By: Rob Wolter
Blizzards during planting season and spring flooding.
Unpredictable political shifts and conflicts.
Pressures to buy lower than your competitors.
In the commodities markets, every fraction of a cent counts. When you’re dealing with large volumes, a few pennies can have a significant impact on margins, profitability and operating capital. As a risk manager, the pressure to make the best decision could leave you in a classic “paralysis by analysis” situation.
You’re concerned you might make the wrong decision — so you take no action.
You’re apprehensive you might disappoint your leadership team — so you take no action.
You wait until market conditions change — so you take no action.
While commodity prices and volatility remained low the last few years, taking no action and not implementing a hedging strategy has worked out for some. It wasn’t until the recent weather events in Argentina that we saw a more dramatic market swing, and many felt the consequences of no price protection. Agriculture is an outdoor sport. Droughts, hurricanes and floods are not anomalies. We also operate in a global market where political and trade decisions have an impact.
Do you have a hedging strategy in place to manage potential volatility when the unexpected happens again?
One of the most effective ways to start is to build a more robust framework around managing commodity price risk — something we call the “DDC” approach. And, it includes three basic elements:
# 1 – Diversification
Managing your price risk in the market is like managing your personal investment portfolio. When you diversify your financial portfolio, you usually include a mix of stocks, bonds, real estate, savings and other products. The idea is to spread that risk around by investing in a variety of areas — each with their own level of risk.
Diversifying your hedging strategy is no different. You should be looking at things like component price, flat price, exchange options, cash price and customized OTC structures. Having a diverse set of strategies not only can optimize the return on hedging costs, but also allows you to benefit from the various paths the market may take.
For example, what if prices unexpectedly go up – quickly? Is a diverse portion of your strategy protecting against or participating with these unexpected price movements? This isn’t about guessing the right day to set prices. Risk management is about managing year-over-year savings, meeting budgets, and not being disadvantaged in the competitive market place, regardless of what could happen.
A diverse portfolio balances firm protection, participation if the market moves in your favor, and optimal hedging costs to match your preferred portfolio.
Step #2 – Discipline
Do any of these scenarios sound familiar?
- You are very close to executing your company’s target level until your leadership team calls and tells you to cancel the order because they think the market will move even lower. The market briefly drops to the original target and runs up again.
- The market unexpectedly drops to your target and marches back up before you can hedge because you can’t reach your management team.
- You buy and five minutes later the market plummets.
- You hedge at the market low and your board asks why you didn’t do more?
Chances are you’ve experienced a comparable situation. The key to avoiding this in the future? Discipline.
Hoping prices come back to your objective, or better than last year, is what keeps you up at night. After establishing your diversification plan, you must have the discipline to execute. Rather than waiting and hoping for your target to come in sight, your diversified plan should give you the confidence to act.
With so many variations, it’s not “set it and forget it” but rather “set your strategy and benefit to varying degrees no matter which way the market moves.” Knowing that your strategy is protected can allow for your point-of-entry decisions to be more decisive.
So, how do you insert more discipline into your hedging strategy? Here are a few simple ways:
- Maintain strict discipline on targets
- Make decisions based on the current market — not your past positions
- Scale into price and consider covering percentages
- Protect and enhance margins
- Set a plan and stick to it
#3 – Controls
Last, but certainly not least, you should have a series of controls in place to ensure processes and regular events are completed and deliverables are executed. For example, clear reporting, stress testing and regularly maintained dashboards can go a long way.
A clear reporting structure is vital to your success and gives your executive partners and colleagues a transparent view into your market position and your risk exposure on a regular basis.
Regular stress testing can also be an effective tool to better understand the worst-case scenario and give you a certain price point to stress your position.
Finally, always measure results. After all, as the saying goes, “you can’t manage what you can’t measure.” Create a monthly dashboard to share with your executive partners to show your progress to date and how you’re performing against annual goals.
Having a comprehensive DDC strategy in place won’t prevent the next flood or geopolitical conflict. It could, however, help make the decision-making process a bit less challenging.