Price Risk Perceptions meet the Inconvenient Truth

“We’re a conservative company – we don’t have commodity price risk here.” Hmmm…something smells…sound the alarm! Every commodities based company has price risk in one form or another. The chain of buying and selling, especially when coupled with a conversion process in between, is complicated. Yet this is a common claim we hear when we talk with metal-based businesses. Put through Google Management Translate this assertion converts more specifically to “we don’t really know about our risk and we don’t track it”. So would these same managers happily leave uncertainty in their own personal exposures (mortgage, car loan, health insurance, etc.)?

The usual defense is that “purchases and sales are back to backed”. But without proper monitoring how can they really know? Time and time again we’ve seen variations in commercial terms, production and shipping patterns or even fiddles to the way ERP systems handle pricing, frustrate even the most deliberate attempts to reach back-to-back nirvana, and sometimes creating exposures that are truly non-trivial. And then there are exposures we sometimes encounter that are deliberate – where management is using big inventory to “catch a possible profit by positioning for the trend”. So what do you say there? The truth is that the presence of both unattended exposures is the same as off-track betting regardless of whether they are deliberately taken or deliberately ignored. And just like betting you lose as easily as you win. So how does permitting unmonitored exposures square with being conservative? It doesn’t. Casually subjecting an otherwise healthy business to the volatility of commodity prices without stated purpose or internal control should be cause for serious concern by management, the board and company auditors.

“But surely these aren’t risks to worry about. Our knowledge of our market will allow us to take protective action if we need to”. Unless you’re multinational with up-to-the-minute global intelligence, your knowledge of the market is likely a local one. You may indeed have a superior understanding of local premiums and discounts but what about the rest of the price that is dictated by world conditions? And if you’re thinking the latest world supply-demand balance is defense enough, think again. While excellent work is done to derive them, inputs are “ancient” history in market terms, and their forecasts are static. They can’t help you anticipate the market and the frequency of unanticipated events is certainly not decreasing. And not only is this true for metals priced via traditional exchanges but also for those in the ferrous and minor metals sectors, where a proliferation of emerging Asian exchanges has become the tail wagging the dog of many a widely used price index.

And then there’s “we can make a quick fix when the time is right”. Watch it – this is not so easily done. The past 10 years has seen a big evolution of the business of making prices. The advancement of trading platform technology has meant trading is now 24/7, unconstrained by either the London or New York days. During this time there has been a 1300% increase in non-precious metals derivatives trading and a big driver has been investors who are diversifying. The recent growth in their trading volumes is increasingly directed to the short term. These trades arbitrage differences between geographies and times while pricing in the impact of both fundamental and economic events. And the speed at which they do it leaves even hardened professionals, manning telephones and instant messaging, in the dust. By using trend-monitoring programs, they make market-moving nanosecond adjustments that anticipate the next price level and ever move prices away from the last “screen print”. So more swiftly than ever before that unanticipated supply loss from the pit wall collapse in Africa, that demand impact from a surprise devaluation in the Yuan and the collateral effect on trader sentiment of that sudden plunge in the price of Brent crude are incorporated into the price metal (and by default the mark to market of your exposure). A coffee break at the wrong time and you’ve missed it.

What does this mean? Simply put, typical metal-based businesses with a slapdash approach to managing price risk stand little chance of making last-minute market-neutralizing corrections for significant price exposures. Does the fix then mean your business must “cease all risk-taking” by adopting scorched earth nuclear back-to-back buying and selling in whatever form? ABSOLUTELY NOT – many of the best risk-managed companies take exposures daily. But to do this they have laid the foundation of a strong management framework, solid control, clear visibility and meaningful measures. And rather than shoot darts in the dark, they have learned what bite-sized quantities of risk they can live with and how to take advantage of it in a structured, controlled and continuous way. If you’re thinking this sounds too good to be true, we’re here to tell you it’s not and if you want to know how you can get there you know who to call.

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