Hedging is risky...Look before you leap
The increasing volatility of commodity pricing calls for a risk-management strategy if you're going to hedge.
By Tom Stundza -- Purchasing, 4/10/2008 2:00:00 AM
High and volatile energy and commodity prices generate uncertainty for buyers. One way for supply executives to manage future price risks is to hedge a portion of their energy and commodity purchases. The idea is to reduce the volatility of the future purchasing spend by betting that prices could be lower at some time ahead for such commodities as crude oil, electricity, natural gas, nonferrous and precious metals, plastics, basic chemicals, various agricultural commodity products and carbon dioxide, the chemical byproduct of ammonia and hydrogen plants.
Hedgers are buyers who are concerned that the costs of the traded commodity may change before they can buy the product in the cash market. The hedge allows the buyers, therefore, to lock in prices well in advance of those actual purchases. Thus, the buyers reduce the risk of unanticipated losses if there is price inflation in the future. And, according to the market mavens, prices of energy, metals and other commodities will remain elevated for some months even if the manufacturing economy stumbles. Global geopolitical, economic and trade issues will keep supplies tight and pricing volatile.
Corporate hedging strategies usually are based on futures, forwards, swaps and options—which are financial instruments known as derivatives. Several surveys of commodity buyers, however, consistently find the majority buying on the spot market or using fixed-supply contract arrangements with periodic price re-openers. Only a minority use hedging in the futures and options markets as a risk-management tool. A survey in 2007 by global consulting firm KPMG International finds only 38% of purchasing groups worldwide hedge their commodity and energy buys.
Bruce McLeish is a senior vice president of products and pricing at Constellation New Energy, the Baltimore-based supplier of electricity and natural gas to commercial, industrial and institutional customers throughout North America. The firm helps customers manage and control energy costs through hedges and other services. So, McLeish, a hedging proponent, has six keys for buyers willing to try a commodity hedging strategy as an insurance policy against future price risks. They are:
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Understand your consumption patterns and the impact to your business.
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Understand the broader factors that impact prices.
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Monitor the market all the time.
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Take a risk management approach as opposed to a market timing approach.
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Determine your risk appetite.
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Make some long-term purchases but not 100%.
So, to McLeish, all hedges must be preceded by the buyer understanding how the use of energy and other commodities impacts the company's overall business objectives. In a recent interview with Purchasing, he says buyers looking to hedge must ask several key questions: How does my company use energy and other commodities, and what is the impact on total corporate costs? What is cost of energy and other commodities as a percentage of the cost of our final product? As a percentage, how much of the total buy does the buying group need to hedge to smooth out raw materials' cost volatility? Can the firm pass along increases in costs onto the final market price of the final product?
McLeish suggests that the buyers look at all the underlying factors that impact marketplace costs of energy and other commodities. "Some of those things are going to be supply and demand issues, some are going to be global geopolitical issues," he says. Looking at energy, for example, he says that "obviously we all notice that when there's tension in the Middle East, prices of crude oil go up." For energy, weather is a big wild card: extreme temperature variations can boost or depress energy demand and storms and hurricanes can dramatically disrupt supplies.
For other commodities, wild cards include strikes, natural disasters, demand surges and excess production gluts. "Other supply and demand issues for manufacturing commodities are related to the strength of industrial economy," says McLeish, noting that energy and raw materials are key inputs of many industrial processes. "When manufacturing is robust, energy and materials use goes up," he says, adding that "when you have a recession, businesses curtail use of inputs and that tends to push down prices."
The risk-management guru says the commodity market needs to be monitored all the time because hedging isn't a stationary purchasing exercise. "Hedging isn't static so buying factors need to be reviewed," he says. "Monitor the market all the time and take a long-term view. You want to be hedging out (looking out) several years into the future." A mistake for many buying groups is that "they settle for six-month or one-year purchasing deals," he says. Why should buyers examine supply, demand and pricing in the market all the time? "Simply because, without constant vigilance, it's next to impossible to perfectly time the market," he says, discussing the so-called inflection points when market factors cause prices to move up or down.
Buyers who take a long-term view can take advantage of opportunities, and can see what trends are occurring. "Some people make one-year supply deals to meet the next calendar year's needs and don't focus on costs again until the following December," he says. "It's those people who wonder 'what happened?' a year later when they see their costs may have doubled."
Buyers should take a risk-management approach to hedging rather than a market-timing approach. "What we find with a lot of people, particularly the least-experienced buyers, is that they're always trying to buy or hedge their buy in such a way that the results are a certain amount of savings," he says.
The problem with that approach is that it sets a bogey that's changing constantly and the buying decision may be off kilter from the company's business planning cycle. A risk-management approach anticipates and manages risk for supply chain continuity and allows the hedged commodity to be purchased in such a way that it meets corporate business needs without overpaying if market supply tightens.
This can be difficult for most users, which is why the role of expert third-party suppliers can be crucial. Competitive suppliers often have the expertise necessary to monitor markets consistently and implement a hedging strategy that effectively meets budgetary requirements.
The hedging maven says that there are risk/reward tradeoffs when hedging commodities. So, it's important that buyers know the company's risk appetite. Some companies, for example, have little appetite for risk so they lock in all their energy, metals or other commodity at fixed prices under multiyear contracts. Other supply groups buy commodities based on indexes, spot availability, current-pricing schedules or even on some long-standing formulas. "These all are risky since some commodities are extremely volatile," says McLeish. "That's why if none of the buys are hedged, there can be a drastic impact on the buying firm's financial viability."
Buyers need to ask corporate purchasing and financial management exactly what are the company's hedging objectives. "Are they to achieve the lowest costs possible? Are they to have budget certainty? Does the corporation have risk policies in place that sets low (minimal amount) or high limits of volume or dollar amounts that can be hedged?"
Finally, when hedging, it's best that buyers take a long-term view on the transaction but not to fall into the trap of hedging the entire future buy all at once. Using energy as an example, he says that although there's a lot of volatility in energy markets in the short term, for example, the longer term tends to be driven more towards some sort of historical market norm. This also is true with nonferrous metals.
"Of course, the problem lately is that the expected future norm has continued to rise," he says, "but it has continued to be lower than the short-term average." When graphed, for example, there is less volatility on a three-year charting than on a three-month strip. "So, we don't recommend that buyers hedge out all of their needs all at once," he says, "because the idea is to have the flexibility to smooth out price volatility over time."
McLeish says that "volatility is great for traders but not for users." He says that if a buyer locks in all of its needs in a one-time hedge, the buyer is taking away some opportunities for lower prices. It is very difficult to predict where commodity prices are going. "In a nutshell, the advice is to make some long-term purchases but not 100% of your long-term purchases so you don't miss the opportunities for lower prices when they come along."
FOR MORE INFORMATION:Read How to think about hedging, from Hortencia Barton, manager of domestic supply in the purchasing operation of American Airlines on Purchasing.com
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