Commodity Risk: the Blind Spot in Overall Risk Management

Commodity Risk: the Blind Spot in Overall Risk Ma...

Source: KPMG Corporate Treasury News, Edition 39, January 2015   Modern treasury has undergone an evolution for decades which certainly can be described as remarkable, giving it the confidence to present itself as an integral part of corporate financial risk management. However, on closer examination there are still some blind spots in risk management, one of which is up-to-date commodity risk management.

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The defining term in the evolution of treasury is 'interlinkage': it has been solely responsible for creating a basis of information for decision-making at treasury. The objective is to achieve a smooth cross-functional flow of information by putting processes and solutions in place for the vast majority of treasury functions to allow well-founded and highly efficient decisions.

'Well-founded' and 'efficient' is often not the first thing that comes to mind in treasury in connection with commodity risk management. Of course, this is not the function of treasury, but the responsibility of purchasing – which is the usual response. However, this argument is not convincing in practice.

According to the most recent KPMG study Commodity and Energy Risk Management in Industrial and Commercial Enterprises (Rohstoff- und Energierisikomanagement in Industrie- und Handelsunternehmen) of September 2014, 91% of companies surveyed in the German-speaking region use financial instruments to hedge exposure to commodity price volatility. For that reason alone, hedges are relevant for treasury, as the use of financial instruments outside treasury jeopardizes compliance with segregation of duties, accounting standards and regulatory requirements.

It is therefore not surprising that 71% of companies surveyed hold treasury responsible for the use of derivatives. In 63% of cases, on the other hand, purchasing is responsible for identifying and surveying exposure to commodity risk. Treasury and purchasing are also involved in decisions on hedging ratios (35% and 32%, respectively); these mainly are operational decisions within a framework specified by the executive board or risk committee.

This study confirms the close interlinkage between treasury and purchasing, but the real challenge for treasury is in determining and assessing commodity risks in the context of overall risk. Because, while purchasing defines its hedging strategy exclusively in terms of commodity contracts, treasury strives for higher-level overall risk management and considers commodity contracts (apart from foreign exchange risks, for instance) only part of overall risk.

Due to the fact that commodity price risk is greatly determined by the terms of commodity contracts, commodity price risk is clearly different from the largely standardized structure of foreign exchange risks. This is made more difficult for treasury because most of the IT systems currently on offer for treasury applications have no or only insufficient functionalities for adequately presenting exposure to commodity contracts and thus quantifying risk.

Therefore, most companies do not have the technical, and frequently also not the organizational, framework for aggregating commodity risks with other risk types such as foreign exchange, interest rate and counterparty risks, into one aggregate risk position. Such aggregation would have the benefit of integrating commodity hedges with the group's overall risk management system. Especially the correlation between commodity and foreign exchange risks and also the risk of default from counterparties with major exposures would create considerable added value for evaluating overall risk.

A lot of interlinkage will still be necessary before this ideal of integrating commodity risk into overall risk management will become a reality. At least there is hope based on recent developments at system providers that this blind spot will be removed from treasury's field of vision in the not too distant future.

Author: Paul Ratzenböck, Manager,

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