Pan American Grain and
Oilseed Conference
CME Group and Informa Economics
May 16, 2013
Contents
Practical Viewpoints on Risk Management
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Determining Business Needs
Supply Chain Impacts
Process Framework
Risk Assessment
Risk Management Tools
Policy & Controls
Best Practices
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Commodity Risk Management Overview
Determining Business Needs
What is commodity risk management and why do you do it?
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In basic terms, it means managing your margins. This could be for sellers (e.g.
farmers) or buyers (e.g. food companies).
You project or budget what your costs will be along with your revenue. Hopefully,
that results in a positive margin. You then use hedging tools to lock-in that margin
or manage it to remain profitable.
Commodity risk management is also called hedging and is defined as buying or
selling futures (or physical) contracts as protection against the risk of loss due to
changing prices in the cash markets.
Cash Position
Futures Position
If you own inventory or expect to sell a
product in the future, your risk is falling prices
To protect against falling prices, you sell futures
(or physical) contracts that gain if prices fall
If you use inventory or expect to buy a product
in the future, your risk is rising prices
To protect against rising prices, you buy futures
(or physical) contracts that gain if prices rise
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Commodity Risk Management Overview
Supply Chain Impacts
Price volatility exists all along the supply chain and hedging is used by each
participant to manage the impact from price changes to their business.
Farm
Cooperative
Manufacturer/Processor
End Users
 Risk from lower prices
for production (e.g. milk)
 Risk from higher costs
for inputs (e.g. feed,
fertilizer, land, etc.)
 Producer forward
contracts
 Supply/sales contracts
 Inventory ownership
 Risk from higher prices for
purchased items
 Inventory ownership
 Producer forward
contracts
 Supply/sales contracts
 Risk from higher prices
for ingredient costs
 Risk to plans/budget
from price volatility
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Commodity Risk Management Overview
Process Framework
After understanding why you need to manage commodity price risks, a structured
process can be defined to establish and implement a commodity risk management
program.
Identify Risk
• Identify
commodity risk
exposures
• Understand the
impacts each risk
has to the
company
Quantify Risk
• Quantify the
potential impact
of market risks
on your financial
performance
• Determine the
overall risk to
the company
given these
underlying risks
Adapted from Citi’s Holistic Risk Management Framework
Set Risk
Strategy
• Define the
company’s risk
tolerance,
constraints, and
the overall
objectives of the
hedging program
Hedging
Strategies
• Evaluate
different hedging
alternatives in
terms of tool
selection
• Choice of
strategy should
be consistent
with policy
objectives
Review and
Refine
• Assess the
effectiveness of
hedging tools
from an
accounting and
economic
standpoint
• Hedging
strategies should
be adjusted over
time as markets
are dynamic
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Commodity Risk Management Overview
• Margin risk depends on the
ability to pass through
commodity cost changes to
customers
• More coverage should be
taken on inputs that cannot
pass on cost changes
• Less coverage should be
taken for inputs that can pass
on cost changes
• Determine what your risk
tolerance is. Which is worse
for a buyer?
 Uncovered and market goes
up (margin contraction)
 Uncovered and market goes
down (margin expansion)
 Covered and market goes up
 Covered and market goes
down (covered risk)
Need for Risk Management Coverage
Low
Medium
High
Risk Assessment
Low
Commodity as
% of Product
Cost
CommodityRetail Price
Elasticity
Competitive
Response
Business Needs
Medium
Ability to Pass Through Costs
High
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Commodity Risk Management Overview
Risk Management Tools
There are a variety of risk management tools available to use. The selection of the
proper tool depends on factors such as risk tolerance, financial vs. physical
settlement, and cost. Hedging strategies range from fixed price to variable price
contracts.
Hedging Tool
Advantages
Disadvantages
Forward Contract
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Easy to understand
Flexible quantity
Locked-in price
Minimizes risk
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Difficult to exit
Must deliver physical product
Opportunity loss if prices rise
Futures Contract
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Easy to enter/exit
Minimize risk
Potentially better prices
than forward contracts
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Opportunity loss if prices rise
Commission cost
Performance bond (margin) calls
Set quantities
Options Contract
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Price protection
Minimize risk
Benefit if prices rise
Easy to enter/exit
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Premium cost
Set quantities
Commission cost
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Commodity Risk Management Overview
Policy & Controls
Given the large amount of financial risk exposure from commodities, hedging
activity needs to be governed by robust policies and procedures. A commodity
hedging policy can serve as the framework for the definition, measurement, and
reporting of price-risks related to commodity hedging activity. Additionally,
standard operating procedures are developed for each process step. The
commodity hedging policy should contain the following:
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7.
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Scope of Commodity Risk Management Activities
Commodity Risk Management Oversight
Commodity Risk Management Strategies
Commodity Risk Management Tools
Controls
Risk Measurement
Accounting for Commodity Risk Management Activities
Authorized Commodity Brokers and Trading Advisors
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Commodity Risk Management Overview
Best Practices
 A best practice is to establish a risk management philosophy and guiding
principles that will help you in your decision making.
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Align objectives of risk management with company goals
Ensure management understands objectives of risk management
Know your cost structure so you can effectively manage your margins
Have specific, written risk management strategies
Maintain discipline in executing risk management strategies
Work with experienced professionals
Develop policies, controls, and standard operating procedures
Don’t operate in a silo – involve others in the process
 Risk management is not speculating and should not be considered a profit
center. In fact, not using risk management is speculative.
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Commodity Risk Management Overview
Summary
A successful commodity risk management program helps a company manage
their margins and reduces the impact from commodity price volatility. Key steps
in the commodity risk management process include:
• Determining your business needs
• Identifying and quantifying your risk from commodity prices
• Developing a structured process for establishing and executing hedging
strategies
• Focusing on margin management
• Ensuring policies and procedures are robust
Thanks!
Mike McCully
mike@themccullygroup.com
www.themccullygroup.com
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