Commodity Price Risk Management A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Contents 1. Introduction 04 2. Commodity Price Risk – An Overview 10 3. How do Corporates Address Commodity Price Risk? 16 4. What is Commodity Price Risk Hedging? 20 5. Methodology of Hedging Commodity Price Risk 24 6. Using Futures and Options to Hedge Commodity Price Risk 30 7. Benefits of Hedging Commodity Price Risk 34 8. Understanding Hedge Accounting 36 03 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates 1. Introduction Figure 1: A typical risk universe of a corporate as part of the enterprise risk management framework Strategic Operations Compliance Financial Emergence of Risk Management and instruments to manage or ‘hedge’ against • Board Performance / • Marketing and Advertising • Management Fraud • Interest Rate Changes Corporate Treasury insurable or uninsurable risks began Tone at the Top • Research and Development • Contract • Foreign Exchange The origins of risk management pre-dates to be used – and went on to be widely • Shareholder Expectations Fluctuations the 1700s with the use of probability used from the 1980s. The wide-spread • Customer/ Support • Ethics theory to solve puzzles and its use was use of derivatives naturally lead to • Third-Party Relationships Management • Liability • Commodity Price Fluctuations largely limited for theoretical purposes the formation of various international • Strategic Planning • Procurement and Inventory • Trade Regulations – however, during World War II risk regulations of using derivatives with • Cash Visibility & • Annual Budgeting & • Transportation and • Customs Regulations management began to be studied and financial institutions developing Forecasting Logistics Forecasting Capabilities • Tax Compliance and Audit implemented for various purposes. internal risk management models and • Cash Movement – • Alliances and • Recruiting and Retention Management Traditionally, risk management in the capital calculation measures to protect Domestic & Cross-Border Partnerships • IT Security/ Access market place was always associated themselves from unanticipated risks and • Accounting, Reporting and • Competition • Funding Abilities with the use of insurance to protect reduce regulatory capital. • Natural Events Disclosure • Liquidity Concentration institutions and individuals from bearing • Macro-Economic Factors • Geopolitical Events losses associated with accidents. • Working Capital At the same time, in the corporate • Socio – Political Events • Property, Plant and Management space as well, the governance of risk • Employee Equipment However, from the 1950s, there were management became essential with • Insurance Communication • Scalability other forms of risk management that the emergence of the enterprise risk • Growth • Debt Management emerged as alternatives to insurance management framework – a framework • Management Information • Equity – especially when insurance coverage that helps identify the various risks • Innovation Systems became costly and did not cover the risk affecting the institution (see figure 1) • Control Environment exposure expected by the institutions. across its business and operations and • Environment / Health and Modern risk management practices measures and plans to address, mitigate Safety began to emerge around 1955 and in and monitor its impact on the institution • Intellectual Property / the 1970s, the use of derivatives as Trademarks 04 05 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates At many of the enterprise risk Figure 2: An illustration of the typical roles of the treasury department of a corporate – Budget-to-actual variance – which • Commodity price fluctuations that The objective of the financial supply chain management meetings, financial risk may especially have a significant may affect the price of the commodity management function of a corporate management became an important impact on the profitability of an entity procured, maintained as inventory (raw treasury is to “ensure adequate discussion point at the Board of Directors that is either significantly dependent material or finished goods) or sold to liquidity” to the underlying business and senior management level due Interest rate risk on purchasing from overseas overseas parties or even on domestic functions either through cash or through to the emergence of additional risks management suppliers or selling goods to transactions – where the reference the utilization of short term or long term upon expanding business into new overseas buyers price of the commodity is affected by debt facilities - and the optimization of geographies, establishing trade relations price fluctuations. the cost of financing by deploying surplus with overseas buyers and suppliers – Foreign currency translation with funds in those investment instruments and managing liquidity and cost of respect to consolidation of financial that are permitted as per the risk appetite debt through effective funding and performance – limited to entities of the entity. Commodity investment strategies. Accordingly since Foreign Financial risk having subsidiaries outside of its price risk the late 1980s, several corporates began exchange risk management country of domicile to establish a dedicated unit separate management management from the traditional financial & accounts Figure 3: Key Components of the Financial Risk Management Lifecycle department - which would manage these financial risks and supply chain costs for the institution – this would be known as Risk Appetite the treasury department for a corporate. Risk Management Strategy An Overview of Corporate Treasury Risk Management Treasury management activities may Treasury Risk be distinctly divided between the Exposure Exposure Hedging Management mitigation/ financial risk managementand identification/ aggregation/ transaction performance financial supply chain management recognition consolidation execution assessment functions respectively as highlighted in figure 2 below. The objective of the financial risk Risk Management Governance management function of a corporate treasury is to “protect and preserve” Risk Operating Model the value generated from the underlying business against external market forces Financial such as: Cash & liquidity supply chain Investment • Changes in the interest rates in the management management management domestic or overseas geographies which may have an adverse impact on the interest charges on the existing domestic or foreign currency loan facilities undertaken by the group or its entities Debt management • Foreign currency movements that may impact an entity in the following ways: – Gain/ loss on foreign exchange transaction within its trade cycle – mainly due to the fluctuation in currency movements resulting from the timing difference on recognizing the payable/ receivable for import/ export to actually paying/ receiving the foreign exchange amount 06 07 Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Commodity Price Risk Management | A manual of hedging commodity price risk for corporates Components of the Financial Risk controls established for monitoring and used here include ‘gross exposure’ Management Lifecycle flagging instances of potential breaches which is the total value of exposures to The most important element with to the risk management strategy and a particular financial risk and position respect to risk management to establish most importantly, the information in the value chain. For example: total and assess the “Risk Appetite” of required to measure, monitor and report value of foreign currency imports the entity. As per the Institute of Risk the effectiveness of the risk management of bauxite in case of an aluminium Management, risk appetite can be strategy to the Board of Directors and manufacturer. Another term used here defined as the ‘the amount and type senior management of the entity. is ‘net exposure’ which amounts to the of risk that an organisation is willing total value of exposures to a particular to take in order to meet their strategic Keeping the above pillars in mind, financial risk after considering the objectives’. It establishes the tolerance a typical financial risk management offsetting impact of the same set that the Board of Directors is willing to lifecycle involves the following of exposures. For example: the net accept with respect to the impact of risk work-steps: exposure to USD for an entity that on the entity’s top-line (i.e. revenue) and imports copper ore and exports copper • Exposure identification and bottom-line (i.e. EBITDA). Typically, the wires will be the total value of imports recognition – To assess which elements risk appetite of an entity is established in USD adjusted against the total value of the business value chain of the as part of the enterprise risk of exports in USD at a certain maturity entity is affected by the specific area of management framework – based on period of settling the payment/ receipt financial risk i.e. interest rate changes, which the financial risk management of USD. commodity price or foreign currency strategy can be established.Upon fluctuations. This