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Hedging Commodities to Manage Business Risks

The most fundamental principle of finance measures the amount of risk you have related to each dollar of potential profitability. Yet, companies have a tendency to focus more attention on absolute returns, rather than on what they are risking to generate each dollar of profitability.

Over the last decade, a significant portion of global GDP growth has come from developing countries. With more and more people competing for the same natural resources, we have experienced elevated levels of volatility as it pertains to overall commodity prices. The global growth story is compelling and, quite frankly, one of the few areas of positive economic progress over the last decade. However, with persistently heightened levels of volatility, it makes it more challenging for producers to manage their associated commodity risks.

Much of what is carried out in commodity-market (e.g., metals, agriculture, energy) risk management is focused on output prices. While locking in the price of your finished product is important, if you don’t have long-term input pricing certainty, this hedge becomes less appropriate and subsequently less valuable.

Where we have witnessed considerable value creation for our clients is when we are able to lock in long-term input cost certainty for their businesses. They are then able to secure their output costs whether thru hedging or thru long-term customer contracts. Companies want certainty and predictability. When you can establish long-term input cost certainty, you can redistribute long-term output cost certainty to your clients. Frequently, with a firm price clients are also more comfortable committing to larger-volume obligations. It’s a three-step process: input, output, and volumetric hedging. Rather than playing the game, both supplier and customer are able to focus on their core business and competencies while sustaining normalization of their order-flow and overall profitability.

Just because products are not actively traded in markets, doesn’t necessarily mean that a structured solution can’t be created. Here is a generic example:

Let’s assume you are in a market with very low price transparency. There is no traded market and each week or perhaps each month through your network of industry contacts you call around to get a sense of current (spot) market prices. Your clients want a long-term contract with a firm price, but it’s challenging for you to provide one when you can’t secure an input price for more than a week or a month out at best.

Try to approach your suppliers not from what you need, but from what influences them. In many cases, pre-paid structures will get their attention and are beneficial across the complete supply chain. Let’s assume you needed to purchase $60 million of product over the next year, based on current input costs. Conversely, the value of your finished product is $75 million. Of the $15 million differential, you have $5 million of costs and thus a $10 million net margin. The challenge is getting your client to commit to purchasing $75 million of product for delivery over the next year because you can’t lock in their price. Without a tradable market to hedge your costs, where do you go?

A pre-paid structure would offer your supplier perhaps 20% in an up-front payment, but you would request a 5% discount on current market prices. Your total purchase would be $57 million, with $11.4 million paid up-front and the remaining balance paid in the future upon delivery of a pre-determined quantity of product and delivery schedule. Many times, suppliers will lock in a price and even accept a slight discount if you are willing to partially pre-pay for forward deliveries. However, your clients are willing to commit to long-term volumes if they have price certainty. If you can structure the transaction for less than the cost of your money, it’s not only a value-added structure for the entire supply chain, but you can arbitrage the transaction with enhanced margins, improved capital efficiency, greater revenue certainty, and with the end result of a prudent, favorable risk-adjust return.

This article was contributed to Blackman Kallick’s Manufacturing Edge by Jeff Hodgson, Founder & President of Chicago Weather Brokerage, LLC. Chicago Weather Brokerage focuses on commodities, energy, and weather and works with a multitude of industries to create unique risk management products and solutions. For more information contact Jeff at Jeff.Hodgson@cwbrokerage.com or 312-466-5666; Tom Kinder, Partner in Charge of Blackman Kallick's Audit Services department, at tkinder@BlackmanKallick.com or 312-980-2904; or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.