Commodity Futures -Hedging Strategy

22 January 2015 06:16 am Views - 5078

I spent my entire career in various multinational organisations and have pioneered in this sector, and helped institutional investors, fund and asset managers to gain exposure in commodities, optimal commodity asset allocation strategies, and best practices into actively managing a commodities portfolio or commodity futures programme.‘Commodity hedging is an important business tool, and one should simply think of it as an insurance policy against risk associated with price fluctuations in world commodities’


I used various derivative financial instruments and technical tools to optimise my hedging portfolio to eliminate exposures to commodity prices in the derivative markets. Derivative trading is merely trading paper. So the paper trading can be complex and complicated, and one should know all limitations before buying or selling a derivative instrument.


In today’s context, there is absolutely no control over price fluctuations in futures commodities. By learning this art of hedging strategy, you could minimise your risk exposures. Hedging is a new word to Sri Lanka until recently when oil derivative project launched by Ceylon Petroleum Corporation (CPC); and subsequently was poorly managed by the previous government.



Commodity hedging has a very long history, it goes back to many decades, and modern commodity markets have their roots in the trading of agricultural products. Wheat and corn, cattle and pigs were widely traded using standard instruments in the 19th century in the United States.
Other basic foodstuff such as soybeans, sugar, cocoa, coffee and many other essential commodities have been only quite recently in most markets. For a commodity market to be established, there must be very broad consensus on the variations in the product that make it acceptable for one purpose or another. The economic impact of the development of commodity markets is hard to over-estimate. Some commodity experts that tried to profit from inside information on a pending crop report; took a financial beating as speculators because they were on the wrong side of a huge price move. They risked the farm and lost it.
Hedging terminology


How do you define hedging? In layman’s terms, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment.
Hedging is a strategy designed to minimise exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Hedging is essentially a risk reduction technique , which allows informed traders and commodity dealers to profit from their intuitive knowledge of future changes in the difference between futures and spot prices. On the whole, commodity price risk management, or hedging, is simply the process of identifying and managing commodity price risk.


Whilst commodity price risk cannot be eliminated, it can be effectively managed. The primary goal of commodity price risk management is to protect the economic value of your business from the negative impact of commodity price fluctuations, at the lowest possible cost. Because commodity price volatility also provides opportunity for gains, a secondary goal is to strike a balance between risk and return. Risk management provides the ability to accurately budget on cash flow receipts.


Some form of risk taking is inherent to any business activity. Some risks are considered to be “natural” to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency.Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short term (implicitly variable rate) deposits



Importance of commodity hedging to Sri Lanka
There is no doubt that developing nations like ourselves are vulnerable to the world market prices, and even the currency tends to be tied to the price of those particular commodity items until it manages to be a fully developed nation.For example, one could see the nominally “fiat” money of Cuba as being tied to sugar prices, since the lack of hard currency paying for sugar means less foreign goods per peso in Cuba itself. In effect, Cuba needs a hedge against a drop in sugar prices, if it wishes to maintain a stable quality of life for its citizens.


The volatility in the world commodity markets has a huge impact both on developing economies and on the people who produce the material or such economies heavily dependent on imports. Therefore, it is important to find a way of flattening out the markets’ peaks and troughs. We should set up a task force intended to allow both individuals and organisations within access to the same means of protecting against risk that richer countries and large corporations use. The tool is hedging: the process of making deals, which guarantee a price for a commodity at a future date. By buying options - the right, although not the obligation, to sell a specific quantity of a good on a particular date at a preset price - the risk is lessened. Since we are heavily dependent on foreign imports on essential commodities, fuel, other energy products, it is important that we have the right financial infrastructure as a cushion from wild price shifts in the world futures exchange markets.


Let’s take oil imports as an example, with our economy worth US$76 billion (2014); oil import bill is over US$4 billion according to recent statistics.
It is also a known fact that the annual oil bill varies depending on world prices now stands at around US $ 5 billion while the GNP is around US $ 60 billion. It is therefore of paramount importance to take advantage of lower oil prices when prices in the world market is very low. It should be done with right expertise. One should follow futures prices in the world market and very closely and monitor any changes.


What went wrong at CPC?
I have been following up the recent turbulent times at CPC from the beginning when hedging deals with several banks have struck in 2007 right until it went to International Arbitration courts in London 2009, when the oil market crashed, the hedging deals’ negative payoff for CPC reached several hundred millions, where CPC defaulted on the hedging payments which resulted in the banks taking CPC to International Courts.

The irony there was no proper risk assessment done by CPC and it was completely mismanaged, as it was only one-sided strategy has been used as zero cost collars. One of the reasons behind the fiasco was the failure of CPC to appoint specialized experts in such complex option deals. CPC instead focused on the banks to provide them with the expertise to minimize CPC’s losses. I am of the opinion that international banks have done nothing wrong there, they simple act as provider of hedging solutions as any other bank. CPC hedged itself against rising prices whereas they failed to recognized the risk of falling prices. It would have been taken care of possibly by buying a simple put option at a strike price a little lower than the floor. Or simply going long on a call is a profitable strategy when the underlying price rises in value.


Sadly it was an unforgettable lesson to the Sri Lankan economy. The country has lost millions of public money, and it simply reasserts the lessons of the past that firms who are involved in dealing with complex sureties should first understand the principles involved behind those complex options trading, and one should seek professional people around to structure such complicated hedging mechanism.


Stress testing should be carried out in order to determine the maximum losses that the firm faces under different scenarios. Instead of depending on bank’s expertise, who might have their own sets of interest. Else they should have created an independent risk reporting framework which is not influenced easily and makes the right calls for the organization, no matter how difficult it is.


World economic outlook
Global economic growth is slowly steadying up, barring major geopolitical upheaval, global economic growth in 2015 with hold at a rate of 3.4 percent in 2015. USA, Europe and China will continue to grow, other major emerging markets will continue to grow, but growth will vary, depending on the pace of reforms.
Africa and parts of Asia offer opportunities to build sustainable growth models, and this with the current political climate in Sri Lanka, will provide more scope to grow with challenges on economic, legal, and institutional fronts. And I do not see any downside to Sri Lankan economy as long the current policy makers make the right calls for the economy.


Upsides relate to the ability of policy and business to invest in people, raise productivity, and rebuild trust and confidence in business.
The current recovery in the world economy is having many effects, unleashing forces of reform and conservatism and change in political and social spheres in countries around the world.


Rapid global growth is also changing the relationships between developed and developing countries, as the latter grow two to three times faster than the developed countries. Moreover, the full range of industries and occupations feel the impact in different ways and to varying degrees by this fast growth, including financial markets. Strong demand from the industrialising countries, and from the developed countries that has also seen strong growth in the last few years, has led to huge increases in the prices of industrial materials. Crude oil prices behave as any other commodity with wide price swings in time of shortage or oversupply.


Year 2015 crude oil outlook
Not long ago, crude was trading at triple-digit before prices plummeted below US$ 50 per barrel mark as per depicted chart above. Slump in crude prices is the biggest pull back in crude oil history. This has created an unprecedented buying opportunity, as well as encouraged investor participation to take advantage of it.


On the other hand, sentiment in the market is that crude will bounce back, and will stage a recovery. View is that crude is unlikely to go below US$ 40 per barrel mark, which is the line in the sand. If it does go below this level, it will have devastating impact on producers, subsequently oil producers will soon cut their production, and marginal producers will go out business. It is only a matter of time before the mighty oil cartel cuts output and drives up oil prices.
Internationally, for countries like China, Japan, and South Korea, which are huge energy importers, each 1 percent drop in crude prices is the equivalent to billions of dollars saved on their trade balance. Japan, in particular, has been suffering from a trade deficit for the past few quarters.


The predominant reason is due to the mounting cost of energy imports (which they were forced to increase due to their shutting down all of their nuclear reactors following Fukushima in 2011). Plummeting oil prices is net-net a huge positive for them.


In other parts of the world, low oil prices are squeezing countries like Russia, Iran, and Venezuela in very negative ways. China is buying as much oil as possibly they can, it is reported they are buying additional 1mln barrel per month to the 7.2mln barrel. On the hand, Russia is one of the world’s largest producers, with oil and gas accounting for 70 percent of export incomes.


Lower oil prices are sending us a strong signal that all oil importers should be locking in as much as this downturn as possible and get ahead of the curve. Lower energy prices mean more money for discretionary spending for our country. If you think about how low gasoline prices are now compared to where they were a few months ago, this saving generally translates into higher consumption on other things like retail spending. For airlines, this will be awesome because the cost of fuel and flying decreases, the effects of which may be passed on to consumers.


For an academic standpoint, this is simply the market’s way of solving the demand = supply equation. Lower oil prices are a consequence of the oil glut we’re starting to see over the past few years. In short, we have more supply than demand. It also means that oil producers with higher costs of production than the current price of oil will now be forced to shut down. This will drive down supply, eventually forcing the price to come up to a certain equilibrium.
Hedging principles and when to hedge


For example, rising fuel prices can cut into your profits and make budgeting difficult. That’s where we need to set up this mechanism, if your business purchases oil; you can certainly budget with greater certainty by effectively managing the risks associated with fluctuating fuel prices.
The fuel price risk management solution allows buyers to cap the base cost of their oil purchases. The price you pay for fuel is dependent on many factors, including the world futures market price, transportation costs, distribution costs, taxes, the wholesale/retail margin and the SLR/US$ exchange rate etc. The most volatile of these is the futures market price and this is the component that is hedged using certain strategies. Changes in government taxes, transportation, oil company wholesale margin, retail margin and other costs, impact the pump price of diesel but are not managed as part of the futures market strategy.


This would allow you to effectively manage the risk associated with fluctuating oil prices, gives you more control over your cost base, improves cash-flow budgeting and management. The factors driving trading are the differences and perception of differences of the equilibrium price determined by supply and demand at various locations. For instance, suppose there is a shortage of oil in New Zealand to feed livestock. If I believe that I can profit from buying corn in Australia, paying shipping costs, and selling corn in New Zealand, I will continue to do so until the supply and demand for corn is equal in New Zealand; thus the Australia corn price plus the shipping costs equals the New Zealand corn price.


In a nutshell, by knowing your base cost, you can determine at what prices you might consider forward pricing a portion of your purchasing. Thus, it is imperative that an importer knows his base cost when hedging. Whatever your exposure is, there’s no way to eliminate your risk but you can certainly manage it. This is very important to understand, because commodity price volatility also provides opportunity for gains; a secondary goal is to strike a balance between risk and return. The primary objective of hedging is not to make money, but to minimize risks and this includes using hedging to minimise losses.
(The wrier is a specialist consultant in commodity derivatives and resides in Lausanne, Switzerland. He can be contacted via demindabandara@yahoo.co.uk)