Treasury is increasingly becoming responsible for managing commodity exposures. But while treasury is a good fit for a commodity hedge programme, treasury risk managers who have not previously handled commodity hedging will need to educate themselves on certain areas.
First, they need to understand which commodity derivative will best match the underlying risk being hedged. An education on the different reference prices for commodities and why they vary is also critical.
Unlike currency, which can be transferred and stored electronically, commodities must be physically transported and safely held in a storage facility. This introduces the issue of location basis risk when hedging commodities. It is important to understand what price index best matches the price of the commodity in the location where it will be used.
For example, the price of natural gas to be used in a product in Chicago is likely to be based on the NGI Chicago Citygate natural gas price rather than the NYMEX Henry Hub price. While both price indices will normally closely correlate over time, a local disruption in one market can result in a large spike in price with very little movement in the other market. These locational variances are not observed in currency prices.
A grasp of the inventory cycle and accounting treatment is important for understanding the correct exposure to hedge and avoiding a timing mismatch between the settlement of the hedge contracts and the impact of the price when the commodity is consumed or sold. Understanding the time from purchase of the raw material to the sale price will impact the product margin, especially where there is price flexibility, and the sale price can be increased to reflect the rising cost of the commodity.
Market fundamentals are an important influence on commodity price. Disruptions to the supply of a commodity will result in upward pressure on the price until availability of the commodity exceeds demand and a surplus occurs sufficient to stabilise the market price. If the supply is far outstripping demand, suppliers looking to sell the commodity will lower the price, exerting downward pressure of the market price.
In addition, the commodity markets attract a large proportion of speculators relative to the currency and interest rate markets. Speculators are not trying to hedge their exposure to minimise volatility, but are adding exposure to benefit from a perceived positive or negative movement in the commodity price.
Another difference between currency and commodity markets is market volatility. Some markets such as gas and electricity need to be supplied in real time. Electricity storage is difficult, resulting in considerable volatility compared to currencies. While annual volatility of major currency pairs when high is about 10%, spot natural gas prices can often fluctuate more than 100% on an annualised basis. Spot power prices can jump 1,000% or more on an annualised basis, as seen in 2021 when the Texas power grid suffered weather-related power failures.
In addition to the commodity itself, the currency in which a reference commodity contract is quoted is important. For example, let’s say a company is hedging with an over-the-counter future or forward contract that is priced in US dollars, but the company’s functional currency is not USD. The company’s exposure to that commodity will change even if the quoted commodity price does not change if the USD strengthens or weakens against the company’s functional currency. It is important to understand this, because hedging against the commodity exposure using a USD-denominated forward or future will not eliminate the exposure to the hedged USD due or received at delivery.
One approach is to enter an FX swap for the nominal contract amount of USD and link the FX hedge to the commodity hedge. If the commodity exposure changes and the company moves to unwind the commodity hedge, it will also need to unwind the FX contract as well.
Placing the oversight of commodity hedging within treasury requires strong communication with operations. Changes in production, contract terms, reference price, etc, can have an impact on commodity exposures. Contract term changes is an area that is often not communicated in a timely manner to the risk management group.
Treasury departments are increasingly being asked to manage commodity hedge programmes. Many already hedge interest rate risk, FX risk and counterparty exposure, and it is seen as a natural extension of the financial risk management oversight mandate.
To efficiently manage a commodity hedge programme, treasury departments should consider the advantages of utilising a solution that seamlessly integrates with the rest of its technology stack. Treasury teams that take on this responsibility and are still relying on Excel will find themselves overwhelmed.
Ron Stott is a value engineer with treasury software provider Kyriba