You just landed the big purchase order you’ve been chasing for 12 months. Pricing looks right and you forecast a margin that exceeds expectations. You knew your costs… until an unexpected event pushed input prices against you. Now your big purchase order is upside down and all that work was for nothing.
Food and agribusiness companies can use commodity risk management to spare themselves this heartache and create stability. But there’s more to commodity risk management (CRM) than just slinging futures and options.
Building a robust CRM program requires creating a thoughtful strategy that is tailored specifically to your business and its objectives. This planning process should be just as rigorous as the one your management team uses to plan and execute on an expansion or an acquisition.
At BPFG, we’ve built CRM programs for large and small dairy companies, we’ve worked in global grain merchandising, and we’ve even worked on the floor of the CBOT as an independent trader and CBOT member. We’ve seen the commodity markets from every angle, and we recommend considering the following steps to create discipline around a CRM process:
Define your objectives
It is important to be realistic about what can and cannot be accomplished by a CRM program. There are a small number of companies that are so large that they can use the information their activity in a market generates to consistently produce trading profits. For the rest of us mortals, CRM should be thought of as a mechanism to create value through stability. Some realistic CRM objectives include:
- Revenue protection and stable operating margins for financial stakeholders
- Long term pricing visibility for customers who want long term contracts
- Strengthened cash flow forecasting to enable long-term capital planning
- Insulation against downturns to enable expansion while unhedged competitors stall
Create alignment with financial stakeholders
BPFG strongly advises companies discuss CRM plans with their financial stakeholders before jumping in. Executing on a CRM program means that a company is deliberately choosing to separate itself from commodity market prices, which can create tension if financial stakeholders are unprepared.
Expectations should be managed by setting margin objectives prior to executing any forward pricing. The success of a CRM program should be evaluated based on company performance versus the forecasted plan and not versus what could have been with 20/20 hindsight.
Build the infrastructure
It is important to build
- Functional controls
- Who can make pricing decisions?
- Who can execute contracts on pricing decisions?
- Segregation of CRM reporting duties
- Separate trade execution from accounting.
- Monitor reporting to manage against the nightmare “rogue trader” scenario.
- Ignorance is not a defense.
- Employees responsible for a CRM program need to educate themselves on the rules.
- Backup execution capabilities
- If the market does something that gets you excited about calling your broker, there’s a pretty good chance your broker’s other clients are trying to call him too.
Know your costs
Whether you’re a farmer, a cheese converter, or an oil refiner, it doesn’t make any sense to lock in pricing on your revenue until you can forecast your cost per unit with a high degree of confidence. Basic cost accounting and forecasting are just as important as futures and options in this game.
Another important cost consideration is identifying where your company falls on the cost curve. If your business is an extremely low-cost producer, you should consider only locking in your margins when extreme margin opportunities present themselves. A top 5% low-cost producer will usually be profitable and there’s a less urgent need to hedge a position that’s always winning.
Thoughtfully designed physical contracts can frequently accomplish the exact same thing as futures and options with less complexity and less ongoing work. It is important to remember that there are a lot of CRM tools that should be considered before futures and options. Some of these include:
- Cost plus contracts with commodity pass-through to vendor or customer
- Pricing grids with scaled pricing based on exchange traded settlement prices
- Matched physical contract timing on input/output pricing
If these types of arrangements aren’t possible, it is still important to be strategic about physical contract design. To the extent possible, physical commodity contracts should be priced as a function of a highly correlated exchange-traded commodity to allow for utilization of futures and options as hedging tools.
Futures, options, and other derivatives
There are many futures and options structures that can be used to hedge various commodity exposures. Successful execution of a CRM program will be a function of both in house resources and reliable order execution capabilities. A few maxims to consider:
- Keep it simple
- Manage against your downside
- Leave some room open on the upside
- Make sure your banker is prepared for margin calls
How can BPFG work with you to design or improve your commodity risk management program? Our team is prepared to help you create a solution that makes sense for your business.