Commodity Hedging Strategies: An Introduction
This is the first in a series of articles where we will explore various hedging strategies across the primary market risks faced by companies today.
A key point to understand in relation to hedging is that if you have an exposure to risk (commodity price, interest rate, foreign exchange , inflation or otherwise), doing nothing about the risk is in effect doing something – it is deciding to take the risk and allow your performance to be impacted by its variability.
In this article we look specifically at commodity risk and a basic vanilla hedging strategy.
What is Commodity risk?
Commodity risk is the financial uncertainty caused by fluctuations in the price of commodities. These fluctuations are beyond control and affect future market values and future cashflows.Commodity prices can be quite volatile partially because of their supply-demand dynamics. In addition, geo-political risk is another important inflence factor.
An important starting point in the process is to identify the commodity risks that a particular company is exposed to. Once identified, make sure you understand how these risks impact future cash flows.There can also be a significant impact due to foreign exchange rate movements. This depends on the currency that your company functions with.
For example, if you company operates in Euros and you do not hedge your fuel costs, the company will be exposed to EUR/USD movements over the period. These can be underlying benchmark price movement (likely Dollar denominated). Some large shipping companies saw their fuel costs increase by 13% in 2017 becasue of fuel costs/bunker price increases.
The table below illustrates the impact on commodity price movements to revenue and profitability:
Commodity price movements
Why Hedge the Risk?
Implementing an appropriate commodity hedging strategy can help provide more budget certainty, help manage liquidity and result in a smoother cost profile and limit operational risks. An appropriate commodity hedging strategy implementation can help you limit financial risks. Having a strategy in place helps to:
provide more budget certainty
to manage liquidity and as a result
to achieve a smoother cost profile
Again, not hedging when you have an known risk is a decision in itself. You sould not underestimate the potential impact of overlooking the risks.
How can I hedge the risk?
It is essential to have a robust approach to your hedging strategy. This means achieving the right level of oversight and the relevant approval procedure. The below outlines the high-level approach to implementing a suitable hedging strategy:
High-level hedging strategy
Consumers use fixed-rate swaps to hedge their price risk by fixing or locking in their fuel costs. This happens accross many indutries such as air, marine, rail and road transport. Sellers of commodities also use fixed-rate swap strategies for inventories as well as price risk management.
To illustrate how a hedging strategy can work from a consumer perspective, let’s take the example of a shipping company. This shipping company wishes to hedge 75% of its bunker consumption over the coming year. Say the company consumes 120,000 Metric Tonnes (MT) of fuel oil and they would like to hedge their price risk on 90,000 MTs over a 12-month period (from Jan 18 to Dec 18) – allocated evenly.
The shipping company can do this by entering into a fixed-rate swap on the benchmark (e.g. 3.5% Fuel Oil Rotterdam) for 7,500 MT per month at e.g. €305 per MT.
Let’s have a look at how that would play out for the shipping company over a 12-month period:
Fixed Rate Hedging Strategy (Example)
Example of fuel price & costs under the different scenarios in 2018
As you can see from the table and graph, if the shipping company had passively accepted the price risk over the 12-month period, they would have had significantly higher (€2.7m) and less predictable costs.
Therefore, using a simple fixed-rate swap strategy, the shipping company in this example has reduced total fuel costs, proactively managed their price risk and stabilised their ability to forecast costs. However, it is important to note that if the price had moved the opposite direction over the period, there would have been a missed opportunity for cost saving on the hedged part of fuel costs. This is the cost of implementing an effective hedging strategy which mitigates price risk and stabilises the cost line.
Moreover, from an accounting perspective, it will be important to be in a position to put hedge accounting in place on the trades to reduce any Mark-to-Market volatility on the P&L.
In the following articles we will explore a variety of hedging strategies depending on risk appetite and business requirements.
If you would like to discuss your hedging needs across any asset class (Interest Rate, Commodity, Foreign Exchange, Inflation etc.) do not hesitate to get in touch with us.
Centrus provide independent advice on hedging strategies and support through every stage of the process. From assessing risk and developing an appropriate hedging strategy through to execution and accounting impact post implementation.
Find out more About Centrus here.