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Rising Commodity Prices and the Role of Treasury In Managing Risk with Help from Technology

June 26, 2018
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Volatile commodities markets threaten profit margins and put new focus on treasurers' needs and abilities to tap technology to capture exposures, effectively hedge risk. 

Commodity Risk Reality Check

The growing list of companies calling attention in 2018 to rising commodity prices and their potentially negative effects on profit margins and earnings—not to mention stock prices—includes Caterpillar, General Mills, Harley-Davidson, PepsiCo, Hershey, Procter & Gamble and Colgate-Palmolive. The catalysts for commodity and other sources of inflation that threaten P&Ls range from trade war fears (steel and aluminum) to tensions with Iran (oil, gasoline, diesel) to shrinking capacity (freight, shipping) and bad weather and/or rising demand (corn, fruit, grains and nuts).

"We expect steel and other commodity costs to be a headwind all year," Bradley Halverson, Caterpillar's chief financial officer, said during a conference call in April. In May, Wells Fargo senior economist Sarah House told the Wall Street Journal, "Domestic producers now have to ask if they can pass those costs on to consumers, and protect their margins, or take a hit on margins."

The problem is perhaps most acute for consumer packaged-goods companies that have limited ability to raise prices, says Jerald Seti, vice president of product management at Openlink—an ION Investment Group company, and provider of trading, treasury and risk (including commodity risk) management systems and software. "In the case where a corporate can't pass price increases along to their consumers, the rise in commodity prices is going to erode the earnings of the firm. So there's a real need to be able to do something to mitigate that risk, to try to anticipate it and possibly offset it, and to do that they need the right tools."

Rising input costs are one reason for what website InvestorPlace in late May described, with a good helping of hyperbole, as "a bloodbath in consumer stocks." The site said that of 25 large, US-listed companies (excluding durable goods and apparel), "the best-performing consumer packaged goods stocks this year are up 1% to 2%. Elsewhere, the news ranges from bad to disastrous. Eighteen of the 25 stocks are down more than 10% this year. Ten have declined more than 20%."

Treasury and Commodities

After several years of little to no inflation, the spike in raw materials costs is putting new focus on the role of treasury in managing commodity risk, the extent to which treasury works effectively—or doesn't—with purchasing and procurement teams to hedge the risk, and the role that technology plays in revealing commodity, currency and other exposures across the entire company, allowing corporates to optimize hedging. For some companies, the return of volatility provides a needed wake-up call.

"When you start to see volatility, that's when people realize the suboptimal way of looking at things separately is costing a lot more," says Craig Jeffery, managing partner of consulting firm Strategic Treasurer. "Managing commodity risk is always important, it's just not as evident that it's always important. This is an area that has to be watched and managed at all times."

NeuGroup Peer Research indicates that hedging commodity risk is one of the responsibilities of a significant, if not overwhelming, number of foreign exchange managers within treasury. As the chart shows, 28% of responding members hedge commodity exposure as part of their jobs, a third of the percentage who hedge balance sheet risk. But HSBC recently told another NeuGroup peer group that new, more favorable hedge accounting rules that are less onerous and complex have some companies considering commodity hedges for the first time.

What's more, NeuGroup interviews with treasurers and consultants suggest that companies with commodities exposure have, over time, given treasury either a primary, equal or advisory role in setting commodity risk strategy, in some cases after turf battles with procurement groups. Chris Nolan, treasurer of Coca-Cola, says the company's approach evolved from a more siloed approach to one where both procurement and treasury have a seat at the risk strategy table, with treasury executing hedges.

"I think what treasury brings when we come to the table is more of the macroeconomic environment and our outlook on what we think is going to happen in the world, particularly with the dollar, which is very important for commodity prices," Mr. Nolan says. Treasury's broader view of the company's entire risk portfolio has prompted Mr. Nolan, on occasion, to react to a business unit's desire for a commodity hedge by executing an "internal derivative" with the unit rather than hedge the risk externally.

Mr. Nolan says he offers to give the procurement team "the price that you want, but I'm not going to go out and hedge that risk externally, because that suits my overall portfolio risk of what I'm trying to achieve for the company." His wider view of Coca-Cola's risk portfolio, Mr. Nolan says, allows the company to achieve better overall hedge efficiency and reduce costs by taking into account inverse correlations between currencies and commodities and other natural offsets between various positions.

What Do You Hedge in the Normal Course of Business 

A Blurred Picture

Having a big-picture view of a company's commodities risks and exposures is essential for businesses with major commodities exposures that want to achieve the kind of hedging efficiencies sought by Coca-Cola, which has reduced its commodities exposure in recent years. Andre Jäger, senior vice president of product management at Openlink, says for effective risk management, "You need to be able to see that holistic picture of what's happening."

The problem, according to some treasurers and consultants, is that many companies don't have the ability to easily view that holistic picture, in part because the treasury management systems (TMS) they're using have relatively weak commodities analytics. Openlink's Mr. Seti puts it this way: "Most treasury systems today kind of, I will say, fake it when it comes to representing commodities in their system. They basically handle a commodity like it was an equity. They put an asset on the books and they give it a price and they have something to work with."

Coca-Cola's Mr. Nolan has a similar view. "This is a problem in the treasury management space," he says. "The big players … don't really have robust commodity risk management solutions. It is very helpful to have all your risk exposures in one system so you can look at it as a portfolio and do portfolio risk analytics. There are very robust commodities platforms out there, but there's nothing that's kind of in the lower to middle tier for corporates that are not in the business of commodities, like a grain producer. I think there's a little bit of a void in the systems space for that type of functionality."

That void has left many companies doing what they've done in the past—using spreadsheets. NeuGroup Peer Group Consultant Ed Scott, who retired as Caterpillar's treasurer in 2016, says, "It's a cost-benefit thing: how much exposure do you have, and if you have higher exposures, you're going to be more willing to pay for a system that's going to capture that. You have to have some way to bring your exposures together. A spreadsheet can do, it's just more manual, time-consuming. We all know the benefits and the disadvantages of spreadsheets."

A recent ebook by Strategic Treasurer and Openlink, "Acquiring Treasury Technology: Understanding ROI and the Overall Business Case," urges treasury to view technology upgrades as an investment rather than an expense. It therefore recommends a "brutal elimination of the suboptimal" that "allows you to take out redundant and stand-alone systems and spreadsheets. They must be viewed as costly and risky. As such, they are a threat. Systematic and dispassionate elimination of these threats is in order."

A Single View of the Truth

Think of spreadsheets on one side of a risk management tool continuum. On the opposite side of that continuum are robust technology solutions that are tailor-made for commodity intensive corporates (CICs), including energy companies. Openlink's Mr. Jäger says CICs that hedge commodity risk with contracts for physical goods (often entered into by procurement) as well as with financial instruments like derivatives (executed by treasury) require a system that offers a combined view of both types of exposures and allows stress testing and a variety of other functions.

"You need to have a system that's able to combine the physical procuring of certain commodity assets you need for your production," Mr. Jäger explains. "You also want to kind of put that in comparison to what is my expected demand based on my sales forecast and how much I'm hedged from the price risk perspective, and what does it mean for earnings at risk or value at risk based on the market volatility."

Openlink argues its systems provide a real-time view of commodities markets and hedges that few, if any, other TMS offer. Tasja Botha, vice president of capital markets and corporate treasury, recently described why that's critical for CICs. "Every physical commodity has a different nuance attached to it, it also has a different curve attached to it. So the trick would be to really ensure that this tool can understand the movements of the market, can actually place the different kind of elements that control that particular commodity and also be able to see the movements of the FX against it as well. So really to be able to see this real-time view of the world."

For companies that need them, powerful systems like Openlink offer a single view of the truth that gives them confidence their hedging strategy is based on the best available information, says Strategic Treasurer's Mr. Jeffery. "If you don't have confidence in your numbers, you're going to spend more because you're going to be cautious, or you're going to hedge less and therefore face more volatility than you need. So the more you know the better your results should be, the more you have confidence in everything. A single view of the truth allows you to do the right type of analysis and optimization," he says.

Benefits: Real World Examples

Etihad Airways, the national airline of the United Arab Emirates, turned to Openlink in 2016 as part of a transformation aimed at consolidating fuel risk management and treasury into a single strategic platform. "They needed sophisticated risk analytics, and system integration," says Openlink's Mr. Seti. "They implemented a single platform for risk, hedge accounting, cash management, and their jet fuel hedging is performed now by the treasury group. Having implemented that using our system along with a few others, they were recognized in the industry" with various awards.

Indeed, the airline's then-acting group treasurer said: "We are delighted that Etihad's treasury transformation project continues to be recognized, winning highly commended in the best risk management category at the Adam Smith Awards. Openlink is a key foundation and strategic platform for us to manage all our daily treasury and risk management activity as the business evolves."

A major retailer also adopted Openlink technology following accounting difficulties and inaccurate earnings reports. "One of the reasons why they ended up looking for a new system was to improve controls over their procurement, accounting and hedge management operations," Mr. Seti says. "They were a very spreadsheet-dependent company running their books and tracking their hedges and positions on spreadsheets. They implemented a single platform for production planning, forecasting, procurement hedging, risk reporting, following all of that through to back office, including payments and settlements."

While Openlink realizes that companies with minimal or moderate commodities exposure may not be able to justify the cost of its systems, it has developed ROI (return on investment) calculators to show other corporates the financial benefits of investing in robust solutions. Among other uses, the calculators allow firms to plug in a variety of current data on their commodities, procurement and cash management, and estimate the savings.

The calculator then shows "functional areas that could be addressed and it provides market data based on industry-wide polls and feedback that we've gotten," Mr. Seti explains. This demonstrates to treasurers "who may be in denial" how other companies in a similar market segment have benefitted in those same categories by adopting technology. "What it can really do is illustrate to someone who's skeptical what the potential savings could be based on what others have done before them," he says.

Along the same lines, a white paper commissioned by Openlink and produced by research firm Hobson & Co. makes clear some of the possible costs of not adopting systems that provide a holistic view, and the potential benefits of taking the plunge. The paper focused on eight energy companies that have adopted Openlink's energy trading and risk management (ETRM) software.

Among the notable findings: Customers said Openlink's risk management function helped companies transform from data gathering to data analyzing. And the paper cites the head of trading systems at one company who says the business was "able to reduce credit defaults by about $12M annually" after adopting Openlink's solution. On the flip side, "A number of customers stated that, historically, they had experienced losses of $10M or more a year due to issues such as inadequate hedges, lack of visibility into inventory positions and counterparty defaults."

In the end, says Mr. Jeffery, to justify the cost of implementing improved technology solutions to help manage commodity risk, treasurers must provide convincing answers to questions like: "How am I adding value to the organization? How am I bringing my exposure levels in line with my risk appetite? How does this eliminate the extreme elements of what can occur, but also how can I realize that I can be more effective in my hedging, for example? Can I look at some different models and run different scenarios and then apply a more effective way of meeting my overall objectives?"

"We're not saying that this turns treasury or procurement into a profit center," he says. "But when you look at how am I reducing my costs, my costs of losses, my cost of achieving my objectives, you are delivering better service to the organization."

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