The Ten Worst Mistakes You Can Make in the Management of Commodity Price Risk

Over the years we’ve seen a lot of different price risk management problems during the course of our travels. Needless to say, lack of experience is often the culprit. As it is always best to learn from the mistakes of others, we thought it could be interesting to summarize the worst ones we’ve seen:

• Thinking you can cover any problem by hedging. The biggest problems happen on the commercial pricing side and that is where they have to be solved. Making a business hedgeable is a lot more challenging than doing the hedging
• Paying too much attention to the financial results of the hedging account alone. It is the combined financial impact of supply pricing, sales pricing and hedging that matters. Big profits or big losses in the hedging account are not cause for alarm or jubilation on their own.
• Believing that hedging is like a perpetual motion machine for trouble free automatic risk avoidance. Like any other management program it requires discretionary judgment, skill, experience and collegial participation. Letting that funny little guy with the market screen just get on with it is a recipe for disaster. That is why we like to call the process risk management
• Asking an advisor for a hedge program as if it was a manual for operating a television. Risk swarms around a business in many different idiosyncratic ways and detailed analysis of your business’ particular risk profile and your shareholders’ risk appetite is a vital precursor to launching a program.
• Picking the wrong person from a banking or trading environment to run your hedging and then not supervising him properly. Training a trusted insider to master the skills is often better than bringing in someone who does not understand your business or ignores your motives. Risk management itself can be risky and the management team needs to trust the person who is executing the hedges.
• Skimping on controls is unwise. The principals of risk management are straightforward, but the details can be tricky and somewhat invisible. The financial flows involved in risk management can be large and the ways that money can trickle – or flood – out of the hedge system are legion. Having a good control system with visible reports for everyone in the management chain from top to bottom will always pay for itself.
• Hedging is not a way of avoiding market judgments. All risk management decisions involve a degree of market discretion and any company which faces commodity risk has to find a way to trace an optimal path through market choices. Commodity driven costs, revenues and assets like inventory need to be managed with skill and experience. Avoiding unnecessary speculation is best achieved by market knowledge not by shutting your eyes to volatile market factors.
• If you are involved in commodities as a manufacturer don’t ever say “We don’t speculate in commodities”. If you don’t have an active risk management program the statement is blatantly untrue and if you do have one the best thing to say is “We speculate as little as we can – and always with full knowledge and in a controlled way”
• If you are the boss don’t insist on making the timing and pricing decisions on discretionary hedge transactions. You have too many other things to do and you will miss the best market opportunities while you are in a meeting. Bosses are to set the rules and the limits and monitor the performance. Give the risk professional his parameters and leave him or her to pull the trigger.
• If you are starting out on the risk management journey, or wondering if you are doing it right, don’t go it alone. Get help from a risk professional.

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