Hedging Your Bets

By Neal Walters
Partner
August 2009

After the wild financial ride of the past few years, one thing has become clear in the commodities markets: They will continue to change rapidly, and not necessarily in the direction we expect.

What was once a rather simple paradigm—commodity prices rise and fall in gradual, rather predictable cycles, according to supply and demand—has been replaced by a world in which prices can climb to record highs and plunge to stunning lows in a matter of months.

Corporate earnings have clearly been hit by the direct and indirect effects of fluctuating commodity prices, and there’s no reason to believe that this volatility will change anytime soon. Yet at many firms, top executives watch from the sidelines while lower levels of the organization assume the responsibility for not only procuring commodities, but also managing their significant earnings and cash flow risks.

This landscape demands a better approach. Given the implications, top executives must take responsibility for understanding the amount of risk their companies are taking, and exercise the strong judgment needed to navigate choppy waters.

Locked Out by Locking In?

Commodity markets today are between two and four times more volatile than they were just 20 years ago¹. Additionally, seemingly unrelated commodities—say, sugar and copper—can fluctuate in unison, according to changes in the general economy rather than commodity-specific factors.

In this environment, a common misconception is that companies that manage risks by hedging are more profitable than those that don’t. Remember the energy price bubble of 2007 and 2008? A lot of smart companies took long-term contracts on commodities at what they thought were safe prices, based on an assumption that prices would inexorably rise. When the global economy crashed and prices plunged across the board, those hedges ended up locking in prices far above prevailing market rates.

What is the appropriate risk management strategy? There are four major factors for executives to consider when answering this question:

• Set an acceptable level of financial risk from the top down. In order to develop an appropriate risk management strategy, a clear, unequivocal level of risk tolerance in commodities must be set by the firm’s senior management. This should then be used to develop individual and aggregate commodities strategies.
• Know your products’ cost structure and risk levels. If you’re protecting against risk, you must know how big that risk is. How much will you face if prices move significantly? Can you pass on increases to your customers, either directly or through indexed pricing? If so, how much will it affect your product demand? Can your supply partners bear the risk they’re exposed to and, if not, what are your alternatives?
• Know the derivative markets. If you decide to the take the derivatives route for managing your risk, hire experienced people or partner with a broker you trust. Derivatives are complex and the market is dominated by professionals who know how to make money trading commodities. Don’t fall into a talent disadvantage by simply adding risk management activities to an existing function.
• Implement an effective governance process. The best oversight includes a definition of your risk tolerance threshold, evaluation of potential risk management strategies and consistent monitoring of your performance and compliance. No strategy is effective 100 percent of the time, so consistently beating the competition as a result of better risk management strategies is an unrealistic objective. But expecting that there won’t be any “surprise” outcomes is certainly appropriate.

Wild swings in commodity prices have demonstrated the need for top-level responsibility for both understanding and setting the right levels of risk.

But improving your commodity management is no trivial exercise. It requires strong leadership, rigorous analysis and sound judgment from top executives who, given the complexity of the situation, understand how much is at stake for their company. Set this in place, and your company can maneuver through the commodities landscape.

¹ Sources: A.T. Kearney, Economist Intelligence Unit

Neal Walters is a partner based in the A.T. Kearney Toronto office.

For more information, please contact the author.

The views expressed in this paper are those of the author(s) and do not necessarily represent the views of A.T. Kearney or the Global Business Policy Council. The views are not meant to suggest specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinion.