Unpredictability of commodity prices.
Long-term commodity scarcity.
Sudden one-off supply disruptions.
These are the big issues impacting most companies when it comes to commodity markets in 2017.
What’s more, companies are also coming off a year of dealing with an uncertain and volatile business climate fueled by events like Brexit, the U.S. election and OPEC cuts.
And now in 2017, they face even more issues like: a rapidly changing political & regulatory landscape, reflationary Federal Reserve policies, commodity financialization, and strengthening of the U.S. dollar.
Whew! I’m stressed just reading all that! But, the reality is this: The “new normal” for most companies is a world of significant commodity price volatility. So, managing that commodity risk well is going to be critical to creating real business value in the year ahead.
And, it’s all about your approach.
Essentially, there are four different commodity risk management approaches:
A passive approach is just what it seems—a reactive strategy that uses spot purchases and does not include a risk policy to guide the way. It’s an approach a fair amount of companies take—but mostly because they’re just not aware of a better, more proactive strategy.
A ratable approach is more of a methodical approach where predetermined quantities are hedged at predetermined hedge intervals. This generally works great in range bound markets but is not optimal in trending/volatile market regimes.
A tactical approach is one that attempts to time the market to optimize price entry. This is the approach you’ll see most companies taking. And, it’s not all bad since it’s much more proactive than the passive approach above. But, in that zeal to time the market, many companies open themselves up to unnecessary risk—and miss out on a myriad of opportunities a more methodical approach would provide.
And finally, a dynamic approach includes a mix of ratable and tactical strategies. In my view, this is the ideal approach—but also the one that’s used the least by risk managers.
When it comes to managing your commodity risk, the key to success is being tactical in your thinking and ratable in your implementation. Historically, the theory has been to be blindly ratable. But, markets are too unpredictable to not be in a position to constantly re-assess your approach and make appropriate changes.
Price points are impacted by a variety of factors—some of which I mentioned at the top of this post. That means simply hedging risk through futures trading or a fixed instrument will not meet all needs. Tailored options, currency hedging, structured products and other customized solutions are being used more often each day. A strong hedging portfolio is not overly concentrated in any one of these methods, but utilizes the appropriate solution to meet needs, objectives and risk tolerance.
That’s taking a dynamic approach.
On the other hand, having no hedging strategy is a risk, too. Even if you do not know where the markets will be this week, a few months or years ahead, you can thoughtfully construct a risk management plan with your bias, experience and needs in mind. The goal is to feel confident that you have made the right decision for your company, in your markets, at that particular point in time.
Bottom line: You can’t control the markets, but you can make confident decisions, utilizing diversified strategies and a proactive, dynamic approach to managing your commodity risk.