Trading the price risk versus building a competitive edge
In previous articles (visit our Insights page here) we have covered commodity price risk management from the perspective of the producer. For this sector the decision on whether and how to hedge is driven by a budgetary or return on capital targets and hedging activity is therefore focused on maximisation of revenue. By contrast, the universe of explicit or indirect commodity consumers, which includes virtually every corporation and individual in the world, dwarfs the number of commodity producers. Commodities are literally the raw materials for the production of everything. However, sophisticated hedging programmes are only effective above a certain scale and hence these techniques will be applicable up to the wholesale level but not at scales below this. As we shall see in the discussion that follows, the commodity consumer’s decision on whether and how to hedge is less straight forward.
Commodity consumers can be split into two broad groups, each having a distinct commodity price risk profile and therefore requiring different strategies for risk management.
Firstly let’s consider those consumers for whom the commodity in question is essentially both the input and the output. Their role is in the transformation of a Primary Commodity into a more refined or value-added form (a Secondary Commodity). Examples would be an oil refinery which takes in crude oil and ‘cracks’ it into refined products, or a jewellery fabricator that buys gold bullion and turns it into jewellery. Because what they are selling is a commodity with a clearly observable market price, the oil refiner or jewellery fabricator can use commodity derivative markets to hedge both their commodity inputs and outputs
The oil refiner could achieve this by selling Crack Spreads to lock in its Refining Margin; that is buying crude oil swaps to hedge its input costs and simultaneously selling the relevant amount and type of Refined Product swaps to hedge the price of its outputs (the topic of crack spreads is vastly more nuanced than the simplified explanation provided here and will be the subject of a separate future article). Dependent on the state of the crack spread market, a refinery will constantly adjust its physical operating parameters to maximise the net revenue it can produce. In favourable markets processing is ramped up to capacity whilst in less favourable markets the processing will be slowed down accordingly. Forward markets are used proactively to lock-in attractive rates when they are available. A refinery therefore is effectively a physical option on the crack spread markets and its revenue stream can be valued that way.
For the jewellery fabricator the strategy is a little simpler as both the input and output price are calculated using the same gold reference price. The jewellery fabricator takes on gold price risk from the moment it buys the bullion pre-fabrication until the point of sale of the jewellery, a date which may be unknown.
The discussion becomes more complicated when we consider the second group of commodity consumers. This group consists of companies for whom a commodity is a meaningful input or cost of doing business, but who cannot simply pass on this cost in the sale of their final product or service. Some good examples would be airlines and jet fuel, shipping companies and fuel oil, and auto manufacturers and metals.
Global airlines’ fuel costs are expected to be approximately 24% of overall expenditure in 2019, a number that was as high as 33% in 2013source. In an industry where margins are slender to begin with, eliminating the uncertainty around this major cost is critical. However, the airline must tread a fine line between protecting against margin erosion should fuel prices rise, and being locked into high price fuel hedges should prices fall, potentially rendering them uncompetitive against rival carriers. Their decision is further compounded by the lack of liquid jet fuel derivative market which thus introduces additional Basis Risk when the airline decides to use crude oil or Distillate hedges instead.
An effective hedging strategy will consider their programme from three aspects:
- Volumes: Volumes up to 100% of calculated fuel consumption based on load-factor utilisation can be used for short term hedging decisions, with this volume stepping down at intervals as the consumption forecast becomes more uncertain.
- Choice of Instrument: Risk appetite, business model, and strength of confidence in market direction will inform the choice of hedging structure, starting with the outright purchase of Call Options (least confident), through Three-ways (medium) to Collars (more confident) to Swaps (most confident).
- Underlying Index: An airline could use Jet Fuel for near-term hedges, but use Gas Oil or Crude Oil forwards on longer-term hedges. There is a trade-off between Liquidity and Basis Risk that has to be considered. The liquidity of longer term Crude Oil hedging is generally valued more highly than the potential cost of the Basis Risk it introduces
*Labels in Red: long-term markets; Labels in Green: near-term markets
In a similar fashion a shipping company will risk-manage its fuel oil costs to lock in freight margins. This is a particularly pertinent topic for the shipping industry currently with the International Maritime Organisation (IMO) set to enforce a new 0.5% global sulphur cap on fuel content, down from the present 3.5% limit. This regulatory change has had a colossal change in the forward marine fuel demand characteristics increasing the volatility of the price differentials between Low sulfur Fuel, high sulfur Fuel, and Gasoil prices. Refinery and storage supply-side responses to this are complicated by the uncertainties on how shipping companies will formulate their compliance strategies.
Although there are ramifications for bunker fuel suppliers and refineries (the middlemen in this supply line), in this paper we focus solely on the impacts on the shipping industry.
There are two main strategic avenues a shipping company can travel to comply wth IMO2020:
- Commence using compliant fuel from implementation date and base it’s hedging programme around that index. Compliant fuel can be either 0.5% sulphur Fuel Oil, suitable Marine Gas Oil, other suitable blend of Gasoil/Fuel Oil, or LNG.
- Continue to use the non-compliant high-sulphur Fuel Oil and install ‘Scrubbers’ (an emissions abatement technology) on-board their vessels on the assumption that the investment in the machinery ($5m-$10m/vessel) is substantially less than the price-differential between the high and low sulphur fuel oils
For strategy 1, a shipping company can use similar techniques to an airline except that it can assume the benefit of some natural embedded netting. A shipping company is essentially Long Freight Forwards (the price of Freight is valued along a pricing Term Structure) and short Fuel Oil. Once the net position has been established the same three aspects (as per an airline) can then be considered in the construction of an effective hedging programme.
This second group of consumers will often be dynamic in adjusting hedging as markets allow and will typically be able to employ extra sophisticated hedging instruments to more closely reflect the inherent risks and the competitive nature of their industry. This may includes spread options or barrier options which have properties that provide hedging capabilities to offset their exposure with greater precision. For true consumers of commodities, a well-designed hedging programme can become a competitive advantage.
One final notable point: like insurance, a well considered and structured hedging policy will view this function to be a cost-centre and not a profit-centre. It is commonplace to read in the press, shareholder criticism of the cost of hedging that often views cash payouts made under these arrangements in isolation whilst ignoring the benefits of the cheaper refined product that the organisation was able to procure. In any situation where there is less than 100% hedging a lower price will always be of net-benefit to the consumer. An organised and systematic hedging programme should eliminate much of the price risk and build competitive advantage over the long term.
So for companies for whom a commodity is a significant input or cost of doing business the primary purpose of their hedging programme is to manage the liabilities of the firm but used wisely can become a major commercial advantage.
As we have hopefully shown, the decision of whether and how a commodity consumer should hedge is complex although for the purposes of this introduction we have restricted our focus to the broader and simpler concepts.
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This article was first published by Inside Out Advisors on 5th March 2019
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