So You Want to Launch a Commodity Hedging Risk Management Program

For any one company, there are many types ofthe same as that of a bakery exposed to the
financial risk - credit risk, market risk, operationalvolatility of wheat prices. However, what is most
risk, to name a few.important is being able to understand what your
However, one type of risk that has emerged asexposure is, what drives the prices of the
a key issue in today's global economy iscommodities, and then coming up with a specific
commodity risk.strategy to address it. Luckily, there are a
Commodity risk refers to the exposure tonumber of commodity risk management systems
uncertainties of future income, caused byout there that make this process quite easy.
fluctuations in the prices of commodities. TheseIt should be noted that an effective hedging
can include price risk, quantity risk, cost risk, andprogram does not attempt to eliminate all risk.
political risk. Take, for example, natural gas.Rather, it attempts to transform unacceptable
Between 1999-2003, prices skyrocketed from arisks into an acceptable form. The goal of any
low of $1.70/MMBtu to a high of $10.00/MMBtuhedging program should be to help the corporation
only to drop back down to $2.00/MMBtu by 2003.achieve the optimal risk profile that balances the
Today in 2010, natural gas trades roughly in thebenefits of protection against the costs of
$3-$4 range but not before it hit a high of $15hedging.
MMBtu in 2008.Listed below are 5 steps to establishing an
The natural gas example illustrates the extremeeffective and tailored hedging program's needs.
level of volatility and unpredictability associatedStep 1: Discover why you are hedging
with commodities. Many people mistakenly believeThe first thing that is necessary is a clear
that a good hedging program will generate costdefinition of the objectives of the hedge program.
savings. Instead, the primary purpose of a goodSenior management must provide the owner of
hedging program is to eliminate a major source ofthe hedging program, with clear measures of
uncertainty and volatility while enabling companiessuccess. An example could be to ensure the cost
to strategically focus on items and issues withinof fuel does not exceed 25% of revenues over
their control.the next year. Without clearly defined and
Take a large multi million dollar bakery and askquantifiable objectives, the outcomes from
yourself how would this company differentiatehedging cannot be accurately measured as
itself from the competition. Generally, it is throughsuccessful or unsuccessful.
unique and interesting products, solid marketingStep 2: Identify how much to hedge, and what to
expertise, and efficient operations like distributionhedge with?
and purchasing. Indeed, most strategic plans focus· Optionso Capso Floorso Putso Calls
on these key areas and plan accordingly.Two key considerations are 1) how much of the
When it comes to wheat futures trading though,projected commodity exposure to hedge, allowing
it is little more of a stretch to believe that anyfor a predetermined level of flexibility 2) which
one bakery could really have a competitiveinstruments and markets the company should
advantage in commodity trading. In fact, if ahold. There are a wide variety of listed and
bakery was so adept at trading, one would haveover-the-country commodity instruments available
to wonder why operate a bakery at all. Closefor companies to employ. However, the fact is
down the bakery and make a heck of a lot morethat most derivative solutions are constructed
money by trading the futures.from two basic instruments: forwards and
While wheat futures may be a critical costoptions, which comprise the following building blocs
component, companies have to recognize the· Forwardso Swapso Futureso FRAso Locks
difference between a controllable cost componentStep 3: Execute the hedging strategy
and a non-controllable cost component. For theWithin executing the hedging strategy it is
most part, manufacturers are price takers and doimportant, like all other financial activities, to
not control commodity prices which are set byimplement a system of internal policies,
the market at large. That does not mean thatprocedures, and controls to ensure that it is used
companies should just throw their hands up andproperly. The system often documented in a
give up. Rather they should strive to institute ahedging policy, establishes names of managers
risk management program that helps themauthorized to enter into hedges, the managers
control the uncontrollable. Hence the importancewho must approve trades etc.
of a good hedging program.Step 4: Ensure hedges are on track
This brings us to the first point aboutIt is important to revalue the trades, track the
implementing a hedging program. Companies haveP&L, and monitor the risk, ensuring that the
to recognize their exposure to a particularhedges remain effective versus the underlying
commodity risk. Generally, if your profit and lossexposure.
is subject to variability, based on what's beingStep 5: Quantify the final outcome:
bought in commodity markets, this is anOnce the hedge trades have settled, the next
important issue. You are at risk.step is to net the realized cashflows from the
There is certainly no overarching hedging strategy.derivative hedge trades against the physical
Every hedging program is different and needs tocommodity purchases or sales. This provides the
be evaluated based upon criteria unique to anet commodity cost to the business, and enables
particular corporation, its risk tolerance, and itsmanagement and the board to evaluate whether
respective industry. The risk appetite of an airlinethe hedging program was a success versus the
to jet fuel price volatility, for example, will not beoriginal corporate objectives.