“ We Have a Natural Internal Hedge” - A Cautionary Tale From Stainless Steel

This is an observation we often hear. People who make it believe it to be true but things are not always as they seem. What follows is a description of commodity price exposure in the stainless steel industry and the pitfalls of complacency – which could just as easily apply to your business, with the names changed.

The stainless steel industry realized long ago that, in risk terms, it was basically a nickel trading industry with steel-making overtones. On top of that, nickel is one of the most volatile commodities known to man. To avoid disaster, the industry had to deal with that volatility and so it came up with what it called the “nickel surcharge”. If nickel prices go up (or down) the price list of a company’s many stainless steel products is automatically adjusted to nickel cost by an indexing formula. Later on the industry added indices for other alloy metals – et voila, back-to-back pricing with no metal price risk.

However, it did not work out quite so neatly. As with any Price Risk Management Program, the devil is in the details:

• The price of stainless steel product sales is related to nickel supply prices from several months prior – i.e. known prices – which gives stainless consumers extensive look-back options. When prices fall, customers defer their purchases to take advantage of lower prices later, and in rising markets they double their volumes to benefit from backdated bargains. The financial impact of this on the producer is always adverse
• Purchasing decisions for nickel intake by stainless mills are based on production needs whereas stainless sales are driven by market demand. The volume of purchases and sales is not related, even without look-back options. Cash flow exposure between sales and purchases is created by volume mismatches, and, under volatile prices, unpredictable and unmanaged losses (or gains) for the mills can be enormous
• Producers’ accounting records relate to nickel raw materials and a long list of stainless steel products with different alloy metal contents so the nickel value content is very hard to track and, consequently, the actual financial exposure to nickel price volatility is mostly invisible, until it shows up in the quarterly financial results three months later – too late to do anything about it.
• Accounting treatment of inventories is that a charge to income is made when market values drop below cost, but no gain is recorded when prices rise, until the gain flows through the cost-of-goods-sold cycle. This creates timing mismatches that compound the impact of nickel price volatility on monthly EBITDA making it almost meaningless as a measure of management effectiveness.

What is the answer? There is nothing wrong with indexing sales to raw material costs. In the long run it is beneficial. In the medium term however it is not enough on its own to smooth out unacceptable income volatility. The key steps to success are, firstly a detailed understanding of the mechanism of your financial exposure to nickel price fluctuations, and secondly, getting visibility of its financial impact within your business. With that in hand there are many tools to manage the exposure, including but not limited to financial hedging.

The lesson for all commodity processors is that a detailed understanding how commodity price exposure happens within the business must come first. How to manage it then becomes more obvious.

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