Case study – Guide to managing commodity risk
“Tom” is an Australian Wagyu beef farmer who exports his beef to Japan and also sells it domestically. He has three types of commodity risk:
- Beef
- Grain (the feed for his cattle); &
- Fuel (getting product to market).
In order to manage his profitability and cashflow, he adopts a range of commodity risk management strategies that vary each year in line with his production and inputs costs.
Tom’s commodity risk policy varies depending on the price of grain and fuel.
He has forward contracts with customers for the beef each year to lock in his revenue and then looks at hedging the grain and fuel (input costs) to minimise his expenses as they operate on very tight margins.
He takes into account the volatility of grain pricing, competitive position and future expectations in the market.
In managing the grain risk, Tom undertakes a mix of forward buying, swaps and futures contracts. Utilising these three types of hedges enables him to manage both costs and cashflow.
The futures contracts require regular margin payments, so Tom has to ensure that he has adequate cashflow to cover these margin calls.
His swap contracts require upfront payment when the contract is taken and the forward buy contracts lock in the future price, which means that he has lost any potential downside to grain price on delivery. By undertaking a mix of the three strategies, he is minimising his risk to cashflow through margin calls and fixing a portion of input costs to provide some certainty over his costs.
Transportation of the beef also incurs substantial fuel costs.
Tom manages this risk by negotiating fixed transport costs each year.
However, there is a clause in the contracts that allows the transport company to increase the price of transport where fuel price increases more than 25 percent of an agreed baseline price. To manage the potential increase in fuel prices, Tom has been seeking expert advice (not from me :-), before entering into the fixed cost contract with suppliers to ensure that the risk of large movements above the agreed baseline price for fuel is low.
When discussing his hedging strategies, Tom pointed out that his overall strategy is to minimise input costs and maximise revenue.
He is aware that maintaining a flexible hedging strategy can at times increase his risks.
Recently, for instance, the grain price increased over a four-week period. He had received advice that the price was going to drop and had been waiting to put cover in place, so he is now left with an unhedged position and the possibility of paying the increased price for grain.
Key tips that Tom believes are important when looking at commodity risk management are:
- When using futures and swap contracts, which do not entail a physical settlement, you need to ensure that the contracts mature in line with when you are taking physical delivery to avoid a mismatch that creates additional risk.
- When undertaking any hedging with third parties, ensure that you check the counterparty risk. A few years ago, one counterparty Tom had contracts with closed down and he was left with no hedging for that season, as well as a cash loss due to payment of margin calls before the company closed.
- Ensure you understand the risks associated with hedging. Locking in future price on revenue can lead to an increase or reduction in your competitive position.
- Do not always rely on advice from ‘experts’. If you understand where your risks are, then you are probably in the best position to make your hedging strategy work for your business, after due consideration of professional advice.
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About the Author
Jason Novobranec is Implementary’s Chief Operating Officer.
With over 20 years of Consulting, Program Management & Senior Leadership experience, Jason has delivered initiatives for large multi-national / multi-regional organisations as well as SME’s and is an expert in shaping solutions to fit a customer’s project needs.