Treasury departments in commodity-intensive industries increasingly also have to address corporate commodity risk in addition to the traditional tasks of cash and liquidity management or surveying and hedging currency and interest rate exposures. The same applies to the treasuries of traditional commodity traders, because here also quite often the necessary derivatives are acquired by treasury or at least reported together with other market risks.
The first step in this examination naturally consists of an analysis of the risk arising for the company from commodity exposures. A uniform definition of what the company considers commodity risk is therefore indispensable. This definition is then used at a later stage to directly derive the tonnages of various commodities be included in risk exposure. Many misunderstandings in internal communication about commodity risk result from differences in understanding and definition of risk. This affects the various departments involved (procurement, logistics, sales and distribution, controlling and treasury) as well as regional or organizational entities of the company. For example, the required purchase of a certain quantity of raw materials for production does not necessarily mean that direct risk will arise from this purchase. If, for example, it is current market practice to pass on price fluctuations one-to-one to the customer or there is an explicit agreement to that effect, no price risk will arise initially. Hedging this risk, i.e. fixing the price for required purchases by treasury, would create a risk in this case.
Consequently, to accurately survey exposures, integrated end-to-end analysis throughout the entire value chain is necessary, from procurement to sales, and possibly also across several group entities. This also includes a thorough analysis of the direct and indirect dependence of purchase and sales prices or expense and income items on fluctuations in commodity prices. In this context it should also be investigated to what extent, for example, customer demand depends on prevailing price levels, and thus earnings are influenced not only by price but also quantity. Equally, it would be wrong to only focus on purchase cost and selling prices, and advisable to also consider the effects of inventory valuation. Apart from identifying the entire 'mechanics' of the influence of fluctuations in commodity prices on corporate ratios, such detailed analysis also allows identification of the database which is indispensable for continuous management of commodity risk as well as identification of a lack of data availability and quality.
Once the responsibilities and competencies of risk management have been allocated to treasury and other corporate entities systematically and precisely, treasury is usually entrusted with the following responsibilities:
This assignment of tasks and the associated responsibilities and authority to make decisions determine the structures and processes to be defined for the risk management of commodity exposures. Once these preliminary considerations have been made, planning and implementation of the survey of exposures can begin. All the essential information usually is already available at the company, however may be spread across several departments depending on sector and corporate structure. For example, short-term requirements can be found at production planning and procurement, stocks and availability at various locations as well as type and quality of materials at logistics, while controlling is responsible for long-term sales and purchase planning. Moreover, corporate divisions tend to be spread across regions and countries, so that intercompany transactions need to be taken into account as well of course. Such a survey usually can be implemented at the desired level of accuracy and in time only with appropriate IT solutions. As the required information and data − needless to say − are available in a range of systems from standard software to in-house software and sector-specific solutions as well as Excel spreadsheets, in-house tools are required also for this purpose to create a uniform database.
As with so many things, the devil is in the detail when it comes to implementing the planned solution. Even the planning and definition of requirements depends on extensive expertise on a multitude of issues such as risk management, commodity markets, sector specifics, derivatives markets or long-term planning of IT infrastructures. During implementation, this knowledge then needs to be transferred to the process by individuals with detailed knowledge and experience in implementing such projects. Each project phase − from the detailed definition of functional requirements, system selection and configuration to implementation, roll-out in all divisions as well as approval and the going live process − presents its own special challenges.
Once such a survey of exposure has been undertaken, other applications and possible analyses will follow, which support focused corporate management, and the question will inevitably be asked how it was possible to operate in the past when it took one month to survey commodity exposures, requiring extraordinary effort on the part of controlling and the departments providing the necessary data.
In many industries, e.g. the energy sector, it is possible to survey exposure, including the evaluation of scenarios, at the push of a button. Many other sectors are following suit however, and quite a few leaders in technology have successfully completed their implementation. The transition to digital technology is also in full swing at commodity processors and traders.
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Author: Bardia Nadjmabadi, Senior Manager, email@example.com
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