Commodities hedging has been around for nearly 150 years. Traditionally, it has been used to manage the risk of fluctuating prices or margins in commodities markets.
Companies producing commodities have a need to lock in future sales prices, allowing them to invest in the labor, materials and other assets needed to produce and deliver commodities in the future.
On the flip side, companies consuming commodities have a need to mitigate future price risk of raw materials at an affordable level relative to future agreed sales, in order to remain profitable.
These are essentially two sides to the same coin.
In recent years, two new dimensions of commodities hedging have emerged: managing inventory risk and building customer relationships. Participants in the supply chain of any given commodity have an opportunity to gain a competitive edge if they use these two tools. And in modern, hyper-competitive markets, those edges can be hard to find.
1. Dynamic inventory hedging management
For companies that carry inventories of raw materials, products in the midst of the manufacturing process, or final goods, the exposure to changing markets does not diminish. Imagine being a company that takes raw aluminum and manufactures parts of consumer goods that have fluctuating market prices. While the aluminum sits in a warehouse, is being processed at a plant or is sitting on the shelf waiting to go to customers, it remains susceptible to underlying market forces. As prices fluctuate, it is important to keep the inventory hedged with fixed market prices to avoid impairment charges or commercial margin reduction.
A useful strategy is for companies to assess their net exposure at least monthly and hedge that exposure for a time interval that coincides with their anticipated manufacturing or sales activity. What this means in practical terms is that several teams inside the company (sales, finance, production, accounting and credit) need to work closely together to understand risk and how the value of the inventory might change.
A month-end review and hedging action plan can provide the following benefits:
- Alignment with typical reporting and results activity across a company’s functional areas
- Keeping hedging costs low by using less working capital and fewer credit lines to support the activity, for example through a 30-day inventory protection horizon
- An “insure as you need” approach to hedging while maintaining a high degree of certainty on the quantities to avoid under- or over-hedging
This practice cannot be applied with a one-size-fits-all approach, since it depends on accounting standards, company jurisdiction, valuation methodologies (LIFO/FIFO), hedge accounting practices and other considerations that should be carefully reviewed before decisions are made. However, it can be a highly useful method to help control exposures.
2. Differentiating with customers through hedging and price risk management
When competing for sales in most markets these days, participants offer comparable prices, quality, logistics, credit financing and certifications. Globalization has largely flattened the advantages domestic producers previously had, and technology has made accessing real-time information easy to do.
All of this has made it challenging for any one market participant to create value and differentiate a product or service offering.
Increasingly, companies use tailored hedging solutions to achieve an additional edge that allows them to stand out from the crowd. It is essentially a way for a company to de-commoditize their product offering by helping customers manage risk from inside the supply chain.
Companies like Cargill Risk Management facilitate this from outside of the supply chain by providing customized risk solutions that can be adapted to hedge unusual volumes, targeted time tenors for delivery, foreign exchange conversion and other specifics. This approach can transform the relationship into a true partnership, where your customers’ objectives are aligned with your own.
Modern financial modeling has given us a variety of tools that can be combined to offer effective risk management solutions to clients that are designed to facilitate:
- Buying below or selling above current market levels
- Not paying a premium for optionality
- Having protection (cap or floor) and participating in further upside or downside of markets
- Getting compensated while waiting to buy or sell at better market levels
- Many others tailored to specific budget needs
Cargill Risk Management can work with you to effectively deploy solutions like these for your key customers, so you can build partnerships that endure in today’s fiercely competitive markets.