Treasury, backed by the C-Suite and Chatham Financial, worked with procurement to better manage commodity risk exposure.
Starting or reviving a commodities hedging program requires risk managers in treasury to collaborate with procurement teams and secure the backing of the C-Suite to overcome challenges in securing changes in contracts that facilitate the use of hedge accounting. In addition, some corporates will benefit from having a knowledgeable advisor help navigate the complexities of hedging commodities.
- Those are few of the takeaways from the first meeting of NeuGroup’s Commodities Working Group, which focused on the commodities hedging program at Polaris, a NeuGroup member company that makes off-road, on-road and marine products.
- At the session, advisors from Chatham Financial joined Matt Koller, a Polaris treasury manager who oversees currency, interest rate and commodities hedging. Polaris engaged Chatham to help it hedge commodities.
- A growing number of NeuGroup member companies have discussed hedging commodities in the past two years amid rising costs and their negative effects on corporate earnings. Recent declines in some commodity prices have not dampened interest in the topic, even if some risk managers face more questions about timing.
A cross-functional hedging program empowered by the C-Suite. Polaris had dabbled in commodities hedging in years past but had paused the program, in part because of the impact on earnings from mark-to-market accounting prior to the ability to apply hedge accounting to commodities. The significant headwinds created by rising prices for base metals including steel led to new conversations with executive leadership about mitigating the risk of price volatility.
- With backing and direction from the CFO, Mr. Koller’s team engaged Chatham on the feasibility of reducing risk through hedging and the risk of not hedging. Chatham helped visualize the impact of remaining unhedged by looking at the historical price ranges of commodities through the lens of outcomes that were possible, probable and expected. “We were not comfortable with the unhedged basis,” Mr. Koller said.
- The full support of senior finance executives helped treasury conduct some challenging conversations with the procurement, or sourcing, team about modifying existing contracts—including those settled with a handshake—to include indices and be eligible for hedge accounting—a condition of the program Polaris established. Discussions between executive leaders from sourcing and finance helped pave the way for contract changes.
Risks, objectives and alignment. Treasury needs to dig into the risks (and embedded derivatives in some cases) within commodities contracts and define a corporate’s exposure, its size and the indices related to it, Chatham director Matt McGill said. Chatham begins by identifying and consolidating all of the exposures that may lurk in various contracts.
- Quantifying risk includes measuring how movements in, say, metals prices, will affect a corporate’s expenses and bottom line. Statistics help decide “if the juice is worth the squeeze,” as Mr. McGill said.
- Objectives for programs range from capping costs, fixing them or establishing a budget rate for the commodity. “The objectives are not as simple as FX and interest rate hedging programs,” Mr. McGill said.
- The complexity in part reflects differing objectives of stakeholders affected by a commodities hedging program: procurement wants to reduce costs; treasury wants to reduce exposures; and accounting wants to reduce volatility on the income statement. These three groups, Mr. McGill said, “have to get aligned.”
- At Polaris, clarity and alignment on the objective of using the hedging program to reduce risk and volatility in addition to minimizing cost was critical to establishing a program that will prepare the company for future periods of significant price volatility, Mr. Koller said.
Keeping it simple, transparent. While Chatham helped Polaris understand the potential benefits of using at-the-money calls, collar strategies and more complicated approaches, Polaris decided to go with a swaps strategy for hedging commodity risk. “We want to keep it pretty vanilla,” Mr. Koller said. Mr. McGill said using less exotic products often results in “the most effective accounting” outcomes for corporates.
- Polaris uses Chatham to: initiate trades Polaris executes with banks within its credit facility experienced in commodities trading; measure the effectiveness of its hedges and help with reporting; and determine how long a hedge stays in other comprehensive income (OCI) before being released to the P&L.
- Mr. Koller said it’s important that business units and executive leadership are not surprised if cash flow hedges produce losses when the underlying commodity price declines. The good news is that lower prices for the commodity will help offset the losses to some extent.
- In the same vein, it’s essential to be clear with the C-Suite on the objective of the hedging program and make clear, for example, a given time may not be optimal to layer on hedges for 80% of the company’s exposure. But it’s also key to keep the program in place no matter what direction prices head and avoid market timing.
- Mr. Koller recommended peers give themselves “plenty of runway” to start a program. Polaris started the process about 18 months ago. It took six months, Mr. Koller said, to put hedge designation memos in place for hedge accounting and to update documentation and connections with banks regarding ISDAs.
Follow a road map. The implementation road map in Chatham’s presentation listed these five steps:
- Define the risk profile.
- Quantify the economic risk.
- Establish institutional objectives.
- Evaluate available strategies.
- Implement a competitive program.
Questions to answer. To establish an effective commodities risk management program, Chatham identified three main areas of activities and decision-making: economics, accounting and operations. Within each category were questions, including:
- What is the worst-case financial impact of a given exposure?
- Can suppliers offer fixed pricing? If so, your hedging needs may be reduced.
- How much risk can be mitigated through hedging given forecasting and accounting constraints?
- Is the commodities contract a derivative?
- Do we need to minimize the P&L impacts of hedging?
- Is the contractually specified component in a contract eligible to be hedged?
- What is the optimal hedge strategy given the objectives and constraints?
- What tools do we need to manage the program?
- What metrics will be used to measure program effectiveness?
- How will we report program performance to key stakeholders?
Key accounting elements. Chatham listed these six aspects of accounting when hedging commodities, which can be complex, in part because not all commodity indices are liquid and forwards aren’t always available. This can result in proxy hedges or additional charges.
- Contractually specified risk. Understand if contracts have a specified index included in the pricing.
- Derivative qualification. If a contract qualifies as derivative, can normal purchase, normal sale (NPNS) be applied?
- Multiple indices. Need to prove correlation and pool into single designation.
- Exposure window. Compare historical forecasts vs. actuals to determine probability assertion window.
- Effectiveness assessment. Identify the index of the hedging instrument and test effectiveness vs. a hypothetical derivative.
- Exposure lifecycle review. Perform a walkthrough of the exposure to determine proper lifecycle events.