Redbridge and FIS held a round-table discussion on Thursday 25th June 2020 with:
Alessandro Mauro, MKS
Mihai Andreoiu, Redbridge
Roger Frost and Alex Hofmann, FIS
To listen the complete recording on Webex, please click on the link below :
The world has changed as a result of Covid-19 in ways which we do not yet fully comprehend. This round-table discussion focused on commodity-intensive corporates and the challenges they face in a volatile market. It may be worth defining what we mean by a commodity-intensive corporate: these are typically companies which purchase large quantities of commodities and transform them into finished products although many of the strategies which we will discuss apply equally to producers and traders.
Lockdown has resulted in the greatest global economic downturn since the great depression and the global economy is forecasted to contract by 5.2%. In this webinar, we will focus on the areas of commodity risk management which have been most affected by changes to the business environment caused by the Covid-19 pandemic and these include:
- Hedging strategies for coping with fluctuating sales forecasts
- Automation of trade execution
- Strategies for coping with Increased price volatility and rapidly changing order-books
- Changes in trade finance, supply chain financing and credit lines
- Accelerating trend towards SaaS in treasury and commodity management systems
- Measuring commodity exposure across a diversified product line
Question 1. The importance of pre-trade analysis
FIS provides commodity trading risk management (CTRM) systems to a large number of corporates, but on the whole our systems are not used extensively for pre-trade analysis. What would you recommend that risk managers do to make better use of their systems pre-trade as opposed to after the hedges have been booked?
Pre-trade analysis is fundamental to a successful hedging strategy: without doing advanced scenario analysis based on changes in FX, interest rates and forward prices, you are taking on substantially increased risk and you may not even be aware that you are taking this risk.
Pre-trade analysis requires a lot of data and new data is becoming available all the time, but not all of it is useful. Data providers have an incentive to sell their data, but this data is not always very useful in pre-trade analysis. A competitive advantage comes from non-standard sources of data, while low quality data can be worse than having no data at all. If you have non-standard data, whether it is ‘big data’ or non-time series data, you must be able to drilldown into the data for any given task.
In order to interpret how your non-standard data is likely to affect your commodity exposure, you need to build additional price curves including eg physical premiums to see the cash impact on your portfolio. You need to consider price and volume changes when building your curves: you need the cash to be available as well as agreed credit facilities.
Question 2. The trend towards automated hedge execution
Has the current crisis accelerated the trend towards automated hedge execution of FX and commodity trades?
Automatic hedge execution is more important than ever before because we are seeing more and bigger price shocks than in the past. For example, in April 2020, the price of the CME WTI future turned negative on the day before expiry of the May contract after losing $55 per barrel in a single day, caused by a shortage of storage facilities. In the gold business, at the end of March 2020, the spread on the EFP trade (the EFP in gold is an Exchange For Physical comparing the future price traded on the CME vs the spot price traded in London); jumped from a few dollars to $70. When you have price shocks of this magnitude, you need to automate your hedge execution strategy, in particular if you are a commodity buyer which can not continuously monitor market conditions is real-time. In this context, technology is a crucial enabler.
It is important to highlight that we are talking about automating hedging transactions using financial derivatives. (The possibility with physical transactions is much more limited, especially for non-centralised non-electronic markets).
From an IT standpoint, hedge execution is already possible in FX and commodities: you need to have quality forecast production data, merge that with existing hedges to calculate current exposures, AND combine that with company’s hedging policies. AND you need automated integration with exchange platforms, FX platforms or Bloomberg.
Queston 3. Monitor & Control
What is the best measure of risk for a corporate treasurer? Is it VaR, CfaR or hedge ratios?
Before you start thinking about using VaR or CfaR, it is essential that you identify all of your risks forensically. Successful hedging policies based on VaR or CfaR models are not implemented overnight. If you have already have a VaR model up and running, then this is an excellent starting point. Having said that, managing the additional adoption of a CfaR is a good idea because it will enable you to attach probabilities to future cashflows.
In our experience, most corporates have simpler ways of measuring risk and they still use hedge ratios to control their risk. A hedge ratio shows how much of your forecast consumption has already been covered with hedges and the hedging team must hit these ratios at different points in the production lifecycle (the ratios are likely to rise as you get closer to delivery).
Some of our more advanced clients have started creating multi-dimensional VaR reports which include FX and commodities; these reports are then broken out by different sections of risk. For example, VaR limits can be applied geographically, by operating unit or by trader and limits are set according to these siloes of risk. VaR models have the obvious benefit of taking into account historical market behaviours, making it easier for the risk manager to control their exposure based on the recent past. You can go far with VaR!
Question 4. Business benefits
What are the tangible benefits of implementing a technological solution to managing commodity price risk?
At Redbridge, we see clients embarking on two types of journey:
- Corporates which do not yet have a formal company-wide hedging policy come to us to help them to define their policy in terms of identifying, quantifying and managing their hedging policy. We continue to meet with many corporates which do not hedge today: they take things as they come.
- For corporates which are already hedging, we help with operational transformation and change management. For example, we helped a large Geneva-based metals company to instigate structural change to their systems as they were split off from their parent company. We helped them to create the Target Operating Model for their TMS and FX platforms and we helped them to integrate these with the rest of their IT systems. And we managed the negotiation with the vendors, all in a short timeframe.
At FIS, we have helped many corporates with simple challenges, such as removing the manual creation and maintenance of reports in Excel; this frees up staff time to analyse and act upon the data. Removing manual processes and speeding up month-end reporting improves companies’ control of risk allowing them to get a better view of core business. Strong hedging policies which have been well implemented allow you to remove noise caused by market price fluctuations.
Question 4. Risk Management Strategy
With increasing market volatility and the chance that commodity prices could fall again if we face a second wave of Covid-19, is there a place for options in a corporate hedging strategy?
From a purely theoretical point of view, options sizeably enhance the number of payoffs available to investors and, in this way, they “complete the market”. From an operational point of view, a static option strategy can allow you to efficiently enter or exist strategies at pre-selected price level. It is rather simple to put this in place and this can be attractive to commodity end-users. Many customers are worried about making an upfront payment at the start of the contract (the premium), but for many corporates, it makes a lot of sense to use a simple option strategy.
If your business is trading commodities, (rather than transforming them into an end product), then you will need a more advanced strategy to monitor in real-time the price and volatility of the underlying, the Greeks, etc. It is a much more specialized job, which requires subject matter experts and proper IT systems.
If we look at the fall in the price of oil and refined products, if you are a consumer of these products, either as an airline or a logistics company, then purchasing outright call options would have offered far better value than futures in the case of a dramatic fall in prices. No-one would have priced in current levels of volatility into the premium last year when they would have bought the options, so the option premium cost would have been manageable.
One reason why corporates don’t often use options is because the option premium must be paid upfront and this will impact the balance sheet with no guaranteed return (and shareholders don’t like that!) That’s why airlines and logistics companies tend to trade swaps using zero cost collars but if you expect volatility to rise, then spending money upfront on an option premium will almost always be money well spent.
Question 5. Trends in supply chain finance
What trends are you seeing in trade finance and supply chain finance in light of the current crisis? Have credit lines been affected and is credit insurance in greater demand?
For Redbridge, trade finance is a discipline and supply chain finance is a sub-section of that. Cheap bank or capital markets finance is not always easy to access, so debt financing which is backed by receivables and inventories can be very attractive to many corporates and to the banks which provide the finance, especially if they are covered by credit insurance. Structuring the finance agreement plays the most important role: the better structure, the lower the pricing. However, there will be upward pressure on pricing (with potential higher regulatory capital requirements) and more stringent structuring requirements.
With some recent defaults in the Asian energy space, structuring has become even more important and certain banks have closed for new business and only manage their current exposure. Corporates seeking supply chain finance solutions need to better understand the risk perception that banks have of the credit risk and structure risk: in the case of suppliers, finance for their own company, in the case of receivables, finance for their off-takers / clients. Credit allocation for supply chain finance is often also a political decision within banks as direct relationship lending is often preferred.
Credit insurance is often added as further risk mitigation. Corporates must try and understand the risk appetites of their banks. Those who do trade finance or supply chain finance may not be at the head of the queue! Corporate treasurers should assess the right mix of risky unsecured lending vs risk-mitigated lending based on working capital finance using payables, receivables and inventories). Lower commodity prices will also mean less revenue for the same physical volumes hence banks will return hungrier than before. However, they will come back.
Supply chain finance i.e. supplier finance and receivables finance will continue to develop with the help of alternative lenders, dedicated providers and technology advancement. An effective TMS will show you the use of facilities which can be allocated against specific trades or groups of trades, to help you manage your financing.
Question 6. Measuring the commodity content of items in the supply chain:
How can commodity-intensive corporates measure their commodity exposure if their commodities are tied up in SKUs in a factory ERP system?
Getting production forecast data into your CTRM system is vital. We have seen a trend for CPG (Consumer Packaging Group) companies to merge their commodity procurement analysis into their CTRM system. This provides detailed analysis of their procurement performance and links this data directly to the commodity forecasting used by Treasury to hedge their exposure.
By giving the system a breakdown of every Stock Keeping Unit or SKU, it can automatically create the commodity forecasts. This means that the forecasts are updated immediately when a change in demand is seen by procurement at the factory rather than on a monthly or quarterly basis.