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Risk Management

Applying a Holistic Approach to Commodity Hedging

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August 20, 2018

Chatham Financial explains holistic hedging amid jump in commodity prices

football x's and o'sThe price of Brent crude oil jumped more than 70% between June 2017 and June of this year while the price of aluminum climbed from under $1,500 a ton in early 2016 to more than $2,400 a ton in April—an approximately 60% jump—before falling to around $2,100 by mid-August. Then there’s the 10% tariff on aluminum imports imposed by the Trump administration.

The significantly higher costs for some commodities present big challenges for many companies, especially those in competitive, thin-margin industries such beverages, and they are no doubt prompting some to reevaluate their hedging strategies.

Bryant Lee, a director on Chatham Financial’s risk-management team, said his firm saw a jump in corporate clients seeking to review their hedging strategies in 2018, as FASB finalizes guidance for new hedge accounting rules that go into effect at the start of 2019. The Trump administration’s trade policy and overall approach to global politics have since provided another prompt.

Emphasizing the apolitical nature of his statement, Mr. Lee said that “there is significantly greater uncertainty relative to the markets with the current administration compared to the previous, particularly when it comes to tariffs.”

Chatham Financial specializes in supporting companies’ efforts to hedge such uncertainty, so iTreasurer requested Mr. Lee to explain how the Kennett Square, PA-based firm works with companies to determine their hedging needs. The key to hedging, Mr. Lee said, is to remove the uncertainty in futures prices, and as the threat of a trade war grows, enable US companies to compete against competitors who may not face tariffs. He noted that Chatham Financial works with several consumer packaged-goods companies in the beverage business that are affected by the changing prices of commodities including aluminum, resin, sweeteners and fuel.

“They have some of it hedged and some not, so we’ve helped them to think about their hedging programs more holistically,” Mr. Lee said.

That means considering not just a hedge’s gains and losses relative to the hedged item, but how much the price of aluminum and/or other relevant commodities can move before impacting the company’s profit margins.

For example, Chatham Financial’s clients in the precious-metals mining business typically do not hedge the metals themselves, because they want that exposure. But, in the case of silver miners, they will hedge the price of mining byproducts, such lead and nickel.

“They’ll hedge those metals off and let the earnings reflect to some extent the volatility in silver, without the extreme volatility of directly holding silver,” Mr. Lee said.

In the case of beverage companies, they’ll hedge the various commodities that go into producing the drinks—the volatile inputs—because the competitive nature of the industry gives little room to increase prices. Mr. Lee noted that beer prices have barely budged even though the price of aluminum has leaped. Nevertheless, it is important for corporate finance to understand the extent to which their companies can absorb price increases.

For example, if a beverage company’s plan to make a gross profit of $100 million includes spending $20 million on aluminum, but it determines that the cost of the metal could swing between $30 million and $10 million, resulting in earnings ranging between $90 million and $110 million, is that acceptable? Then, if adding potentially higher costs for sweetener and the fuel to distribute the drinks widens the earnings range to between $60 million and$140 million, do investors and other stakeholders concur with taking on that risk?

“If not, the company has to look at each of those drivers of risk and determine what is acceptable. If it has risk of $40 million and the acceptable range is between $85 million and $115 million, how does it get the risk down to $15 million,” Mr. Lee said. “What’s the most efficient way to do that? Maybe it’s hedging two or all three of those factors.”

Mr. Lee called mortgages an appropriate analogy. If payments on a variable-rate mortgage could increase by $1000 a month, some homeowners will find that risk unacceptable and decide to pay more now for a fixed rate mortgage. “That’s the core [benefit] of a hedging program. Over the long haul, if you hedge, you’ll pay more than if you just floated with the market. But what you’re getting in exchange is certainty about future prices,” Mr. Lee said. “So the question becomes: Is that certainty worth the price I’m paying?”

Mr. Lee said the price to hedge commodities should remain about the same even when the commodities’ prices are rising—similar to the fee for locking in a mortgage loan as rates rise—and increase only if the “cone” of uncertainty about where prices are going widens. Enter Trump Administration policies and the geopolitical climate overall.

“The cone has widened, the uncertainty in the future is greater, so it’s becoming more expensive to hedge,” Mr. Lee said.

Chatham Financial doesn’t try to predict where commodity prices are headed. Rather, it does a statistical analysis based on the market’s past performance to determine how high or low prices are most likely to go over a certain time period. Supply and demand factors do not come into the equation, which is purely mathematical.

“Clients ask, ‘What would have to happen to make the price rise,’ and we say that we have no idea what’s coming in the market. We’re just telling you that based on what we’ve seen over the last two years, this is the range we think we could find ourselves in six months,” Mr. Lee said.

He said a major challenge is that clients often will view hedges out of context. For example, a company may hedge 25% of an exposure to copper and then fret when the price falls and it loses $1 million, although the remaining 75% will be $3 million less expensive to purchase. However, if the price rises the customer benefits on the 25% it hedged but pays more for the rest.

“Think about a roller coaster … hedging reduces the heights of the hills and the drops. If those ups and downs represent risks and rewards, and the company just can’t take all the risk because it’s not financial strong enough to absorb it in-house, then it has to flatten out the peaks and valleys,” Mr. Lee said.

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