Re-evaluating risk
management in the
metals supply chain
White Paper | Re-evaluating risk management in the metals supply chain
Metals and mining firms cautioned to reevaluate their traditional commodity hedging
practices in light of increasing market volatility
and fierce competition.
In this paper
Why more businesses should look
into better hedging........................................................5
How hedging works........................................................7
Hedging with futures................................................................7
Hedging with options...............................................................9
More advanced hedging strategies................................ 10
Good hedging practice............................................... 11
Understand the risk position.............................................. 11
Find the threshold between cost and risk..................... 12
Balance sales with procurement ..................................... 12
Assign ownership of the hedging strategy.................. 12
Set up the necessary systems and software .............. 13
Conclusion ..................................................................... 14
Trading on an everyday icon
Six million tonnes of bauxite are only the beginning. Many businesses are involved in the lifecycle of a
drink can and all of them are, in one way or another, exposed to risk. They may have different triggers
for being interested in proper hedging, but all can increase their margin by attempting a decent or
perfect hedge on the annual production of 100 billion American aluminium cans.
Phases of production
and hedging opportunities
The thicker the arrow, the
bigger the impact of the
aluminium market and the
better the chance of
achieving a perfect hedge…
Usage phase
6 million tonnes (250 million tonnes globally)
Bauxite mining
Bauxite mining is some distance from the volatility
of aluminum markets and, furthermore, the few big
players dominating the market have enough
market share to consider the market risk of
aluminium secondary. Even so, there is a price
risk, despite the fact that only a small part of
bauxite is aluminium.
3 million tonnes
Alumina production
The higher the aluminium content, the closer
the distance to the market on exchanges like
the London Metal Exchange (LME) or
Commodity Exchange (COMEX). The number
of players in the field increases with each
step, margins become smaller, and the
interest of businesses to hedge increases.
Recycling profit
As 60% of cans are recycled
globally, recyclers seem able
to predict demand and
supply. They live by their
own pricing rules and often
deliberately only hedge part of
their risk position. Nonetheless,
market volatility and declining
margins loom as real threats,
which may push recyclers to
adopt more sophisticated
hedging strategies.
1.5 million tonnes
1.3 million
tonnes
Again, with a 12-14%
loss during can
production, most of
the loss is recycled as
scrap that will be
re-used by close-tomarket businesses.
Primary aluminium
Businesses producing primary
aluminium have maximum market
exposure. Some will have a steady
cash flow, while others will have more
volatile financial figures. In either
case, derivatives may be used to
offset exposure to risk. Their
proximity to the very liquid and
transparent market makes it
possible for them to achieve a
(nearly) perfect hedge.
390,000 tonnes
Filling phase
Not only aluminium is relevant. For example,
a can filled with cola (or similar beverage)
contains sugar: 390,000 tonnes of sugar are
needed for one billion cans, worth about
USD 130,000. Also, the paint on the can is
composed of various other exchange traded
commodities, which may be hedged.
1.4 million tonnes
Processed aluminium
With 5-10% of the sheet lost during aluminium processing and rolling, most is recycled. Since it is just as close to the market as primary
aluminium producers, even the simplest derivative – the future – may be useful. Businesses have a big interest in hedging because their
product’s value will change along with the market. Fortunately, this also means that efficient hedging is possible without much effort.
1%
The value of coke cans produced in the USA
annually is equivalent to 1% of Coca-Cola’s
market value.
USD 2.6 billion
A tonne of aluminium is worth about
USD 2,000. The cans made from that are worth
about USD 2.6 billion per year in the USA.
100 billion
Bauxite needed for 100 billion aluminium
cans is equivalent to one year’s bauxite
production in Russia.
All figures are approximate
Sources: BearingPoint; 100 billion cans – TRI-ARROWS Aluminum Inc. (http://triaa.com/Environment-Society/Recycling/Tri-Arrows-Recycling/Fun-Cans/) and Chicago Recycling Coalition
(http://www.chicagorecycling.org/aluminum.htm); Recycling percentage about 60% – American Recycler, 53% for the US (http://www.americanrecycler.com/nov03/aluminum.html) and Materials Recycling World (MRW),
63% for the EU (http://www.mrw.co.uk/news/eu-aluminium-beverage-can-recycling-hits-63/8600444.article); Eric Wootton, 1994, Case Study on Can Making, European Aluminium Association
(http://www.slideshare.net/corematerials/talat-lecture-3710-case-study-on-can-making); 250 tonnes are based on “Bauxite and Alumina Statistics and Information” by the USGS
(United States Geological Survey) and are an approximate average value (http://minerals.usgs.gov/minerals/pubs/commodity/bauxite/).
Too many metals and mining firms are using ineffective
and sometimes outdated strategies to hedge against
unfavourable price movements in commodity markets.
Often, they take past market movements as a guide to
the future. But with market volatility increasing and
margins under attack through globalization, insuring
against price risk in this way is tantamount to gambling
on the future sustainability of the business. Companies
need to revisit their risk profile and hedging strategy, and
consider updating their approach to de-risking commodities procurement.
Why more businesses should look into better
hedging
Many businesses in the metals and mining industry would say that they already insure
against unfavourable price movements in the commodities markets they are exposed to.
After all, not hedging against price risk would be the same as buying shares with the
expectation of selling them for a higher price in the future – also known as gambling.
The infographic shows how businesses at every stage in the lifecycle of even a simple
product are exposed – to a varying extent – to changing commodity prices. Huge losses
can result from adverse movements in commodity prices. Yet the hedging strategy
frequently used by metals businesses is simply to put an alloy surcharge on the base
price of the material produced. This is particularly the case in the stainless steel industry,
where material is routinely sold to customers for a relatively stable base price plus an
alloy surcharge based on past market prices of the component metals. The price to the
customer tends to be fixed monthly to ensure them a certain amount of cost security.
No one has yet found a way to
predict future market movements
just by looking at the past.
Businesses can no longer afford
to accept losses from market
movements in times of shrinking
margins.
The problem with this strategy is obviously that the alloy surcharge is based on past
exchange prices and has nothing to do with how the market price will change over the
coming month. No one has yet found a way to predict future market movements just by
looking at the past. For the last few decades the markets have been relatively stable,
with market prices in general holding steady over short time periods, and the ability to
set sufficiently high alloy surcharges has provided adequate protection against
unfavourable price movements.
In addition, the margin between the cost of the raw materials and the selling price of the
finished product has historically been high enough for the alloy surcharge to be a safe
strategy – sometimes orders of magnitude greater than the potential loss from market
changes. A producer could accept some losses from this quarter because they were small
in comparison to premiums, fees and sporadic market gains.
But this is no longer the case. Since the early 2000s, as the rapid development of China
and emerging economies caught the eye of investors, hundreds of billions of capital has
poured into the commodities markets and they have become closer to stock markets as
an investment destination. This means metals and mining firms accessing the
commodity market for the physical product face a new player on the field. Speculative
capital flows heavily influence the market’s direction and force wild swings in both
directions on bad or good news about China’s future economic growth and the latest
developments in geopolitics.
Re-evaluating risk management in the metals supply chain | White Paper 5
In addition, and perhaps even more significantly, globalization and free trade have
meant that over the past few years the industries depending on commodities have
become far more competitive and margins have shrunk. With a much tighter gap
between the cost of raw materials and the sales price of the finished product, small
losses from a bad – or no – hedge are magnified and cut deeply into profit.
The risks of bad hedging
Consider a company that makes drinks cans from sheet aluminium. Its customers
demand that a price that is valid for the whole month of May is announced at the
end of April. This company has no formal hedging strategy. At the end of April it looks
at the market prices and tries to predict the prices in May. It then builds a price,
maybe based on the average price for April, which it considers a good one and
commits to sell at that price throughout May. This may work if the market doesn’t
move much. If the aluminium price stayed largely stable in January, February, March
and April, it might stay stable in May. To be on the safe side even if the market rises,
the company adds a “safety margin” on the calculated price for May.
In the past, when the assumption of low volatility had some historical backing, that
might well have been protection enough. In modern times of high volatility – think of
the market turmoil during the subprime mortgage crisis and the subsequent financial
crisis around 2008 – this too often doesn’t work any more. Even if the price of
aluminium was constant from January to April, it might rise much higher – or rapidly
fall – in May.
For example, let’s say the price was USD 1,800 per tonne from January to April, never
rising above USD 1,850 or below USD 1,750. For most of the past 100 (or more)
years, this kind of market behaviour was enough evidence to lock in, say, USD 1,950
as the selling price for May. But what if in today’s era of volatile markets and shrinking
margins, prices rise to USD 2,500 in May? Maybe the company has to buy raw
material at short notice just as the price reaches USD 2,500, and a few days later has
to sell that very aluminium for USD 1,950. It loses USD 550 per tonne.
Of course, if prices fall significantly during May, the company profits. But it does not
know what the prices will do, so taking no steps to protect itself from unfavourable
price movements is playing a game of chance.
With market volatility increasing
and margins under attack through
globalization, ensuring against
price risk in the wrong way is
tantamount to gambling on the
future sustainability of the
business.
It is no longer possible to manage risks effectively with uncertain hedging
mechanisms such as alloy surcharges. Commodities businesses must urgently rethink
their risk management strategies and explore other, more advanced, hedging
instruments. They need to develop a coherent and well-executed hedging strategy
that limits the effects of market changes according to their needs and ensures a
stable income based on added value.
Companies must consider proper and well-executed hedging through trusted,
field-tested and comprehensible hedging instruments such as futures or options.
Hedging is not speculation. It’s just the opposite, though paradoxically many people
(and companies) are more likely to associate derivatives like futures and options with
gambling (they think derivatives, evil big banks, financial crisis, etc.) when the truth is
that outdated, over-simple risk-mitigating procedures that have no sound foundation
are much more chancy.
6 White Paper | Re-evaluating risk management in the metals supply chain
Foreign exchange swap contracts
Remarkably, many of the companies that are so careless about the risks in the
commodities markets already routinely use swaps to mitigate foreign exchange rate
risks. Consider a US-based company that needs to pay a supplier in two months’ time
for a delivery, where the contract stipulates that the payment be made in the local
currency of the supplier, which is the euro. The company has some euros available in
cash for transactions with European suppliers but, if the USD/EUR exchange rate
turns against it during the two months, it will still have to pay the contracted amount
of euros, but the USD equivalent will be much higher than expected. The difference
may well be over 1 per cent and, depending on the amount of money involved, this
may well mean a big loss for the company.
The company enters into a swap contract with its broker to fix a certain exchange rate
at the cost of a small premium. The company sells euros to its broker, receiving US
dollars in return at the current exchange rate. Simultaneously, a certain exchange rate
is agreed upon and the broker is required to sell the euros back in two months’ time at
the agreed rate. The company therefore transfers its risk of unfavourable exchange
rate changes to its broker, while the broker charges the company a premium for the
trade (and may also make additional money if the exchange rate moves in a
direction favourable to the broker, because then it can buy the euros to be sold back
to the company at a cheap price). Deciding whether the premium and the agreed
future exchange rate is worth the effort and the mitigated chance of winning in
favourable market changes is up to the company. In any case, with the swap it has
the means to buy full exchange rate certainty.
So, what does a “good” hedging strategy look like, and what are the priorities for
businesses looking to insure against risk in a way that is oriented to the future
direction of the market? And will the cost of implementing such a strategy be worth
the trouble?
This paper aims to support companies on their journey towards managing market
risk, exploring the key elements of developing a coherent hedging strategy.
How hedging works
Hedging is a process that helps companies anticipate and manage financial risk
associated with fluctuating commodity prices. A good hedging strategy will include
the use of financial instruments or derivatives that point to future market prices,
mostly futures and options. These are traded on commodity stock exchanges such as
the London Metal Exchange (LME) and Chicago Mercantile Exchange (CME), by
buying and selling certain commodities on paper while being underpinned by
physical supply and demand. Derivatives are typically used to create a counter
position that offsets a physical one and can be used to minimize unfavourable
market influence.
Futures and options are simple but
powerful derivatives that can do a
superior job at hedging when used
correctly.
Hedging with futures
Hedging with futures is very commonly used, requires little effort and is relatively
inexpensive. It works on both the sales and purchasing sides though the buying and
selling operations are reversed.
Re-evaluating risk management in the metals supply chain | White Paper 7
On the sales side, when a business buys commodities but fears that the commodity
price will fall before it sells the product, it can hedge this risk with a futures contract
due at the same time as the sale. Let’s say the company making drinks cans from
sheet aluminium fears the price of aluminium will fall between purchase of the metal
in March and sale of the cans made from it in May. It hedges this risk by selling in
March to its broker a futures contract due in May for that amount of aluminium. This
contract is between the manufacturer and its broker. The broker commits to buy in
May the contracted quantity at the futures price quoted on LME.
In a perfect hedge, gains from
physical business equal losses from
derivatives trades. Unless you
want to participate in market
movements, this is the desirable
state.
The manufacturing company is now contracted to deliver to its broker that amount of
aluminium in May. However, the broker is not interested in physical aluminium and
would charge huge fees for handling the metal itself. So before the due date, and at
the same time it sells its product, the company must buy back the futures sold to the
broker, paying the quoted futures price at the time – which will converge with the
cash price. Depending on the market situation this may result in the manufacturer
having to pay the broker the difference of purchase and sales prices, or the other way
around.
Figure 1 shows, from a sales perspective, what might happen when the aluminium
spot price and futures price go up and down. The greatest risk with futures is that the
price of aluminium rises and the company cannot sell its product in May. Then it must
buy back the futures at the increased price, without the income from sales to offset
the difference between the futures prices in March and May. It’s important to note
that hedging with futures only works best when a business can reliably forecast its
transactions.
On the purchasing side, the steps are not “sell futures, sell physically, buy back
futures”, but “buy futures, buy physically, sell futures”. A commodities owner (such as
a copper producer) may use a short hedge (sell via futures) to lock in the value of
inventory prior to transferring the title to the buyer; while a commodity user (such as
an copper tube manufacturer) would enter into a long hedge (buy via futures) to fix
acquisition costs and ensure a stable and predictable profit margin.
FIGURE 1 – HEDGING WITH FUTURES
A company manufacturing drinks cans is concerned about a decline in aluminium
prices in the near future. The time between sheet purchasing and can selling is
usually two months. Thus the cans it starts producing in March will be sold to its
customer in May at the cash price listed for aluminium plus a value-added premium
of USD 0.5 per kg. (This premium is constant and so is excluded from the following
calculations.) The company knows it will sell ten metric tonnes (mt) of cans in May.
In March, the cash price of aluminium is USD 1,800 per tonne and the price holds
steady to May:
Financial
Physical
In March, buy 10 mt aluminium
at USD 1,800 = - USD 18,000
In May, sell 10 mt cans
for USD 1,800 = USD 18,000
Physical profit or loss: 0
But suppose the cash price falls to USD 1,000 in May:
Financial
Physical
In March, buy 10 mt aluminium
at USD 1,800 = - USD 18,000
In May, sell 10 mt cans
for USD 1,000 = USD 10,000
Physical profit or loss: - USD 8,000
The manufacturer has lost USD 8,000 since March.
8 White Paper | Re-evaluating risk management in the metals supply chain
It hedges this risk with a futures contract due in May.
In March, the cash price of aluminium is USD 1,800 and the aluminium futures price
for May is USD 1,850 per metric tonne. The company sells a futures contract for ten
tonnes due in May.
In May, the cash price has dropped to USD 500 per tonne. The May futures price has
also dropped (converging with the cash price) to USD 510.
Financial
Physical
In March, sell May futures
at USD 1,850/mt = USD 18,500
In March, buy 10 mt aluminium
at USD 1,800 = - USD 18,000
In May, buy May futures
at USD 510/mt = - USD 5,100
In May, sell 10 mt cans
for USD 500 = USD 5,000
Financial profit or loss: USD 13,400
Physical profit or loss: - USD 13,000
Hedging has ensured the company made a small profit of USD 400 despite the fall in
aluminium price. (Slightly different prices in the example could have led to minor
losses in the same range.)
What if aluminium prices rose in May? Assume the cash price in May is USD 2,500 and
the futures price is USD 2,540:
Financial
Physical
In March, sell May futures
at USD 1,850/mt = USD 18,500
In March, buy 10 mt aluminium
at USD 1,800 = - USD 18,000
In May, buy May futures
at USD 2,540/mt = - USD 25,400
In May, sell 10 mt cans
for USD 2,500 = USD 25,000
Financial profit or loss: - USD 6,900
Physical profit or loss: USD 7,000
In many cases, futures can
be used to hedge price risks
appropriately. If you want to add
some extra functionality to your
hedging strategy, options are the
logical next step.
Again, the company makes a small amount of money (USD 100) and could have lost a
small amount if the prices chosen were slightly different. The financial loss incurred by
hedging has been compensated by the rising price of aluminium.
Note that this works no matter how extreme the price change and no matter how
large the quantity.
However, if the manufacturer cannot sell its cans in May:
Financial
Physical
In March, sell May futures
at USD 1,850/mt = USD 18,500
In March, buy 10 mt aluminium
at USD 1,800 = - USD 18,000
In May, buy May futures
at USD 2,540/mt = - USD 25,400
Financial profit or loss: - USD 6,900
Physical profit or loss: - USD 18,000
The total loss is USD 24,900, because it will have to buy back its futures in May despite
not selling the product.
Note that this is an extreme case and it is more likely that the company would sell
some of its output. Still, futures only work best when sales can be forecast reliably.
Hedging with options
If a company cannot forecast exactly and/or there are other risks in play besides
commodity prices, it could consider options instead of futures.
Using the same scenario as above, an option is a contract between the drinks cans
manufacturer and its broker that says the manufacturer may, but does not have to,
sell an aluminium futures contract due in May. If it decides to do so at any time
between getting the option and the due date in May, it will get paid the March price
for May futures by its broker. For this option the broker charges a small fee, since the
broker is taking some risk.
Re-evaluating risk management in the metals supply chain | White Paper 9
Figure 2 shows the figures for different scenarios as prices move up and down. The
advantage of options is that the manufacturer can let the option expire, and just pay
the broker’s fee. It does not have to sell the future until it knows that it will sell
physically. This works with both rising and falling prices. For the price of the broker’s
fee, the company’s sales are hedged in falling markets and benefit in rising markets.
Again, everything also holds true – with reversed signs – on the purchasing side.
FIGURE 2 – HEDGING WITH OPTIONS
As before, the manufacturer buys ten metric tonnes of aluminium in March to make
drinks cans. Its broker charges USD 50 per tonne as its options premium.
Futures and options are not the be
all and end all. More sophisticated
and complex derivatives and
combinations of derivatives may
be used to implement a wider
spectrum of hedge fund
strategies.
In these examples, the company does not know whether it will be able to sell its cans
in May and takes an option on May futures at USD 1,850 per tonne, paying the
broker’s fee. The manufacturer holds the option for as long as it does not know
whether it will be able to sell in May.
Say the price drops to USD 500 per tonne and at the end of April the company sells
the cans at this price, and at the same time exercises its option.
As in the example on page 9, the May futures price has dropped to USD 510 per
tonne.
Financial
Physical
In March, take option on May futures
at USD 1,850/mt – fee = - USD 500
In March, buy 10 mt aluminium
at USD 1,800 = - USD 18,000
In April, exercise option = USD 18,500
In May, sell 10 mt cans
for USD 500 = USD 5,000
In May, buy futures
at USD 510/mt = - USD 5,100
Financial profit or loss: USD 12,900
Physical profit or loss: - USD 13,000
Without knowing in March that it will sell in May, the manufacturer has realized more
or less exactly the cash price of March, losing USD 10 per tonne, or USD 100 in total.
If the market does not drop but rises to USD 2,500 per tonne, the manufacturer lets
the option expire without exercising it:
Financial
Physical
In March, take option on May futures
at USD 1,850/mt – fee = - USD 500
In March, buy 10 mt aluminium
at USD 1,800 = - USD 18,000
In May, sell 10 mt cans
for USD 500 = USD 2,500
Financial profit or loss: - USD 500
Physical profit or loss: USD 7,000
In this example, the company makes money. It participates in the market, but only if
the market moves in its favour.
Note that without buying the option, it would have made USD 700 per tonne, but
been completely exposed if the market had fallen. With this option it made USD 650
per tonne in bullish markets while being hedged in bearish markets.
More advanced hedging strategies
There are other, more sophisticated, hedging strategies that can far outperform simple
futures and basic options. For example, the straddle – combining options to maximise
participation in rising and falling markets while still mitigating risk – is the next step on
the complexity ladder. It works well if executed well, but increased performance always
comes at a cost. This is not just financial cost. Strategies involving derivatives such as
straddles require expert personnel paying close attention to the markets and taking
care of multiple derivatives.
10 White Paper | Re-evaluating risk management in the metals supply chain
Good hedging practice
There is no one “good” hedging strategy. Each business must define a hedging strategy
that is tailored to its own circumstances, and there are several factors that influence
which hedging strategy is appropriate. This paper introduces a series of steps to help
companies assess what strategy is right for them, and suggests how to put that
strategy in place.
Understand the risk position
The first step is to define the risk position and profile of the business in order to judge
how complex the hedging strategy needs to be, and how much complexity it can
afford. Before a producer or manufacturer can begin to think about hedging, it needs
to understand what and how much market risk it is exposed to.
For example, it is essential to have full knowledge of the physical transactions on both
purchase and sales sides, and to know the commodity percentage of the involved
materials. A drinks can manufacturer may rely only on aluminium to make its core
product. A crane manufacturer needs stainless steel so deals with a number of metals,
of which nickel, chrome and molybdenum are probably the most significant. Some
(such as nickel) are traded on the LME and so can easily be hedged through futures,
but the company would have to seek out a bank or broker to buy or sell a futures
contract or some similar financial instrument on the others (including chrome, which is
not LME traded).
Many metals and other
commodities are traded on liquid
and transparent markets through
exchanges like the LME. An easily
accessible market is an important
prerequisite for decent hedging.
It is then necessary to know exactly the composition of the product being sold. For
example, the crane manufacturer might assume its stainless steel contains 18% nickel
and 8% chrome, and that will indicate a particular hedge position; if an assay finds
that the composition is actually 17% nickel and 9% chrome, the risk position is
changed. The company is now over-hedged for nickel and under-hedged for chrome.
This type of business might need a hedging strategy that is able to deal with this
possibility and ensure that its hedge position is always optimized.
Another major factor in a company’s risk profile is the predictability of the business.
There are those with huge long-term contracts that buy and sell the same quantities
every year. These companies can use futures as the perfect hedging instrument and
keep their hedging costs to a minimum.
For those selling small quantities to small companies or end customers, it is a different
story. Horizons are much shorter and quantities are subject to many other variables.
For example, an aluminium company selling sheet aluminium to truck manufacturers
for the production of truck tanks is exposed not just to the market price of aluminium
but also to the vagaries of the truck market, which might be linked to the car market,
and so on. Its physical transactions are much more volatile and may not be
predictable at all. Such businesses will have to put more effort into hedging. They are
more likely to consider using options or more complex instruments, and so will need to
employ people who understand them and have the time and skills to trade them.
However, for companies that can charge huge premiums on their products, using
sophisticated and relatively expensive hedging strategies is unlikely to make much
sense. The cost of the aluminium in (say) an Apple Watch could fluctuate by a factor
of 20 and it would make little difference to the margins because of the premium an
Apple Watch commands. Few companies are this fortunate. At the other end of the
spectrum, a drinks can manufacturer may pay 45 cents for the sheet aluminium to
make a can and sell the can for 50 cents. This business will want to make sure that it
does not jeopardize a single cent more than needed by being exposed to the random
behaviour of the market.
Re-evaluating risk management in the metals supply chain | White Paper 11
Find the threshold between cost and risk
The hedging strategy should largely correspond in complexity to the physical business.
Hedging with a simple and relatively inexpensive futures strategy can work very well if
the company wants to hedge its complete risk position, and if the business is
predictable and not subject to heavy variation in purchase/sales quantities. More
sophisticated hedging strategies may offer more protection in more complex business
situations, but are more expensive to operate. A hedge is only good if its cost is
appropriate. Options are not necessarily better than futures, nor are they worse; it
depends on what the business wants to invest and what it wants to achieve.
Hedging is only worthwhile if the
costs are appropriate. Take some
time to find out what works best
for you – it will pay off eventually.
Finding the threshold between the cost of hedging and the risk of losses is another key
element in setting a hedging strategy. This depends on the individual business, how
much of a risk position it wants to be hedged, how much money is in play, market
expectations, and other factors both hard and soft. “Gut feel” is not a good way to
make decision, but the computations that can give firm figures are not trivial. For
example, the calculation of the Value at Risk (VaR) takes into account many factors
such as past market movement and the composition of the portfolio of risky assets
and their past prices. The output of the VaR calculation could be a 95% probability
that a tonne of copper that cost USD 6,000 will not lose more than USD 600 of value
within the month. Of course a VaR can never have 100% probability because there are
no guarantees in the market, but if it works 95 times out of 100, the cost will be
outweighed by the savings.
Management often shies away from putting this level of thought into its hedging
strategy because of the complexity. As a result, risky transactions are left unhedged.
Although some of these calculations may at first appear complicated, they are not
that difficult, and the effort involved is well rewarded by correctly identifying what and
how much to hedge, and how much to pay for the hedge.
Balance sales with procurement
Matching hedging on the purchasing and sales side is all-important. It is hard to align
reacting daily to market price changes on the purchasing side with fixing a selling price
that is supposed to be close to the market price for a whole month, but most
businesses cannot switch to changing selling prices daily rather than monthly – their
customers might go elsewhere. The trick is to find the balance and to anchor this
balance in the hedging strategy.
For example, a company could hedge the sales transaction as soon as it has bought
the corresponding raw material. The spread between the cash price and futures price
must be as small as possible to keep the “locked in” sales price close to the raw
material purchasing price. If it waits too long, the market may already have moved
unfavourably. The plan is to lose as little money as possible from the “buy raw material
– sell finished material” transactions combination.
The premium for this “price lock in” is extremely small, and the company is perfectly
hedged even if it has no idea if or how much it will be able to sell.
Assign ownership of the hedging strategy
Few businesses had independent risk management departments in the past and many
do not have them today. Very often, risk management tasks are dealt with by
purchasing departments, sometimes in combination with sales departments. For both,
risk management is often an additional burden to their daily work of buying or selling,
and the people involved lack the expertise and qualifications to manage risk effectively
– hence the continued use of a narrow set of hedging instruments and strategies.
Understandably, the thought of managing a strategy using futures and/or options is
often a step too far for these employees. Additionally, many companies don’t want to
put the necessary effort and investment into risk management because:
12 White Paper | Re-evaluating risk management in the metals supply chain
•they have no intention of participating in the market because they make
money by adding value and want to keep the hedging costs as low as
possible; and
•it would make them “feel” like a trader, which they do not want.
Indeed, businesses that have well-executed hedging strategies tend to have
established hedging departments. For hedging to work properly, the metals and
mining community must be as sophisticated in its knowledge of the commodity
markets as speculators – because very often they are on the opposite side of the
derivatives trades, and a company is in a weaker position if it cannot match up to a
trading partner. That means investing in a dedicated hedging team of people who
understand what they are trading, can operate on their own, and are equipped with
appropriate software tools. Experienced risk managers in the hedging department
understand the different hedging instruments and can assess their usefulness. For
example, they are able to value an option correctly and not rely on others who might
have tweaked the variables in their favour.
It’s essential that the risk management, sales and purchasing departments establish
ways of working together and that responsibilities are clearly assigned. The hedging
department gives to the sales team a price that is insured with hedging instruments,
such as futures or options, and the sales department adds a premium to that price so
that the transaction is profitable. If they can’t sell at that price because they can only
keep the customer if they sell for less, too bad – and the lost profits will not be
attributed to “the market” but to those who are responsible, in this case the sales
department.
Developing a solid hedging
strategy to make the market work
in your favor should be at the top
of your list. But don’t forget about
the effective implementation of
your hedging guidelines.
Set up the necessary systems and software
Today, using standard spreadsheets for hedging purposes is unlikely to be adequate,
given the magnitude of transactions and inventory changes made by even the
smallest of businesses. Furthermore, physical transactions need to be recorded as soon
as possible because only then can the hedging process be triggered – if the purchasing
department buys something today and only records the order in the system two weeks
later, the risk management department cannot efficiently hedge because they do not
know about the new risk. It’s vital to have instant access to up-to-date market prices
as well as to keep track of current hedges, delivery dates of futures contracts, due
dates of options, and so on.
The sheer volume and, very often, speed of information that is involved in sound
hedging indicates that the process should be implemented in an integrated ERP
software system, typically SAP, above all to ensure traceability and auditability. There
is no other way to handle 100 sales transactions per day that all need a metal price
from the risk management team, 30 requesting it by phone, 50 by email and the
remaining 20 over lunch or the office grapevine. An integrated system can keep track
of physical transactions, inventory changes, movements of goods and market price
changes. It can also handle all invoices from suppliers and invoices to customers –
posting them to the controlling department and to finance – as well as broker
settlements, invoices, and credit and debit notes.
An ERP system is the best solution for integrated processes, but is not without
challenges. For example, to perform well in the volatile metals markets, it’s necessary
to hedge at the level of individual metals; and that implies adding the metals level to
each material in the system. It is possible to “teach” an ERP system to deal not only
with materials but also with their composition. A company can sell “tubes” to its
customers, and the system will know they are composed of copper and zinc, provide
the risk management team with the figures they need to come up with a price and an
implied risk position for copper and zinc, and buy futures in those metals.
Re-evaluating risk management in the metals supply chain | White Paper 13
Conclusion
In today’s era of volatile markets and narrow margins, we recommend every business
in the metals industry value chain re-evaluate its hedging strategy. The urgency is
particularly high if companies still rely on insufficient strategies such as an alloy
surcharge. The recommendations laid out in this paper demonstrate that it is not that
hard to design a relatively simple but effective hedging strategy as a start.
It’s time for businesses to stop wondering why they lose money despite having what
they think is a hedging strategy in place. Market movements cannot be predicted, so
any strategy based on past markets projected to the future will eventually, with time
or increasing quantity, fail. But fortunately there are strategies that are marketoriented and do work. Some of these strategies are explained above, and any business
should be able to find the one most suited to its circumstances.
The appropriate execution of any of these strategies can only be ensured if
implemented well and supported by software. Risk management processes are closely
linked with logistic processes and should be considered just as carefully and
implemented with the same level of attention. Hedging strategies, like logistics and
financial processes before them, have become more complex and more effective and,
consequently, are moving on from depending on simple spreadsheets to sophisticated
ERP systems. A company that has invested time and effort in developing a hedging
strategy will find that the implementation of that strategy will require an integrated
system where all processes – including logistic processes, which are the obvious trigger
for hedging, and actual hedging processes such as buying and selling derivatives,
providing hedged prices to sales departments, and maintaining broker relationships
– are available side by side.
We recommend every business, whatever its current hedging practices, to revisit its
strategy and consider an updated approach to de-risking commodities supply chain
management.
WHY BEARINGPOINT?
•We help businesses find a way to identify their risk positions
•We provide consulting and help identify the best hedging strategy for
businesses
•We are able to still their fears of sophisticated hedging instruments and
strategies
•We define processes to implement hedging in an integrated way and
design best practices
•We provide software, and consulting around the software, to do this and
we help businesses find the best approach from a software/technical point
of view
.
14 White Paper | Re-evaluating risk management in the metals supply chain
Committed consultants with
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BearingPoint consultants understand that the world of business
changes constantly and that the resulting complexities demand
intelligent and adaptive solutions. Our clients, whether in
commercial or financial industries or in government, experience real
results when they work with us. We combine industry, operational
and technology skills with relevant proprietary and other assets in
order to tailor solutions for each client’s individual challenges. This
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and engage with them for measurable results and long-lasting
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For more information, visit our website www.bearingpoint.com.
Contact
Andreas Buegers
T +49 211 17143 4495
M +49 172 8168 420
[email protected]
Karsten Kohl
T +41 43 299 6453
M +41 79 714 3285
E [email protected]
Gero Brockschnieder
T +49 30 88004 5849
M +49 175 1141 976
E [email protected]
www.bearingpoint.com
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