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Commodity Risk Management Techniques & Hedge

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9/4/2018

COMMODITY RISK MANAGEMENT
TECHNIQUES & HEDGE ACCOUNTING
CHANGES

September 5, 2018

To Receive CPE Credit

•

Individuals

..

Participate in entire webinar

Answer polls when they are provided

•

Groups

.

Group leader is the person who registered & logged on to the webinar

....

Answer polls when they are provided

Complete group attendance form Group leader sign bottom of form Submit group attendance form to [email protected] within 24 hours of webinar

•

If all eligibility requirements are met, each participant will be emailed their CPE certificate within 15 business days of webinar

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9/4/2018

Bryan Wright

Partner | BKD Indianapolis I 317.383.5471

Allen Douglass

Regional Director | INTL FCStone Financial, Inc. FCM Division Indianapolis l 317.732.4660

Disclaimer

The trading of derivatives such as futures, options, and over-the-counter (OTC) products or “swaps” may not be suitable for all investors. Derivatives trading involves substantial risk of loss, and you should fully understand those risks prior to trading. Past financial results are not necessarily indicative of future performance. All references to futures and options on futures trading are made solely on behalf of the FCM Division of INTL FCStone Financial Inc., a member of the National Futures Association (“NFA”) and registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a futures commission merchant. All references to and discussion of OTC products or swaps are made solely on behalf of INTL FCStone Markets, LLC (“IFM”), a member of the NFA and provisionally registered with the CFTC as a swap dealer. IFM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of IFM.

This material should be construed as the solicitation of trading strategies and/or services provided by the FCM Division of INTL FCStone Financial Inc., or IFM, as noted in this presentation.

Neither the FCM Division of INTL FCStone Financial Inc. nor IFM is responsible for any redistribution of this material by third parties or any trading decisions taken by persons not intended to view this material. Information contained herein was obtained from sources believed to be reliable, but is not guaranteed. These materials represent the opinions and viewpoints of the author, and do not necessarily reflect the opinions or viewpoints of the FCM Division of INTL FCStone Financial Inc. or IFM.

All forecasting statements made within this material represent the opinions of the author unless otherwise noted. Factual

information believed to reliable, was used to formulate these statements of opinion; but we cannot guarantee the accuracy and completeness of the information being relied upon. Accordingly, these statements do not necessarily reflect the viewpoints employed by the FCM Division of INTL FCStone Financial Inc. or IFM. All forecasts of market conditions are inherently subjective and speculative, and actual results and subsequent forecasts may vary significantly from these forecasts. No assurance or guarantee is made that these forecasts will be achieved. Any examples given are provided for illustrative purposes only, and no representation is being made that any person will or is likely to achieve profits or losses similar to those examples.

Reproduction or use in any format without authorization is forbidden. © Copyright 2018. All rights reserved.

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9/4/2018

Risk is ever present… How do we choose to address?

Accept it

  • Don’t Fear it
  • Manage it

Conquer it

If you don’t manage risk, you are assuming risk If you are assuming risk, you are speculating!!!

Normal Business Risks

Buildings
&

Facilities

Equipment, Machinery, Trucks

Family & Employees

Insurance

Health & Safety

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9/4/2018

Another Critical Business Risk:

PRICE!!!

Grains

Oilseeds

More Likely
& More Frequent!

Livestock

Know Your Price Risk & Manage It!

Energy

Interest Rates & FX

HOWEVER,

WITHOUT PRICE RISK MANAGEMENT…

Things can get Real UGLY Real fast!
And Bottom Lines & Margins Can Melt Away!

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9/4/2018

Is Price Risk Management Difficult?

NO! Just remember,

complex concepts stated simply

creates opportunity!
Success favors the Prepared.

Tools to Manage Price Risk

Rights to Buy or Sell at Price Levels with Opportunity to Improve
Locked-in Buying & Selling
Price Levels

Variety of Contracts With Physical Delivery Requirements
Creative Financial Products With Pricing Flexibility

*

*OTC products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of IFM.

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9/4/2018

What is Market Risk?

Uncertainty!

Types of Market Risk

  • Local Cash Basis
  • Global Futures Price

Higher
Stronger

No change
Lower
No change
Weaker

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9/4/2018

What is a BUYER’S Market Risks?

Buyer’s Cash Basis

Global Benchmark Futures Price

  • Higher
  • Stronger

What is a SELLER’S Market Risks?

  • Global Benchmark Futures Price
  • Seller’s Cash Basis

  • Weaker
  • Lower

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Price Volatility

Source: CME Group

What is Volatility?

Example: March 2019 Corn Futures at $4.00

Compare Market Volatility: 10%, 20%, 30%

  • Annualized Volatility
  • 68% Probability Price Range

10% 20% 30%
$3.60 - $4.40 $3.20 - $4.80 $2.80 - $5.20

At what volatility level is your risk the greatest?
At what volatility level is your opportunity the greatest?

Note: 2 Standard Deviations is 95% probability and 3 Standard Deviations = 99% probability

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9/4/2018

Price Risk Management – Summary

Price Risk Management

Remember what I said earlier ???

Stated Simply

Creates
OPPORTUNITY

Basis & Hedging Theory

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9/4/2018

Basis

Key to Successful Hedging

Local Supplier or Buyer Price quote
Global Benchmark Price quote
Local Cash Relative to Futures

Cash Price
Futures Price

Basis

Q. If you have more than one “cash” quote, how many basis tables are needed?
A. Each cash market supplier represents a different basis.

Basis Concepts

Merchandisers
& Their Customers should become Students of Basis!

Cash minus Futures

Locational & Quality
Seasonal & Historical Trends
Differences

BASIS

Buyers want
Sellers want

Weaker

Stronger
Less Volatile

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9/4/2018

Basis Movement & Opportunity

+30 +20 +10
0

Strengthen

Cash Gains Relative* to Futures
More positive or

Weaken

Cash Declines Relative* to Futures
Less positive or
Less negative
More negative
Benefits Short Hedgers
Benefits Long Hedgers

-10 -20 -30

Commodity Buyers
Commodity Sellers

*Basis can strengthen or weaken regardless of the price direction

Use of Basis in Risk Management

Gulf Export Price - Nearby Corn Futures Basis (Sample 10 year period)

  • Maximum
  • Minimum
  • Average

160 140 120 100
80 60 40 20
0

Week of the Year

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9/4/2018

Basis Summary

••

••••••

Cash price relative to a Futures price

Usually less volatile than Futures

Seasonal & Historical trends

Purchasing & Sales Tool

Can have a negative or positive value

Buyers want basis to weaken over time

Sellers want basis to strengthen over time

Key to successful Price Risk Management

True Hedge – Consists of Two Parts

Futures, Options or OTC Swaps

Local
Cash Market

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Hedge Concepts

Fact:

 Most cash markets and futures markets move up and down together  Not necessarily in equal amounts  Relationship between a cash & a futures price: Correlation

Hedge Positions

 Opposite positions in Cash market and Futures market

Hedge Results

 Loss in one market is offset by a gain in the other market  Regardless of price direction, the result is the same!

The “TRUE” hedge result is the combined results of the cash and futures positions

HEDGED RESULTS

Loss in One Market is Offset by a Gain in the Other

Cash Market

Futures Market

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9/4/2018

Types of Hedgers

• Long hedger • Risk of rising prices • Attempt to achieve target prices • Short the basis – wants basis to weaken

Consumer

(buy-side)
• Short hedger

Producer

(sell-side)
• Risk of falling prices • Attempt to cover production costs & profit • Long the basis – wants basis to strengthen

Futures Industry Foundation

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9/4/2018

Futures Contract: Defined

Corn
5,000 bu. =
127 m.t.

Legally binding agreement to accept delivery of or make delivery of a

Wheat
5,000 bu. =
136 m.t.

quantity

standardized _______ and ______

quality

Soybeans: 5,000 bu. =
136 m.t.

place

of a commodity to a standardized _____

time

price

during a standardized ____ period for a ____

Soybean Meal
100 short tons =
92 m.t.

discovered in an organized futures exchange.

Economic Functions of Futures

Price
Discovery

Which impacts the greatest number of people?

Price Reference & Cash Contracts

Futures Markets

Which is the most important economic function?

Risk
Management

For Customers

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9/4/2018

Price Discovery:

Supply & Demand

• Prices are Discovered

• Prices are NOT set by the Exchange

• Closest form of “perfect competition”

• Two-way Price Impact

• Transparent Prices

Types of Traders

Merchandisers
& Their Customers

Cash Market

Speculator

Cash Market

Hedger

  • Risk
  • Liquidity

  • Risk
  • Liquidity

Speculators provide what hedgers need!

LIQUIDITY

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9/4/2018

Speculators’ Impact on Hedgers

Corn Market Liquidity

3.80

3.85
Seller’s Offer

Hedgers Only

Buyer’s Bid

3.81 New Bid

3.84
Better Offer

Speculator

3.82 New Bid

3.83
Better Offer

Speculators

3.82 1/4 Best Bid

3.82 1/2 Best Offer

S

Closing-out a Futures Position

Offset

Offset: Taking a position opposite to your initial position
• Initial futures position creates market obligation
• Offset removes market obligation

Initial Position Long Futures
Sell Identical
Futures

later

OFFSET

Or

Initial Position Short Futures
Buy Identical
Futures
OFFSET

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9/4/2018

Closing-out a Futures Position

Delivery

Transfer of a physical commodity or cash-settlement

•

Only about 1% of Futures volume ends with delivery

•

Great majority are “offset”

•

Initiated “only” by the Seller (short)

•

Short must have approved “regular for delivery” status Assigned to “oldest” long

•

•

Specific Terms & Procedures

•

Varies by commodity – shipping certificates, warehouse receipts

•

See Exchange Rule Book for details

••

Cash Price & Futures Price Convergence

•

Due to threat of delivery in futures contract

Not economically or physically feasible for the Buyer (long)

•

Seller makes delivery decisions: specific date, quality, location

CBOT Grain & Oilseed Futures Delivery

3-Day Process*

First Delivery Day

•

•

•

•

First business day of the contract month

First Notice Day

Short delivers the shipping

certificate to the long

••

•

Last business day of calendar month prior to delivery month. Example: June for July contract.

First Position Day

Long makes payment to the short

by 1:00 p.m.

•

Business day prior to last business

CME Clearing notifies “oldest

long” by 7:00 a.m. that delivery will take place day of calendar month prior to delivery month. Example: November for December contract
If delivery day is a bank holiday, payment is made by 9:30 a.m. on the next banking day.

Short invoices the long by 4:00

•

Short positions: First day that

short positions can initiate the delivery process by notifying CME Clearing. Only shorts that have “regular for delivery” status p.m.

*Note: This 3-day process for first delivery also applies to deliveries up to and including the last delivery day. The last delivery day is the 16th of the contract month

•

•

Long positions: Ranked according

to the amount of time they have been long. Oldest is ranked first

Daily price limits are removed for remainder of trading of the delivery contract month

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9/4/2018

Financial Integrity of Futures

Clearing Models

Bilateral versus Cleared

CLEARED TRADE:

A trade guaranteed by Futures Commission Merchants (FCM) who are members of a clearing house

BI-LATERAL TRADE:

A trade executed between two parties without the benefit of a central clearing house.

Source: CME Group

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9/4/2018

Exchange Clearing Services

• Eliminates Counter Party Risk

 Buyer to every Seller and Seller to every Buyer

• Adjust Trading Accounts Daily

 Marked to Market

• Facilitates Trading Processes

 Futures Delivery  Option Exercise

Central Counterparty Clearing

Source: CME Group

20

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  • Risk Management Strategies for Commodity Processors

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  • Deriving the Economic Impact of Derivatives

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