Commodity crisis

Gain clarity with SkySparc

Turmoil on the international commodity markets has increased since the Russian invasion of Ukraine, further delaying return to the stability as seen before the outbreak of Covid-19. In addition to energy and agricultural product prices soaring, prices of precious metals and other industrial production inputs such as uranium, nickel and aluminum have risen strongly. On March 8th 2022 the Dow Jones Commodity Index (DJCI) reached an all-time high, up 189% since the pandemic low in April 2020 and up 95% since the quarterly high before the outbreak of the pandemic in January 2020.

Commodity price increases could have strong impact on the profit margins of companies and cause cash flow fluctuations. To mitigate effects of the volatility on the business, corporates could hedge their commodity exposures. When done well, financial, strategic and operational benefits can go beyond merely avoiding financial distress by opening up for value preservation and creation. But done poorly, hedging in commodities could overwhelm the logic behind it and destroy more value than was originally at risk.

It is important to make a comprehensive commodity risk analysis on the whole business. In large corporations, business units largely working independently from one another could already have opposing exposures to some degree. If one business department in such an organization chooses to hedge its own position, unaware of exposures of other departments, total company exposure might be increased rather than netted out. It is therefore important to hedge net exposure rather than exposure, and to remember to include the whole corporation in such an analysis.

Examples of financial products that can be used for commodity price hedging are options, futures and forwards, either cash or physically settled. Using exchange-traded derivative contracts tends to reduce the cost of hedging as compared to undertaking an over-the-counter (OTC) derivative contract, especially when the traded contract is highly liquid. This is largely attributed to the lower spreads on quoted derivative prices for exchange-traded contracts, since they do not require additional negotiation compared to OTC trades. This is essential for companies that cannot pass the costs of commodity price fluctuations on to their customers due to competition and other market pressures. Another benefit of exchange-traded contracts is that they often can be closed out prior to maturity.

One downside with exchange-traded derivatives is that they cannot be tailored as closely to the exposures of the subject company as is possible with OTC contracts. For example, the hedge instrument might not be a perfect counter-exposure to the hedged position, or the maturity of the hedge contract does not perfectly match the hedged exposure. In other words, risk from potential mismatch between the hedge instrument and the hedged exposure might arise, also known as basis risk.

A corporate commodity hedging strategy should be part of the Treasury hedging policy. In current IT environments (including Treasury and Risk Management Systems and Data Warehouses), Treasury should be able to closely monitor the company’s commodity risk and act accordingly. SkySparc can help in developing the commodity hedging process, acting as a ‘sparring partner’ in the commodity hedging design phase. SkySparc can help define the data needed and the IT landscape supporting the hedging strategy and build up the data structure to analyze the exposures (for example through a Data Warehouse). We have experience with different technologies enabling such capabilities, including third-party systems and our proprietary solution OmniFi. Once the data has been aggregated and structured, SkySparc can help with the development of analysis reports and automation of the processes for the hedge transactions. This can be realized through a Commodity Trading System or a Treasury and Risk Management System, ranging from high-end systems that have specialized in Commodity Trading, to systems that need a workaround set-up. Beside system configurations we also help clients in the development of interfaces (for example to ERP systems, the Data Warehouse or trading platforms).

To learn more, contact us.