recycle materials and finished goods are common omissions.
  • Estimation. Most early calculations contain a smorgasbord of unfinalized volumes and assays, estimates of in-process materials, poor tracking of plant efficiency and commercial purchase and sales projections that have not been updated.

Each difference tells a story of misrecording and misreporting in your system, and necessitates working through the number trail to find root causes that have been absorbed by your calculations. Each business will have its own permutations. For this a good metals accountant with access to the operation, aided by some expert guidance, is your best weapon.

“Getting to right” can be a tedious iterative exercise of find, fix and educate, but as with many things worth doing, without some pain there is no gain. And once enough problems have been addressed and numbers have stabilized, continuing this calculation at period ends is still a must. Operational processes are fluid things and we’ve seen first hand the results of this oversight. Over time enough subterranean change materializes that causes hedge activity to uncouple from physical reality, with real financial consequences.

Beyond obtaining a SAR number to anchor your hedging to, there are other solid reasons why this undertaking is beneficial.

  • If you’re serious about managing price risk on inventory this exercise will not only tell you how big SAR is but where it is, and why it is there, plus fortify your reporting stream – all important for operational control and better decisions.
  • If the intent is to hedge risk on seasonal inventories only (as discussed in Part One), to avoid long term hedging costs, the permanent stock number that is used must be proven. And if hedge accounting is a goal, you can’t define the program as being one designed to “hedge approximations of cyclical exposure”, you will likely need whole business cycles of proof to satisfy the auditor.
  • A better process behind your risk numbers also means you can add value with them. By projecting your SAR exposures from today’s level using your commercial numbers, and combining them with an understanding of forward spreads and disciplined trading, you can lock in gains from the widest contangos or limit damage from anticipated backwardations. A similar methodology can be employed for arbitrage exposures that result from differing pricing bases incorporated by your purchase and sales prices.

If you’re a metal processor, the combination of metal price volatility and at-risk inventory does your shareholders no favour. Financial statements don’t reflect operational performance, and if investors want the value swings they can buy their own metal to achieve the same effect. For operations serious about controlling the risk, an analysis of Stock-At-Risk is a must and generally entails real work, but the greater understanding and control that results from that the journey will pay dividends for the life of your operation.

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