Historically, steel has been a very volatile commodity –in part because of limited liquidity and barriers to effective hedging outside of supply chain contracts. Today, that path to more effective risk management has fewer roadblocks with the introduction of the Chicago Hot Rolled Contract (HRC) among others, providing greater depth for the bid/ask spread.
Widespread use of this contract for hedging, though, has been slow to pick up steam. Not because of its value, but because of the steps in establishing new risk management processes, including being unable to qualify for hedge accounting within the strict confines of Accounting Standards Codification topic 815 – Derivatives and Hedging (“ASC 815”). While in many cases it can be easier for companies to mitigate price risk within a supplier contract, numerous stakeholders have interest in hedging financially and realize that overcoming this barrier can unlock value and opportunity.
One local company in Minneapolis, HedgeStar, works with corporations and governments to help sort through these issues and overcome some of the various barriers to applying hedge accounting. In particular, they help companies navigate “Proposed Accounting Standards Update—Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities” (the “Proposed ASU”), which applies long overdue changes to ASC 815 specific to commodities that are expected to help break through some of these barriers and better align accounting results with risk management activities. Earlier this week, Cargill Risk Management’s Tim Stevenson sat down with HedgeStar’s Tim Potter to talk about the recent changes to ASC 815 and how companies can navigate the increasingly murky waters of hedge accounting.
Tim Stevenson (Cargill Risk Management): This is a great topic to discuss. I get a lot of questions about hedge accounting, especially for steel consumers. They know it’s evolving and that HRC contract liquidity is improving, but sometimes concerns about hedge accounting can slow down the process. Why do you think that is?
Tim Potter (HedgeStar): Defining the scope of a hedging program is challenging because you typically need support from groups or departments such as tax, accounting, treasury, risk and external audit. This is no small task, particularly when authoritative guidance is so restrictive. Many companies simply default to their supply chain agreements when faced with the task of mitigating price volatility from their suppliers. Companies/risk managers are currently limited in navigating the hedge accounting requirements by defining hedge relationships based upon total purchase price. The Proposed ASU is really encouraging, because it lays out the new hedge accounting requirements in a fairly straightforward manner. It allows companies to isolate separately identifiable risk components or indices through its risk management objective and to reflect achievement of that objective through the accounting process.
When it comes to risk management, there can be so many parties involved internally and externally that it becomes a challenge to move forward and maintain traction. With the corresponding rules and regulations subject to wide interpretation, it even can be difficult to decide where to start.
Tim Stevenson (Cargill Risk Management): Specific to HRC, can you discuss how some of the recent accounting rule changes may make it easier for companies to deploy risk management?
Tim Potter (HedgeStar): We think companies/risk managers would be wise to define current hedge relationships that consider all changes in cash flows for measuring hedge effectiveness. This includes consideration of basis spreads, transportation costs and other inputs. The Proposed ASU will allow companies to designate any component of the overall risk as the hedged risk, as long as it is contractually specified. Take equipment or auto companies, for example– companies buy cold roll steel through their supply chain even though hot rolled steel is the liquid contract traded on the CME. Under the proposed ASU, purchase contracts with sufficient price transparency will allow companies to designate the HRC component as a cash flow hedge.
Tim Stevenson (Cargill Risk Management): Can you provide an example of what this would look like?
Tim Potter (Hedge Star): Yes. Here’s a prime example: Say 85 percent of the volatility in cold roll steel typically comes from the hot roll price, and the remaining 15 percent comes from the basis spread. The proposed ASU changes allow for isolation of the hot roll exposure in assessing hedge effectiveness, without having to accommodate changes in the basis spread. So, a company executing a fixed-payer, over-the-counter (OTC) swap for hot roll steel could see price volatility reduced significantly. Assuming a perfectly effective hedge, a company would see a significant reduction in purchase price volatility, as illustrated below:
In the chart above, unhedged cash flows are subject to volatility from both the HRC and CRC components of the overall steel risk exposure. Hedged cash flows fix the cost of the HRC component, leaving only the remaining CRC risk component as a source of variability.
Using the cash outflows provided above, here’s an illustration of how volatility in those outflows can easily be mitigated through use of an OTC swap.
Execution of the swap alone, however, does not tell the whole story. The HRC index identified in a company’s purchase contract (or another tightly correlated proxy) must also be explicitly stated in its OTC swap. Also, proper documentation of the hedge relationship and ongoing testing procedures are required to allow the company to benefit from hedge accounting. With a well-designed hedge accounting strategy, a company can record changes in gain or loss from its swap on the balance sheet–as opposed to recording those changes in earnings.
Below is an example of how periodic changes in swap value can affect earnings with and without hedge accounting applied:
Tim Stevenson (Cargill Risk Management): What is the best way for a company to determine their choices? What type of information do they need to review?
Tim Potter (HedgeStar): Start by reviewing current pricing agreements to determine exactly how the raw material is priced. Next, run a correlation analysis between your historical purchase prices and the underlying index of the proposed hedging contract(s). In most cases, you’ll find enough historical consistency to prove a highly effective relationship. At a bare minimum, companies should be aware of the risks that could affect their purchasing and consider financial instruments to protect against rising prices. The more they can control, the better the opportunity to improve profit margins and accuracy in forecasts.