Bank of America Merrill Lynch Article

May 2013

Hedging Bets and Insulating Budgets Against Fluctuating Commodity Prices

A trend among financial managers
Wild swings in commodity prices in recent years have affected public sector organizations, whose fixed budgets have also taken hits from uncertain global markets, declining revenues and government cuts. But theyve also impacted private-sector companies, even those that began trimming their workforces and budgets in 2008 in response to the economic downturn. To most financial managers, a 5% variation in an annual budget is significant, to say the least. Not so in commodities like energy and metals, where sharp daily price swings have become part of the landscape. As a result, financial officers at many public-sector agencies and private-sector companies are increasingly turning to risk management tools to stabilize budgets, offset commodity price swings and manage future expenses. to lower crop yields and rising oil priceshave made managing commodity prices critical. Adding to the volatility are emerging market demands, geopolitical uncertainties, unstable foreign monetary policies and speculation.

A perfect storm
In the summer of 2011, a London-based hedge fund bought a substantial percentage of the worlds cocoa bean supply, causing prices to jump to a 33-year high, according to A.T. Kearney, a global management consulting firm. The food and beverage industries were in the eye of a perfect storm of price increases and volatility in the agriculture commodity markets, noted Dave Donnan, a partner in Kearneys Chicago office. Risks of this kind are beyond the control of management in either sector. Yet while most businesses have suffered the effects of economic turmoil here and abroad in the past five years, job losses and budget cuts in public-sector organizations have been especially widespread and deep, leaving no wiggle room when the cost of doing business rises against reduced budgets. Take, for example, energy costs. From January 2011 to January 2013, prices ranged from -3% to +30% for diesel fuel, -4% to +43% for unleaded gas, and -9% to +4% for natural gas. In the same period, public-sector budgets remained static. Fluctuations in the prices of raw materials also greatly influence how suppliers, manufacturers, retailers and other private enterprises do business, and, consequently, how they manage finances. Commodity fluctuations of this kind signal the need for long-term thinking and strong risk management measures within public- and private-sector organizations.

Risk is inherent in doing business, especially in a global economy.

Risky business
According to a McKinsey & Company working paper on risk, it is more perilous for public-sector organizations than their counterparts in the private sector. The role of most government institutions is implicitly or explicitly rooted in managing risks that the private sector is either not equipped or not willing to take, the paper notes, citing massive oil spills, Homeland Security threats, the housing and mortgage crisis, and the fraud and insider trading cases that have made front-page news in recent years. On the other hand, private-sector companies have risks of their own. For multinational food and beverage corporations, for example, a host of issuesfrom heat waves and flooding

Financial risk management

At the same time, less tangible areas are also marked by instability, such as interest rate fluctuations for borrowers and lenders, foreign exchange rates for importers or exporters and, again, rising and falling commodity prices. As the nature of risk broadens, entities are adapting financial risk management strategies and tools to add price stability where there currently is little. The goal is to lessen unpredictable risks so that financial outcomes are based on managerial skills rather than on forces beyond the scope or control of the organizations. One common approach companies and agencies have used is a fixed-price purchase, which enables organizations and suppliers to negotiate a take-delivery date at a price. The downside to such an agreement is that it offers little or no price protection, provides less flexibility, and often restricts buyers from choosing among a range of suppliers. But public agencies and companies alike can exercise a degree of control over the cost of doing business by using one or more key financial risk management tools: futures, swaps and options.

Options
An option contract represents the right, but not the obligation, to pay or receive a certain price on a given commodity. These financial instruments offer different levels of protection against rising or falling prices. Purchasers seeking protection against rising prices can use an option contract called a capshort for cap on pricesto protect their budgets.

Doing more with less

Shrinking budgets and staff, plus increased demand and costs for services, are changing the types and levels of risk and forcing risk managers to do more with less. Futures, swaps and options offer these managers valuable strategies for forecasting expenses and managing budgets, and they provide ways for financial managers to define the price for future purchases. As global commodity markets evolve and become more dynamic, less predictable and increasingly interdependent, both public agencies and private companies need to put in place financial risk management plans with policies that start with top management and establish a risk-aware culture throughout the organizations. Sound, long-term financial strategies will deliver budgeted, transparent protection against commodity price volatility.

Futures
Futures contracts, which trade on exchanges such as the New York Mercantile Exchange (NYMEX) and the London Metal Exchange (LME), entail the obligation to deliver or take delivery of a certain commodity at a certain location at a fixed price. Trading futures typically requires opening a brokerage account and requires initial marginan amount of cash collateral deposited into a collateral account.

With a risk management program in place, organizations can forecast expenses, set realistic budget expectations, improve resource management and protect bottom lines against future volatility.

Swaps
In a swap, two parties agree to exchange one price for another. In most instances, these are fixed/float contracts where one party agrees to pay a fixed price in exchange for receiving from the other party a floating price benchmarked (a benchmark is a starting point against which to gauge performance) by a particular index, such as the NYMEX No. 2 Heating Oil contract or Platts Gulf Coast Ultra Low Sulfur Diesel (ULSD).

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