Commodity Risk Management

Commodity Risk Management: Factor of success for corporate clients by Michael Alt, Head of Commodities Advisory & Distribution

Active management of commodity price risks is increasingly becoming a decisive factor of success. Acting with the future in mind, and following a systematic price hedging approach are becoming the norm, rather than merely reacting as a passive price taker in a volatile market.

Large price fluctuations and complex price-influencing factors make it hard to make reliable calculations, which are a crucial criterion, especially for companies with a high raw materials and supplies ratio. Commodity price fluctuations can soon turn into a cost trap if the factored-in margin is eroded, and a deal that initially seemed attractive can end up generating significant losses.

Active risk management in the commodity sector reduces dependency on market prices and the volatility of earnings, as well as increasing planning certainty. As a result, the risk cushion required in the calculation can be smaller, and the company can impress not only with its product quality, but also by always having prices that are in line with the market.

Analysing and quantifying risks

The first step of implementing a successful commodity risk management strategy involves identifying the risks associated with the product in question. It is not only the ‘direct’ and obvious risks that need to be considered, but also factors such as energy and logistics costs and packaging must also be taken into account. Then the risks need to be quantified and prioritised: How big are they in absolute terms, and how pivotal are they in terms of the success of individual deals or the entire company? Many companies already actively manage their interest rate and foreign exchange risks. The tools available for commodities are the same, but the volatility is much higher in this market, and companies are more directly affected.

Separating the price risk from the physical transaction

Financial hedging results in a separation between the price risk and the physical transaction. This gives the company the flexibility to manage the two elements independently from one another. For example, price hedging can replace the need to accumulate stocks when market prices are favourable, which would tie up capital. The calculation basis is safeguarded, while no costs are incurred for storage and financing of the commodities. In terms of client and supplier relations, clauses concerning the passing on of price changes are no longer needed, because the commodity price can be fixed by using financial instruments. This protects business partners from unfavourable price movements that cannot be passed on, and increases transparency for all involved.

As well as the basic tools – the fixed price (binding price fixation) and the option (“insurance” of a price level with full participation in any favourable price movement against payment of a premium) – individual payment profiles can also be used to achieve risk management objectives. These solutions can enable companies to participate in advantageous market movements, but still keep hedging options in mind. The instruments can be tailored to the underlying transaction in question, the company’s own market view and its individual hedging requirements, so they are a way of actively making use of any windows of opportunity that may occur in the market.