Most companies are affected by potential financial losses due to the cost increase linked to the volatility of commodity prices. In addition, it can also harm production and, finally, sales if commodities are not available in required quantities.
The lack of proper commodity risk management can have serious impacts on the company’s performance. Therefore, all industrial companies and their clients should assess and manage this risk dynamically to maintain their competitiveness and protect their financial fundamentals by understanding market trends better and managing the internal risk exposure.
The following article provides initial ideas for developing and implementing effective price risk management strategies on commodities.
1. LACK OF PRICE CONTROL ON THE COST OF RAW MATERIALS Read more
Commodity markets have become more and more globalized and price fluctuations are outside the control of any company. They depend on multiple external drivers impacting global supply (available stocks, natural reserves, investment on production facilities, climatic conditions or geopolitical issues) and global demand (population growth, economical conjuncture of the emerging countries or new technologies). These drivers are often difficult to evaluate and to anticipate. The increasing interest of financial investors in quick wins from speculation on commodity price changes is also relevant for the increasing volatility of market prices.
From the production of raw material to the purchasing of the final transformed product, most businesses are exposed to financial risks due to this commodity price volatility. Even companies which are not directly purchasing commodities will be impacted by the movement of indirect costs like energies or transportation prices.Due to the lack of direct control of market prices, companies need to understand market trends better and actively monitor and manage their financial risk exposure. By doing this, managers will increase the visibility of prices and better assess the profitability and risks of purchasing and sales contracts.
Based on their risk aversion they can decide to follow one of multiple risk mitigation strategies, such as financial hedging. They need to balance the market opportunities with their financial risk exposure integrating their own environment.
2. FORECASTING MARKET PRICES Read more
Market forecast can be performed internally or externally using expert reports and specialist advice. Even if experts facilitate the price trends analysis process, it is always fundamental for the company to be able to form its own opinion of the market. External analyses will then complement the internal market assessment.
Commodity prices should be forecasted for a short term and a long term scenario. Short term fore-cast refers to a maximum period of 1 year (for tactical decisions), while a long term forecast refers to periods over 1 year (for structural decisions). For both time periods, the market analyst should balance two types of analysis: the fundamental analysis and the technical analysis.
2.1 Fundamental Analysis
Commodity prices are determined by the interaction of supply and demand. The fundamental analysis is the study of supply and demand in order to understand and forecast market trends. In commodity markets these pillars are impacted by several factors.
To understand the basics of demand for each market it is important to understand who uses the commodity and how it is used. Globally the demand depends nowadays on the population and economic growth of emerging countries, such as China.
The variable activity increase of all the sectors in those countries has a direct impact on commodity demand. For example, a slowdown in the automotive industry and the construction sector in 2008 impacted significantly some commodity prices (i.e. the price of copper). In addition, a change in the industrial usage of a commodity will also impact prices. The usage of agricultural raw material such as agro fuels is a good example since this leads to an increase in the global demand of these products. A similar analysis of the basic factors affecting supply will give a global understanding of market movements. Supply is impacted by many different factors depending on the commodity (e.g. a climatic disaster will impact the agricultural production but not the metal production). The fundamental analysis is more appropriate for long term forecasts.
2.2 Technical Analysis
Technical or chart analysis aims to predict future prices based on past performance. Founded on the study of the market action itself, it is purely statistics and to perform this analysis accurate historical prices are needed. The theory considers that all marketplace information about a commodity is incorporated into its price. As soon as new information is available, the prices are adjusted by the market. This analysis does not need any knowledge of the fundamental market factors.
The analyst will need to collect historical data, develop an appropriate forecasting method and assess the accuracy of the model. After having built a price chart, numerous analytical tools are available to perform a complete technical analysis. The most popular way of forecasting price trends is to use the support and resistance combined with other indicators like moving averages or volatility. There is not a universal indicator. Each analyst will prefer one method to another. In all cases it is always better to use less indicators well managed than many indicators not managed properly. The technical analysis helps to make short term forecasts.
The decision maker should balance the outputs of fundamental and technical analysis to get a better estimation of future market trends. Traditionally, the industrial sector and in particular those who transform raw material into a final product are only focusing on the fundamental analysis and use information on their suppliers as a market indicator. But today, since market movements are quicker and have huge volatility in very short-term periods, the technical analysis, initially used by commodity traders, should also take place through the internal skills of the company.
3. MONITORING PRICE RISK EXPOSURE Read more
Evaluating and monitoring the financial risk of the company is recommended to quantify the financial impact of a rise or fall in commodity prices. This measure helps the decision maker to balance the market opportunity (through the fundamental and technical analysis) versus the financial risk taken (potential financial loss).
The target of this step is to estimate the potential financial loss and its implication on the cash flows of the company. This analysis can be performed per commodity and per business unit. However, monitoring the risk exposure by considering all the commodities as a company portfolio is recommended in order to consider any kind of correlation between the different commodity prices.
The Value at Risk (VaR) is a calculation method used to measure the potential financial loss linked to commodity prices. The VaR indicates the maximum potential loss in a period of time under a defined
probability of occurrence. It can be monitored manually or using a specialized software. Ideally the model chosen will integrate:
- Purchasing contracts and purchasing forecasts
- Sales contracts and sales forecasts
- Market information (i.e. futures prices, volatility)
- Hedging instruments
A common mistake in the manufacturing sector is to evaluate the financial risk by considering only the purchasing risk. However, the risk is the result of a combination of long (purchasing) and short (sales) positions in a market environment. When the risk is transferred to the client, the VaR will be equal to zero. It is fundamental to integrate both purchasing and sales parameters in order to avoid an incorrect estimation.
The first aspect to be checked after a VaR calculation is to know if the company would be able to face the potential loss. An internal risk management policy should define the level of maximum exposure allowed.
4. IMPLEMENTING RISK MITIGATION STRATEGIES Read more
By balancing market opportunities and financial risk exposure linked to commodity prices, the com-pany may finally decide to cover this risk. Several mitigation strategies can be implemented. The following levers show different alternatives:
- Purchasing: close long term agreements with a fixed price to reduce price volatility. In this case it is important to check if the sales contracts follow the same indexation rules: willing to purchase at a fixed price while selling at a variable price will increase the risk and not reduce it!
- Sales: transfer the risk to the client by indexing the contract prices on commodity markets. The indexation must be well managed in order to avoid discrepancies between purchasing prices and sales prices in particular regarding time horizons.
- Marketing and R&D: By developing innovative products with a higher added value, the financial risk linked to commodity prices is limited compared to the level of gross margin generated by those products. In parallel, technical innovation can lead to the substitution of a commodity by another less volatile one or a way to reduce the raw material volumes needed to manufacture a product can be investigated.
- Hedging: using futures, options, swaps and other financial instruments can be considered as an efficient mitigation strategy for commodities which belong to liquid markets. When direct hedging is not available, “cross-hedging” opportunities should be investigated.
5. ABOUT THE AUTHOR Read more
Damien Moras is a Partner at TALA Consult, Düsseldorf. He regularly advises European companies regarding risk management strategies for metal, energy and agro-commodities. If you want to understand how your company could take benefits of improving or implementing an efficient commodity risk management strategy, please contact him by email ([email protected]) in order to receive more information.
TALA Consult is a highly specialized management consulting company for Risk Management and Compliance. We advise large corporations and SMEs as well as financial institutions and private equities regarding the compliance in sales and purchasing functions as well as the risk management of raw materials, cash and taxes to help them face their international challenges. The combination of our entrepreneurial and excellent technical know-how with efficient IT tools for mass data analysis is the common thread that runs through our company.