How Do You Handle The Price Risks You Can’t Hedge?
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”.
Risk mismatches fall into two categories, quantity slippage (cancellations, under/over-shipments, returns, estimates vs actuals) and price slippage (look-back options, imperfect correlations, separate hedging medium for purchase and sale). This blog will leave quantity slippage for a future date so we can focus here on price problems.
- With exchange-indexed product sale prices, the losses from look-back options or incorrect metal prices given to customers and suppliers are the responsibility of commercial people, sometimes through lack of understanding, sometimes deliberately to enhance volumes or apparent manufacturing margins. The answer here is to have a deal accounting P&L which charges the commercial margin on each deal with the price actually hedged. This will incentivize increased understanding and pricing diligence. Equally, sales or purchasing people who are able to price an indexed priced product advantageously vis a vis the commodity market should be rewarded by having the benefits of the hedge price posted to their margin evaluation P&L.
- Imperfect price correlation is trickier. In some cases there is a “basis range” between commercial and futures prices, quantifiable over time, for both products and raw materials. Trading in scrap is the typical example. Commercial executives should be directed and incentivized to maximize the “basis” by executing commercial transactions during opportunities when the basis diverges advantageously – buying raw materials when surging exchange prices outpace the raw material price and selling product when exchange prices collapse faster than product prices. This policy places trigger-pulling responsibility in the hands of the commercial departments, but to be effective, it requires the skills, market knowledge and accounting visibility that only the hedge desk can provide. Close co-operation and internal P&L sharing between commercial and risk management is the appropriate incentive to optimize performance.
- Not all imperfect correlations lend themselves to basis trading. This is particularly true when risk is not simply “pass-through” but risk management for purchases, inventory and sales is managed separately and risk positions are defined by policy and evaluated against market prices. Hedge instruments with more perfect correlations may be less liquid than those with lower correlations. Divergent correlations make classic offset hedging “ineffective” in hedge accounting terms. One logical approach to resolving this is the following: quantified financial risk = volume x price so classic offset hedging should only take care of volume x price reduced by the correlation factor (eg 80%). The hedge desk hedges this reduced tonnage using classic offset techniques, and the risk manager hedges the balance (20%) using market discretion and closely monitored risk position parameters. His performance should be evaluated through a combined P&L from commercial and hedge transactions, marked to their respective markets.
- Sometimes raw materials are indexed to one market and product to another. The “crack spread” between crude oil and refined products faced by refiners, and the “crush spread” of soybean/oil/meal processors are the traditional examples, but steel scrap/rebar, iron ore/billet and LME/COMEX copper spreads are similar examples faced by metal manufacturers. Exchange arbitrage, a variant of basis trading, is the discretionary trading technique used to bridge the offset hedging transactions in these cases.
- Occasionally real life makes hedging appear unnecessary. There are natural hedges in a company’s business which offset risk in purchases and sales without you having to execute a financial hedge. Beware however that too simplistic a view of the “natural hedge” can let massive amounts of real risk sneak in around the edges. Make sure you analyze, verify and monitor the details of the natural offset and plug the inevitable leaks with financial hedges where necessary.
In all the above instances, real life brings risk and rewards which do not automatically zero out as classic offset hedge theory advocates. Decisions about correlations, optimal hedging techniques and alternative hedging instruments – futures, forwards, OTCs, swaps, options – need to be made, executed and monitored. Effective risk management in this area requires understanding, policy, organization, market discretion, inter-departmental co-ordination, limits, targets and compliance/evaluation systems if it is to do the job. None of this is simple for manufacturing companies and it doesn’t happen on its own. You would be foolish to embark on it without professional help. You would be even more foolish to ignore it. Be aware that the cost of the unmanaged risk is always many times bigger than the cost of managing it – even if that management is not quite as simple as you would like!