Future Commodity Price Risk Can Damage Your Company’s Liquidity
that hedging future commodity price risk is something to consider, only
if you guard against the chance that the
outcome could damage your company’s liquidity and/or its competitive
you are a producer of an energy commodity or a consumer of wholesale
quantities of natural gas, electricity, coal, aviation fuel, or diesel
(for example) the prospect of fixing the future price at which you will
be able to sell or source such commodity is very attractive.
This is especially the case for your Financial Accountant, who is
keen to produce a neat and tidy three year budget.
However dangers lurk, not only should you consider counterparty
future failure risk (failure to perform contract obligations and/or
failure to pay) you must consider your competitors.
If you hedge and your competitor does not, you will either win or
lose; that is, if market prices move against you, your competitor will
take advantage and you will stand to lose market share and profit.
On the other hand, if prices move in your favour (that is to say
your hedge protects you from an adverse price movement) you will be able
to trump your competitor, at least in the short term.
win or lose ‘gamble’ involved is the reason many businesses either
decline to hedge (decline to agree fixed price future delivery or supply
contracts, or derivatives that achieve the same end) or hedge only a
proportion of requirements.
a decision is made to hedge, a business selling a product faces
counterparty risk in two respects; namely, performance risk and payment
risk. If a buyer, the
hedging business incurs counterparty performance risk exposure.
risk can be quantified daily, by reference to market prices, in order to
deduce the difference between the fixed price contract (hedge) and the
market value of the underlying commodity to be delivered or purchased in
the future. This is
the marked-to-market (m2m) value of the contract each day and the actual
amount that would be lost (or gained) if the contract was not honoured
and the delivery had to be replaced by purchase or sale in the market on
that day. Hence the m2m
value is the quantum of exposure that one party to a hedge has to the
other, its counterparty. This
approach assumes the existence of a liquid market in the commodity and
at the place of delivery in question.
you have a margining agreement with your counterparty, and your position
on any day is ‘out of the money’ (you would owe your counterparty
money if the deal were terminated immediately) and the amount you would
owe exceeds the agreed threshold (effectively a credit limit) you will
have to post margin. That is
you will have to pay cash or provide a Standby LC (if allowed in your
agreement) to your counterparty, equal to the difference between the
amount you would owe and the threshold.
point is that you cannot predict how prices may move – that is the
reason a margin agreement is put in place, it provides mutual protection
since it is usually a two-way agreement.
However this means that you also cannot predict how much cash or
committed LC facility you may have to use from day to day, in order to
cover provision of margin. To
make matters worse, often margin agreement thresholds are tied to credit
ratings or covenants, so if your credit standing deteriorates the amount
of margin you have to post can increase rapidly, an eventuality that is
models can provide some ‘worst case’ future scenarios based on which
you can estimate your potential liquidity requirements.
However the models available assume that the future will resemble
the past. Unfortunately
negative ‘Black Swan’ events1
– the very events that cause massive price volatilities and could
seriously damage your liquidity - cannot be predicted by mathematical
Lehman Brothers failed due to a lack of access to liquid funds; it could
not pay its margin calls due to lack of immediately available cash.
Do not let the same happen to your company.
Understand and monitor daily the possible negative implications
of any margin agreements that exist, and actively negotiate such
agreements to maximise contracted thresholds and minimise the possible
escalation of ‘calls’ if negative events occur.
Furthermore negotiate ‘committed’ (they are never truly
committed) credit lines with your house banks, to cover short-term needs
that may arise.
exercise tight control over any derivatives portfolio to ensure that
hedges closely relate to physical transactions, and that the reference
prices used in determining settlement amounts correlate closely to the
price movements that relate to the physical transactions covered.
In other words, seek to avoid speculative ‘open’ (un-hedged)
derivative positions arising. In
this way, at least, you can ensure that hedged positions will be
self-liquidating when they mature. You
will nevertheless have to manage the day to day liquidity implications
in the interim periods.
Hedging is a
complicated business so please note that this article barely scratches
the surface of the subject. Nevertheless
I hope that it will give you a sufficient basis upon which to consider
the implications that it could have for your business.
© Copyright 2010 R
See article in CCR Magazine, issue August 2009, regarding Black Swan
Events. See a copy at: http://www.barrettwells.co.uk/blackswan.html
is the author of Global Credit
Management - an Executive Summary, published
by John Wiley & Sons Limited.
This is a concise but authoritative work that exposes the
power of credit, see www.barrettwells.com/gcm.html
for details. The Chinese version of this book has been published, it is an ideal
gift for Chinese business executives of all types; Chief
Executives (CEOs), Chief Financial Officers (CFOs), Treasurers,
Credit Managers, Entrepreneurs starting or running their own
businesses, and students of business practice preparing to face
the tough challenges of business management, see
www.t3plimited.com (English) or www.t3plimited.net (Chinese) for
is an active member of the International Energy Credit Association
(IECA) and the Association for executives working in Finance,
Credit and International Business (FCIB).
His free access international credit management web site www.barrettwells.co.uk
is highly regarded as a valuable resource for those interested in
trade finance and business-to-business credit management.
address is: email@example.com.
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