Time to stop beating about the bush with hedging

Posted on 9 Jul 2012 by The Manufacturer

Callum MacPherson, Investec Treasury Products and Distribution, explains why he believes it is time for UK manufacturers to pay more attention to hedging as a route to security of supply and, ultimately, business success.

Since the start of the economic slowdown in 2008, manufacturers have been rocked by a perfect storm of falling demand and rapidly rising costs, pushing many to the edge of survival.

However, as prices for commodities, metals and oil now start to fall, an opportunity exists for manufacturers of all sizes to use hedging to control costs and gain competitive advantage in a highly unstable economic environment.

Volatility is an inherent property of commodities. Because commodities have to be mined or grown or pumped out of the ground, it takes time for production capacity to be scaled up to match increases in demand.

If demand falls abruptly, an overhang of production capacity can lead to a rapid fall in prices, if demand rises then so will the prices of the commodities.

This is illustrated by Brent crude which, in the summer of 2008, reached an all-time high of nearly 150 $/b, but as the global downturn took hold, only half a year later it hit a low around 36 $/b. Then prices rose again as demand picked up reaching a high of around 128 $/b in March this year; an increase of 250% from the low of January 2009.

There are countless examples of these kinds of extreme commodity price movements in oil, distillates, metals and agriculture. Volatility has been further exacerbated in recent years by the increasing involvement of investors and speculators in commodity markets which can lead to prices becoming correlated with stock markets. This may not represent real demand, but it still influences the prices that must be paid by consumers.

Left unchecked this volatility can have a severe impact on the cost bases of businesses that consume commodities.  But while many of the uncertainties facing businesses are beyond their control, businesses can take steps to mitigate the impact of commodity price movements through a programme of hedging.

Figure 1

Swap - Hedger recieves when prices rise, but must payout when the fall
Swap - Hedger recieves when prices rise, but must payout when the fall

Companies which are heavily dependent on oil prices, such as airlines, have been active hedgers for many years. As the range of products available and commodities which can be hedged has increased, large industrial companies have also been hedging. Indeed, most large companies with significant commodity raw material expenses now have some form of hedging programme, but SMEs are still wary of locking in the price of their raw materials.

One of the most difficult questions when considering hedging is when to hedge. Clearly the lower the price locked in at, the better, but should the benefit or otherwise of a hedge be viewed in terms of price movements thereafter?

It’s easy to view an increase in prices after a hedge has been put on as showing that hedging was the right decision. Equally it is easy to criticise a decision to hedge, if prices fall, as a mistake. But the important point is: does the price that has been locked in make sense for the business?

Figure 2

Call Option - Hedger recieves when prices rise, but must pay a premium irrespective of price movements
Call Option - Hedger recieves when prices rise, but must pay a premium irrespective of price movements

Some businesses are able to pass on the cost of price increases to their customers, though there may be a lag which leads to a short term price exposure. Others find that they have difficultly passing on price increases, but customers expect to benefit when prices fall! Fortunately, there are various approaches to hedging which can be chosen depending on the particular situation or concerns of a business. Here a few examples of common approaches:

  • Swaps or forwards: this is the simplest form of hedging and allows the price of a commodity to be fixed. If the price of the commodity increases the business receives a payment from the hedge provider which offsets the increase in price. If prices fall the business must pay the benefit of the lower purchase cost to the hedge provider. (see Figure 1)
  • Call Options: These provide protection against the price of a commodity rising, but the hedger benefits when prices fall. A premium must be paid to put in place this kind of hedge. This may sound unpalatable, but in the same way that businesses pay insurance premiums so that an insurance company rather than them bears risk of fire or theft, the premium on a call option can be thought of as insuring against spikes in commodity prices and is the cost of the hedge provider taking the risk instead. (see Figure 2)
  • Collars: Instead of paying a premium to buy the call options described above, a hedger can give up (or sell) the benefit of the price falling below a certain level. In effect this limits the range of price volatility for the hedger. (see Figure 3)

After rallying since the depths of the financial crisis in 2009, commodities along with stock markets have been impacted by the on-going uncertainty over the eurozone and the effect this is having on the global economy (see Figure 4). Prices started a largely downward trend after the Greek crisis began last summer. A recovery which began at the start of this year as the outlook seemed to brighten has now also faded. However, global crude consumption for example, is now higher than it was before the crisis (See Figure 5).

Figure 3

Collar - Hedger recieves when prices rise significantly, but must payout when prices fall significantly
Collar - Hedger recieves when prices rise significantly, but must payout when prices fall significantly

Which begs the question, is now a good time to hedge? The sell-off in commodity prices in recent months, could present an attractive entry point to businesses looking to hedge. More importantly businesses should consider an approach to hedging which makes their profitability more sustainable in the face of potential commodity volatility and whether the pricing available to execute that strategy in the current market makes sense given the outlook for their businesses.

In a world where profit is being squeezed, cost control is king. For those manufacturing firms that have not done so already, now could be a good time to consider hedging as a core part of their financial strategy.