Is Your Commodity Related Business Having Trouble Explaining a Volatile P/L?

The volatility of commodity pricing can have a devastating financial effect on processing businesses which should themselves be risk pass-through operators. Buying and selling commodities with timing mismatches on prices causes unwitting commodity speculation and this can generate greater financial losses than processors can recover from their added-value manufacture. Additionally, many manufacturing processes combine separate commodity streams, with different processing cycles, some of which may even be left unhedged as a matter of policy. Even with a hedge program in place, if risk is not properly recognized, is inaccurately hedged, and incorrectly accounted for the processor’s monthly income statements can be confusing and unsuitable for use as a basis for measuring success. This makes for a complicated situation and without clear financial risk analysis and sophisticated financial controls the processor’s monthly P&L becomes pure fiction.

To address such situations a good start point is to build a model showing an accurate financial picture of the buying, holding and selling of payable commodity units by the processor, together with related hedge transactions, under both standard accounting rules and hedge accounting. To explain how much income statement volatility is derived from the commodities and how much from operating margins the model should analyze the historic financial flows of the commodity streams, and compare them to the standard historical financial statements. Looking at the monthly P&L as if it were unhedged, as it was actually hedged and as if a full offset hedge were in place will help the processor illustrate the magnitude of commodity risk created by its business flows and the effectiveness of its existing hedge programs.

The transparency such analysis will bring will ensure that the financial impact of commodity price risk is clearly visible and explainable in the public accounts and in management’s internal evaluations. The analysis may illustrate the extent to which commercial activity is generating risk, if there is risk in the system that is undefined or if there is a lack of communication and controls. In any case, with the sharper understanding of the extent of covered and uncovered risk the analysis brings, the processor can move forward to create or further refine its business hedging model.

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