Commodity Management: easier than you think!

Hedging commodity price risks is also efficient for small and medium-sized enterprises

Commodity-Management – easier than you think!

Brent oil -50%, gold -10%, cocoa +10% from last year. The current developments on the commodity markets make it clear that, compared to other indicators important for treasury management such as exchange or interest rates, commodity prices are considerably more volatile. It is indeed the current drop in most commodity prices that offers possibilities to permanently hedge the price level achieved and to gain an advantage over your competitors. In times of increasing kerosene prices, that is just how the Lufthansa Group, one of the pioneers in the sector in the hedging of fuel price risks, saved on average, up to $150 million per year on the corresponding costs.

In spite of this fact, the hedging of these risks is often still in an early stage, since many companies associate it with increased complexity and recoil at the thought of the associated, supposedly higher expenditure associated with commodity hedging. With the introduction of an adequate process and the implementation of a corresponding system solution (e.g. SAP Commodity Management), efficient risk management for commodities is more than possible at reasonable expense.

In principle, the handling of risks from the change in commodity prices does not differ from the corresponding processes in currency and interest management: Both the derivation of risk exposure and the conclusion of hedging transactions and their mapping in the back office and accounting, follows the methods already established here.

Calculation of the risk exposure

The determination of the correct exposure is key for any effective risk management process. Similar to the hedging of currency risk, the expected future commodity demand – or the expected sales quantity in the case of commodity trade respectively – are to be determined. The basis for this is adequate, cash flow-based planning, essentially, the existing purchase or supply agreements which in general, are already captured in an ERP system. In particular for hedge accounting, which may be planned at a later stage, a transparent calculation is essential, especially for external auditors.

In the processing industry, risk exposure sometimes cannot be derived directly from the target figures or agreements. Although the prices of the upstream products used here often depend on the exchange rates of the commodities involved, the risk volumes result from the corresponding percentage shares of the respective commodity. In this case, a good integration between procurement and exposure calculation is helpful. For example, SAP Commodity Management offers you the opportunity for the related percentage share values to be stored directly in the system and automatically calculates the risk from the captured orders.

The corresponding forward exchange rates have to be used to assess the risk volume, which can be calculated from the traded futures contracts on the commodity exchanges. This calculation can be complex and requires a certain amount of expense but there are also considerable advantages to be gained from using an adequate system solution and a direct connection to a market data supply system.

Formulating the hedging strategy and concluding the hedging transactions

Once the commodity exposure has been calculated, the next step to be taken in the hedging process must be decided. In general, two fundamentally different approaches are possible: a systematic process, i.e. the basic hedging of the risk volume according to a fixed target (e.g., full or partial hedging) or a situational approach which is dependent on the current market estimate and selects a respective hedging strategy for each individual commodity. Both options have advantages and disadvantages. As a rule, fixed targets are associated with less expense but, react less flexibly to modified market situations like the current fluctuations on the crude oil market. Whilst the situational alternative sets higher demands on organizational and system based implementation and on the company's specific existing know-how. Many industrial companies choose the first option and practice a substantial full hedging of their commodity requirements given that (apart from the comparatively low expense for the risk management process as such) fixed variables are determined for the planning of costs and price calculation. The disadvantage of this strategy however can be immediately ascertained with the price drop for the majority of commodities in recent months; a full hedging of the exposure 12 months ago essentially ruled out any participation in the most recent lower commodity prices. In this case, from an ex-post perspective, a non-hedging strategy would have led to the best results. Ultimately, with regard to this matter, there is no universal recommendation since each company must make this decision based on individual preferences. It is advisable to look into this issue actively and once the decision has been made to implement it consistently with, among other things, with the introduction of an appropriate benchmark for the hedging decisions made.

The conclusion of hedging transactions for the implementation of the strategy decision is associated with low organizational expense. This part of the process is hardly any different from the corresponding activities in currency or interest management. In this case, typical hedging transactions are commodity forwards, swaps or options, which generally most system solutions on the market can capture and process through settlement. There are differences in the evaluation; however: similar to the evaluation of risk volume, specific market data and algorithms are required to establish correct market values which, in the case of a negative result, could lead to problems when posting the transactions. When selecting the IT solution for example, it should be verified that the common, so-called average rate forwards or Asian options (both refer not to single strike dates but to the average values of the underlying rate of exchange) in the commodity sector can be processed.

Posting of the transactions and reporting

The final steps of the risk management process are the posting of the transactions in the commodity hedging and informative reporting of the hedging results. Providing that an integrated system, with a subledger function and adequate market data, is available, the processing of the transactions in accounting does not pose any significant obstacle, since in this case there are also clear parallels to the procedures in other risk categories.

It can be more complex in case that the hedging transactions are mapped as a hedge relation according to German GAAP or IFRS. Both presume the correct handling of the calculated exposure and the necessary calculations to prove an effective hedge relationship. As already mentioned above, if there is no direct exposure, but it can only be derived proportionally from the upstream products, the provision of this proof is made additionally more difficult and can only be mapped cost-efficiently by a consistent system solution. In this case, SAP Commodity Management, is one of the few standard applications, which offers a complete solution that is adaptable to the company's individual requirements, of this partial process as well.

Another advantage of appropriate, integrated system support is the extensively automated creation of internal and external reporting. Not only the reports required for controlling the in-house risk management process (e.g. overview of the hedging exposures, position mapping, results reports) can be covered, but especially, the various requirements which have been stipulated by the regulatory authorities – referring above all in this context to EMIR and MiFID2, however also to REMIT for energy trading.

In short – commodity hedging is worthwhile!

This summary of a typical process in commodity management demonstrates that behind the hedging of this risk category, still considered as "exotic" for many companies, no insurmountable difficulties are concealed, but that it is rather similar to many of the processes already established in treasury management. With the appropriate system solution, and competent support in methodological and procedural issues, the introduction of efficient commodity hedging can be achieved within a few weeks and is thereby a real alternative for small and medium-sized enterprises with, a usually lower risk volume.