Taking strategic advantage of price developments on the commodities markets

Taking strategic advantage on the commodities markets

Source: KPMG Corporate Treasury News, Edition 42, April 2015 - Prices on many commodities markets are at their lowest level for a number of years. This applies to most commodity types, from soft commodities such as Arabica coffee and sugar through to base metals such as copper and nickel or precious metals like silver – and, of course, Brent and WTI oil and the corresponding petrochemical products, which are currently the subject of particular media attention.

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Although some commodities have already recovered from the absolute lows they recorded shortly after the turn of the year, low levels compared with recent years are still available in terms of both the spot markets and the corresponding forward market prices. For many German companies with good order situations, this means low purchase prices – and hence lower expenditure on commodities – despite the weakness of the euro. Following the recently overcome shock of negative derivative remeasurements and the need for many companies to write down inventories and recognise provisions in their annual financial statements, a more forward-looking view has slowly been emerging again since the start of the year.

The low price levels at present represent an opportunity to secure low costs for the long term. Derivatives can be concluded as hedging instruments to ensure low costs in the future. Using this approach, potentially higher purchase prices in future financial years are compensated by the gains on the respective derivative positions, meaning that the hedged lower purchase price is ultimately paid. Companies can use this cost benefit to improve their competitiveness and hence increase their market share, or to generate improved results of operations while leaving the marketing and pricing strategy for their products unchanged. In this way, the use of derivatives can help to support long-term strategic corporate targets as well.

If prices continue to fall, however, there is a risk that companies will end up having to pay higher costs than their competitors. The optimal approach can only be established through a sustainable analysis that takes into account the sales strategy and market- and company-specific conditions in the main sales markets. Initially, the opportunities for achieving medium- to long-term corporate targets should outweigh the potential risks in the short term, i.e. particularly in the case of a further decline in prices, a company should be able to easily absorb the negative effect of a higher cost base than its competitors. For example, the cost benefit could be applied only in certain markets in order to drive a competitor from the market, or a key price point could be maintained for longer than competitors are able to do so, resulting in an above-average increase in market share.

The commodities projects conducted by KPMG in the past years have shown that companies always make particularly timely and accurate decisions resulting in a competitive edge when the following criteria are met:

  • The company’s market position means it is well positioned to make an accurate assessment of the market. It has been active on the market for a number of years and has an experienced and skilled analysis team.
  • The company has a certain degree of market power allowing it to predict price developments at an earlier stage than other market participants, particularly its competitors.
  • The corresponding decision-making processes are defined clearly and transparently in terms of their organisation. If the time between identifying an opportunity and making a decision is too long, the chance to enter into long-term strategic positions on the market can quickly disappear.
  • The company has structures in place to limit losses in good time in the event of negative developments, e.g. to define and implement a stop loss in advance.

In decision-making situations like these, CFOs are faced with the specific question of which derivatives or combinations of derivatives to use in order to hedge low prices and what the potential implications could be. The process-related and organisational conditions must also be in place to allow decisions for long-term positioning to be implemented promptly. This is where Treasury plays a key role. Processes, controls, IT and reporting, and measurement and accounting logic must all be prepared and established in order to ensure the efficient handling of hedge transactions and the accompanying risk management. This is the only way for Treasury to optimally fulfill its role as an internal service provider for this purpose in the current market environment.

Author: Bardia Nadjmabadi, Senior Manager, bnadjmabadi@kpmg.com

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