By Cesar Canali
In the metals industry, effective commodity price risk management is critical at a time where volatility, duties and increased accounting rules have all become common.
Still, many companies producing or processing metals rely on outdated, insufficient or even inaccurate practices to manage their inventory and their quotational periods (QP).
The primary culprit is a mistaken belief that buying and selling equivalent tons of physical metals makes a company square. Metals procurement and sales managers refer to this in a few different ways – natural hedging, back-to-back or pass through – but they are all similar and carry the same fundamental risk.
Unless your bought and sold volumes have identical quantity, quality, price and averaging periods, there will be slippage, and that creates price risk exposure. Furthermore, it isn’t as easy as looking at monthly averages, because most businesses are buying and selling every day, and prices change by the minute. This strategy also doesn’t account for returns, shipment delays and internal scrap material generation and reprocessing.
After years working with companies on this topic, we have found that they rarely measure the full scope of the risk involved. Many have trouble understanding the true source of inexplicable wins or losses. Here are a few things to think about so you can dig in more deeply to your inventory management and help prevent the kind of surprises that can impact your price risk exposure.
1. Know your true position
If you are hedging inventory and QP, you should start by knowing your position of unpriced or at-risk metals units. Often, companies start by calling us to find the average for the month, but you need to understand your risk first. Many companies believe that because they buy and sell equivalent tonnages at the monthly average, M-1, that they are immune to price slippage and that their risk is mitigated.
Better measurement of your position requires you to know how many tons you have in inventory, how many tons you have committed to the market, your pricing for those volumes, and your pricing formula as well.
These numbers don’t necessarily change at tidy, once-a-month intervals. Most companies buy and sell multiple times a month, making it difficult to estimate true positions. But if prices move against you, it will matter. Consider that copper can move $600 a day, and it’s not uncommon for nickel to swing more than $1,000 a day. Multiply that by your tons of exposure, and you can start to see what’s at stake. Suddenly, the effort to determine true positions seems more justified.
2. Internal connections matter
Internal miscommunication between areas like procurement, manufacturing and sales can make knowing your aggregate position more difficult. Changes in quantities, supply rejections, productions losses, anticipated sales and cancellations will render a company’s back-to-back formula inadequate, since those activities may go unreported or are reported long after they occur, generating slippage.
Purchases and sales are visible transactions with hedges offset by invoices and cashflows. QP and inventory prices are not as visible, and in most cases, the relatively constant fluctuations in inventory could cause potential losses to accumulate undetected. The traditional belief that during a longer period any losses are offset by eventual gains is theoretically true, but in a competitive environment and using real accounting, those practices could not only be dangerous, but also could create consequences for P&L and taxes.
All of this emphasizes the importance of having strong connections and processes internally to get a full picture of where risks or dislocations may be piling up within your business.
3. The devil is in the details
There are many different sources of risk for the metals you have in inventory. A closer look will help convey just how much complexity they create, and how conventional methods might not manage them sufficiently.
At-risk metals units are the tons of material in inventory, production or part of a finished product for which a price versus cost has not been determined. Additionally, you need to take into account materials that were shipped ahead of time or late, returned or cancelled.
To account for this, it’s not unusual for a company to maintain some level of hedging flexibility in quantity, tenor and discretion. In fact, it is worth considering that doing so may be a good alternative to natural or back-to-back hedging, given the dynamic aspects of a business. This is true assuming the company knows its position and is able to quantify not in terms of tonnages in the warehouse, but in terms of volume, prices and periods.
But spreads, or the price differences between two periods, don’t change just once a month. Instead, especially taking into consideration the short-term nature of the manufacturing business, they can change every day. A trader would probably argue they change every minute. This means that deliveries have to be absolutely constant to make the average work. Yet spreads are not linear and can vary significantly. Most of us have experienced moderate contangos between cash and three-month prices on LME while facing steep backwardations between cash and the next third Wednesday.
Tracking all sales and purchases is possible using some systems, but information flow is likely imperfect, and so are the sales estimations. Accuracy inside 90 days in some cases is estimated at around 75 percent, according to some managers we speak with.
Provisional invoice prices and M-1 do help to harmonize price variations, and market experience adds a human component to a hedging policy. However, the risk of trusting instruments with limited quantitative value is not an industry best practice
All of this complexity tells us that any company able to manage these factors accurately using back-to-back formulations would be a unicorn of efficiency. More likely, the company could be exposed to unknown risk.
So what now?
Companies do not tolerate variations in quality, specification or quantity beyond a few decimals points. Why risk double-digit percentage points of risk in imperfect offsets?
QP and inventory hedging are efficient and quantifiable risk management instruments that enable a company to control the cost of its metals inputs and to properly set a margin on products sold.
If you have a dynamic business that is buying and selling throughout the month, QP and inventory hedging will require a higher level of control, communication and analysis. But the benefits far outweigh the risk of not doing it. Cargill Risk Management is here to help you manage your QP and inventory hedging needs.