CME Group and Informa Economics May 16, 2013 Pan American Grain and Oilseed Conference.

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Presentation transcript:

CME Group and Informa Economics May 16, 2013 Pan American Grain and Oilseed Conference

Contents Practical Viewpoints on Risk Management  Determining Business Needs  Supply Chain Impacts  Process Framework  Risk Assessment  Risk Management Tools  Policy & Controls  Best Practices 2

3 What is commodity risk management and why do you do it? In basic terms, it means managing your margins. This could be for sellers (e.g. farmers) or buyers (e.g. food companies). You project or budget what your costs will be along with your revenue. Hopefully, that results in a positive margin. You then use hedging tools to lock-in that margin or manage it to remain profitable. Commodity risk management is also called hedging and is defined as buying or selling futures (or physical) contracts as protection against the risk of loss due to changing prices in the cash markets. Commodity Risk Management Overview Determining Business Needs Cash PositionFutures Position If you own inventory or expect to sell a product in the future, your risk is falling prices To protect against falling prices, you sell futures (or physical) contracts that gain if prices fall If you use inventory or expect to buy a product in the future, your risk is rising prices To protect against rising prices, you buy futures (or physical) contracts that gain if prices rise

Commodity Risk Management Overview Supply Chain Impacts 4 Price volatility exists all along the supply chain and hedging is used by each participant to manage the impact from price changes to their business. Farm Risk from lower prices for production (e.g. milk) Risk from higher costs for inputs (e.g. feed, fertilizer, land, etc.) Cooperative Producer forward contracts Supply/sales contracts Inventory ownership Manufacturer/Processor Risk from higher prices for purchased items Inventory ownership Producer forward contracts Supply/sales contracts End Users Risk from higher prices for ingredient costs Risk to plans/budget from price volatility

Commodity Risk Management Overview Process Framework 5 Identify Risk Identify commodity risk exposures Understand the impacts each risk has to the company Set Risk Strategy Assess the effectiveness of hedging tools from an accounting and economic standpoint Hedging strategies should be adjusted over time as markets are dynamic Review and Refine Evaluate different hedging alternatives in terms of tool selection Choice of strategy should be consistent with policy objectives Hedging Strategies Define the company’s risk tolerance, constraints, and the overall objectives of the hedging program Quantify Risk Quantify the potential impact of market risks on your financial performance Determine the overall risk to the company given these underlying risks Adapted from Citi’s Holistic Risk Management Framework After understanding why you need to manage commodity price risks, a structured process can be defined to establish and implement a commodity risk management program.

Commodity Risk Management Overview Risk Assessment 6 Low Medium High Ability to Pass Through Costs Need for Risk Management Coverage Low Medium High Margin risk depends on the ability to pass through commodity cost changes to customers More coverage should be taken on inputs that cannot pass on cost changes Less coverage should be taken for inputs that can pass on cost changes Determine what your risk tolerance is. Which is worse for a buyer?  Uncovered and market goes up (margin contraction)  Uncovered and market goes down (margin expansion)  Covered and market goes up  Covered and market goes down (covered risk) Commodity as % of Product Cost Commodity- Retail Price Elasticity Competitive Response Business Needs

Commodity Risk Management Overview Risk Management Tools 7 There are a variety of risk management tools available to use. The selection of the proper tool depends on factors such as risk tolerance, financial vs. physical settlement, and cost. Hedging strategies range from fixed price to variable price contracts. Hedging ToolAdvantagesDisadvantages Forward Contract Easy to understand Flexible quantity Locked-in price Minimizes risk Difficult to exit Must deliver physical product Opportunity loss if prices rise Futures Contract Easy to enter/exit Minimize risk Potentially better prices than forward contracts Opportunity loss if prices rise Commission cost Performance bond (margin) calls Set quantities Options Contract Price protection Minimize risk Benefit if prices rise Easy to enter/exit Premium cost Set quantities Commission cost

Commodity Risk Management Overview Policy & Controls 8 Given the large amount of financial risk exposure from commodities, hedging activity needs to be governed by robust policies and procedures. A commodity hedging policy can serve as the framework for the definition, measurement, and reporting of price-risks related to commodity hedging activity. Additionally, standard operating procedures are developed for each process step. The commodity hedging policy should contain the following: 1.Scope of Commodity Risk Management Activities 2.Commodity Risk Management Oversight 3.Commodity Risk Management Strategies 4.Commodity Risk Management Tools 5.Controls 6.Risk Measurement 7.Accounting for Commodity Risk Management Activities 8.Authorized Commodity Brokers and Trading Advisors

9 A best practice is to establish a risk management philosophy and guiding principles that will help you in your decision making.  Align objectives of risk management with company goals  Ensure management understands objectives of risk management  Know your cost structure so you can effectively manage your margins  Have specific, written risk management strategies  Maintain discipline in executing risk management strategies  Work with experienced professionals  Develop policies, controls, and standard operating procedures  Don’t operate in a silo – involve others in the process Risk management is not speculating and should not be considered a profit center. In fact, not using risk management is speculative. Commodity Risk Management Overview Best Practices

Commodity Risk Management Overview Summary 10 A successful commodity risk management program helps a company manage their margins and reduces the impact from commodity price volatility. Key steps in the commodity risk management process include: Determining your business needs Identifying and quantifying your risk from commodity prices Developing a structured process for establishing and executing hedging strategies Focusing on margin management Ensuring policies and procedures are robust Thanks! Mike McCully