Hedging Inventory Part Two – Optimization, Optimization, Optimization
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.
What is this Stock-At-Risk (SAR) expression? Inventory is an accounting definition and it is not precise enough from a risk viewpoint. Priced, in-transit raw materials are included in SAR, as are unpriced unsold consignment stocks and unpriced sales products in transit to customers under a provisional invoice price. All are still “at risk” to the hedger. Material already priced out to a customer is excluded wherever it sits – it is no longer “at risk”, pricewise. Some of these items are partially covered by transactional hedges but the two hedging books are best kept separate. Furthermore, items in inventory, Raw Materials, In-Process and Finished Goods, must be identified in terms of units of payable metal, often a tricky task. More about the requirements for precise identification of metal units, and how to deal with forecast pricing and variable Quotational Periods in Part Three.
Once you have identified SAR, what do you do about it? Firstly, is it temporary or permanent? If it results from a surge in purchases, a decline in sales, or a production interruption which will later be rectified, you run the risk of buying high and selling low, a cash-flow risk, which should be covered by a Cash Flow Hedge, settled out in cash when the surge is over. If it is permanent, there are no cash flow issues until you sell the business – just issues with your auditor who may force you to write down the value of metal units in inventory or in-transit to lower-of-cost-or-market, and take a hit to your P&L.
Some, mostly private companies, don’t care about accountants’ valuations that come and go, but if you have a large public shareholder base that doesn’t understand valuation issues, which, in volatile commodities can be big and nasty, you can still offset the SAR valuation with a SAR short hedge position, and use Hedge Accounting. One side is valued as an unrealized loss, and the other as an unrealized gain, and, since both are valued at the LME or COMEX price, Hedge Accounting will give you overall net financial neutrality – problem solved.
Yes, but other problems are just beginning. SAR is an asset and the hedge is a transaction. The hedge must be settled and rolled forward, which implies a series of cash flow events at current market prices unrelated to the cash cost of the inventory. In rising market trends, rollover settlement payments to brokers can cause a serious drain on working capital, and in backwardation markets the economic cost of the rollovers can be crippling. Here is where the need for a goal of long-term optimization, and a technique involving disciplined management discretion, become paramount.
Commodity markets tend to ebb and flow whereas permanent SAR is, well, permanent. If you know you are going to be executing SAR hedge rollovers for the next year you can plan them in advance when forward prices are low, or spreads are in contango. This works well in a market like aluminium where contangos and mean-reversion price trends are the norm. Less-well in markets like copper and nickel where backwardations are endemic. In this type of more difficult market, SAR hedgers can take a put option based approach aimed at fixing a specific SAR exposure over a limited high risk period, and accepting the backwardation and premium cost as better than doing nothing. If the expected risk occurs the insurance policy is cashed in, and if it doesn’t, you enjoy the higher asset values less the cost of the insurance.
It is also true that commodities have price cycles, though not by any means predictable in length or magnitude. An SAR hedger can make an evaluation of where the cycle will be, over the next year, and carry a hedge position, either in rolled-over futures or options, which is a small percent of the SAR exposure while prices are low and bigger when they rise. If his target is to optimize the year-end P&L the hedger can carry out a self-contained one-year program every year, and only have losing hedge valuations if the market has a consistent trend, blowing out his forecast range and peaking at year-end. There is a good chance that this kind of market will only occur once in a five-year period. In the other four years his outcomes should be beneficial, and the goal of long-term optimization will be met.
So, you can see that this is not mechanical hedging. It is also not wild speculation. It is a long-term management approach, authorized and planned at the highest levels, and executed under a well-structured set of controls which emphasize discipline but permit some market discretion to the hedge manager. Serious market forecasting which uses both in-house and external resources, risk analysis, comparative financial modeling of different hedging strategies and instruments, and reporting visibility, as well as expert outside advice, all play a role in successfully optimizing long term financial outcomes.Not so daunting after all – just standard management techniques. Permanent Link