Introduction to Commodity Risk Management
By this point of the book we have covered many of the factors and the techniques for managing financial risk. The last area we will cover in this brief chapter is commodity risk. Commodity risk is the risk caused by the volatility of commodity prices. Commodities are generally grouped into two categories: agricultural commodities and metals. To this list we will also add weather—yes, it is possible to manage the economic effects of weather.
There are a couple of aspects that make managing the price risk of commodities unique. The first is that a much larger percentage of trading in the commodity markets is being done by market participants who actually want (or need) to use the commodity for some end purpose. In other words, they are trading the product for the use of it, not simply for the direct economic gain from trading activity. For instance, the cereal manufacturer is buying corn, not because they believe the price of corn is going to rise, but because they need the corn to produce the breakfast cereals that they are in business to manufacture and market. The interest rate markets, the currency markets, and the credit markets in particular are markets in which the majority of trading activity is for direct economic gain. Although hedge funds in recent years have begun activity in trading commodities, the number of individual investors or portfolio managers examining their retirement portfolios and thinking about corn or palladium prices is very small. This means that supply and demand are a much more important factor in determining the price volatility of commodities than are the actions and perceptions of speculative traders.
A second unique aspect of commodities is that their price tends to trend, that is, the prices of commodities tend to take long turn swings either up or down, and once commodity prices start to move in a particular direction, then they tend to stay trending in that direction. This implies the use of exotic derivatives to take advantage of this fact. Note, however, that this trending is not always the case, and a change in circumstances can quickly cause a trend in the opposite direction.
A third unique aspect that commodity derivatives share with energy is that they cannot be stored and transferred digitally like interest rates or currencies can be. Thus physical delivery, transportation issues, location issues, and overall basis risk are much more important factors.
A fourth difference that exists with commodity derivatives is that they are highly dependent on the weather. Severe weather changes can drastically alter the price forecasts for certain agricultural products. It is interesting to note that while most traders have a screen in the trading room showing the business news, commodity trading rooms always have the news screens turned to updates on the global weather.
A final difference is that some nonfinancial corporations are actually in business to take on commodity risk. This is particularly true for commodity producers such as farmers or mining companies. The issue of commodity price risk becomes one of whether they should hedge or not hedge. If they are in business to produce the commodity, then it may be the case that investors want them to take the exposure and are expecting them to take the exposure. However, if price level prospects for the commodity are dim, or if the price volatility of the commodity is too great, then not hedging may put the company into financial peril. Managing commodity price risk is thus a strategic decision for these companies. Whatever the decision on risk management is, the issue is to ensure that the decision is clearly communicated to the relevant stakeholders.
From Egypt to India to Peru, gold has long been valued in many cultures around the world for its beauty, with gold jewelry acting as a key indicator of social status. It has also been used for centuries in coins as a direct measure of wealth, and even with the advent of paper money, for a long time many of these bank notes were convertible into gold by the holder. Gold is also used in industrial applications due to its conductive properties. Despite its central place in cultures past and present, all gold ever mined on Earth would fit into a 23-meter cube!1 In 2016, the world’s largest gold producer was Barrick Gold Corporation, with total production of 5.5 million ounces.2 Barrick is headquartered in Toronto, Canada, and has mining operations around the world, although its core operations are primarily in the Americas.
One of the most basic strategic decisions for any gold producer is whether or not to hedge its output. Selling production forward provides guaranteed revenue, dampening volatility arising from changing market prices. At one extreme, hedging 100 percent of production for the upcoming years by selling futures or forward contracts will eliminate all exposure to gold market prices—they will not benefit from rising prices, but will not be harmed by falling prices. The opposite is true for firms that choose not to hedge any of their production. Many investors purchasing the shares of a gold producer do so because they are looking for exposure to gold prices; therefore choosing to hedge may make a producer much less attractive to a set of investors.
Barrick Gold provides a great example of a firm that has changed its hedging strategy. For years Barrick was firmly in the hedging camp, but in 2009 they shifted their strategy, deciding to limit additional hedges and unwind much of their existing hedge portfolio. As gold prices rose through the 2000s, gaining momentum as the financial crisis took hold in 2007 and 2008, Barrick’s hedge portfolio began to show significant liabilities as forward market prices were much higher than the prices at which Barrick had entered their hedges. The company was incurring significant financing charges related to these positions, but more troubling for the company, shareholders were unhappy as Barrick shares underperformed smaller unhedged competitors. Late in 2009, Barrick announced an equity issue of up to CAD$4 billion with the proceeds intended to unwind its 9.5-million-ounce hedge portfolio. This addressed the concerns of shareholders, but came at a steep cost as the additional equity caused dilution of existing equity holders. The immediate reaction to the announcement was negative with shares falling 6 percent; however, there were positives for Barrick as Charles Oliver, a portfolio manager with Sprott Asset Management stated: “I wanted to own gold companies and not companies involved in the hedging business” and that he “may have to revisit the Barrick story.”3
Barrick’s financial hedges worked as they anticipated, reducing exposure to market prices and guaranteeing the net revenues to be generated from their gold sales. There was no fraud, and no issues of inadequate controls or management oversight. Yet Barrick made the strategic decision to abandon its hedging program and leave its revenues exposed to variable market prices. There is no “right” or “wrong” answer to whether Barrick should have made this change, but for strategic purposes at the time they felt it was the right direction for the company to take. The answer to this strategic question will be different for different firms and even for the same firm at different times. The most important takeaway from this story is the importance of understanding both the internal financial reasons to hedge or not to hedge, and also the external requirements by shareholders, debtholders, analysts, and other stakeholders, and arriving at a decision that considers all of these potentially conflicting requirements.
Basis risk is the risk that the price changes in what you are hedging, for example jet fuel prices, is not exactly the same as the price changes in the financial contracts or instruments that you are using to managing the risk, for example oil price forward contracts. As an example, see the case study of Southwest Airlines in Chapter 2. Basis risk was also a key element in energy risk management as discussed in Chapter 7. For energy risk, the basis risk was in large part based on location, in that energy prices had different prices in different locations.
Basis risk is a major issue in commodities as well. To begin, there is the location issue. If one is hedging oranges, one may need the physical oranges. Having the oranges located in a different part of the country is not going to help if one needs to start a production run of orange juice today. Secondly, like most commodities, not all oranges are identical. Again, as in energy where it was discussed that not all oil is equivalent, likewise not all oranges are equivalent. This is quite different from trading interest rates, where the 30-day LIBOR rate for any given day is a fungible rate that is consistently applied on a global basis.
In the presence of basis risk, knowledge of the correlation between price changes in the underlying and prices changes that are referenced in the hedging instrument is key (again, for example, Southwest Airlines using oil price contracts to hedge jet fuel prices). One needs to ensure that the correlation is stable, and that the correlation is high. Any change in the correlation will diminish the effectiveness of the hedge.
One way to manage basis risk is through a basis swap. A basis swap is just like a traditional swap, only the two counterparties will trade the difference, that is, the basis between two reference indices. For instance, it may have been possible for Southwest Airlines to hedge the basis risk between jet fuel prices and oil prices by entering into a basis swap of the market price of jet fuel for the market price of oil as shown in Figure 9.1. At the reset dates of the swap, the airline will pay the counterparty the market price of oil on the reset date (multiplied by the notional amount), and in return receive the market price of jet fuel (multiplied by the notional amount). By combining a basis swap, with the more readily available oil price swap, Southwest Airlines could virtually eliminate all of their jet fuel price risk. The issue is that financial institutions are generally unwilling to offering basis swaps due to the difficulty of hedging them.
Figure 9.1 Illustration of basis swap
For companies that produce commodities, the operational financial risk strategies are basically what they are in business to manage and to profit from. For those corporations that use commodities as inputs, there are relatively few operational strategies for financial risk management.
The most basic operational strategy is to enter into long-term fixed price contracts from suppliers. This of course is shifting the price risk to suppliers who may or may not be willing to accept that risk. Another strategy is to pass any price risk onto customers, but this comes with its own set of associated risks. Airlines of course tried to pass commodity price risk to consumers with fuel cost surcharges on its flights during the last time that oil prices spiked. This led to significant competitive advantage for those airlines like Southwest that had mitigated their fuel price risk. It also led to customer backlash as airlines teased customers with very low flight fares, but then surprised them with high fuel surcharges. The situation got so much out of control that in Canada the government enacted legislation that forced airlines to only promote all-in fare prices in their advertising.
One of the blunt mechanisms to manage commodity price risk is to backward integrate by setting up (or purchasing) a commodity producer. This of course is what many of the fully integrated oil companies do with both upstream and downstream oil sourcing, refining, and marketing capabilities. Of course, it is also what Henry Ford so famously did with his River Rouge combined steel mill, electric generation facility, and automobile factory.
As with other blunt operational strategies, vertical integration solely for the cause of commodity price risk is probably not a sound idea. However, if the commodity is key, and if financial contracts are not sufficient to control the price risk to an acceptable degree, then the company may be left with few alternatives.
Risk Management with Derivatives
Financial derivatives are available for a wide variety of commodities. Due to the nature of commodities, most of the trading is done on the exchanges or with specialist counterparties in the over-the-counter market. Financial institutions, with some notable exceptions, are not that heavily involved in the commodity markets and particularly not for physically settled contracts. Thus, the number of counterparties for over-the-counter bespoke transactions is somewhat limited for many commodity-type derivatives. Thus, the importance of exchange traded derivatives for commodities is much greater.
Having said that, there is an opportunity to take advantage of some of the special characteristics of commodity price trends in offering exotic derivative types. These exotic derivatives are generally cash settled and mainly offered in the over-the-counter derivatives market.
One special type of exotic option that is used in commodity markets is a barrier option. A barrier option is like a conventional option in that it still offers a payout based on the price level relative to a strike price. The difference with barrier options is that there is also a barrier level in addition to the strike price. If the barrier price level is broken through by the price level of the underlying commodity, then the option either gets “knocked-out” or “knocked-in.” In a knock-out option, the option is immediately canceled, and effectively ceases to exist without any payoff if the price barrier is breached. With a knock-in option, the option does not exist, and thus will not make a payout unless the barrier price is broken through.
Let’s examine an example. Assume that a cereal producer is interested in hedging against the price of corn rising, and a corn farmer is interested in hedging against the price of corn falling. Both of them could buy an option on corn with a strike price of $3.50 per bushel. The cereal producer could buy a call option and the farmer could buy a put option. Assume that the current price of corn is around $3.50 per bushel, and thus both of the hedgers have bought at-the-money options which tend to be relatively expensive. Both the cereal producer and the farmer would like to reduce the cost of their hedges. Both also believe that corn prices tend to trend, that is, once they start moving in a given direction then they will continue in that direction for some period of time. That being the case, both of them can reduce the cost of their options by choosing to enter into barrier options which are less expensive than conventional options.
The cereal producer believes that if the price of corn falls to $3.00 per bushel that it is unlikely that they will need their call option. Thus, the cereal producer buys a knock-out call option on corn with a strike price of $3.50 and a knock-out barrier of $3.00. If the price of corn stays above $3.00, then the option will behave, and have a payout just like a conventional option. However, if the price of corn falls below $3.00, then the option will get “knocked-out” and cease to exist. The payout will be zero, even if the price of corn recovers and soars above the strike price of $3.50.
The farmer will likewise buy a barrier option, but they decide to buy a knock-in put option with a knock-in barrier of $3.00. In this case, the option does not exist until the price of corn falls below the barrier price of $3.00. Once the price of corn does that, then the barrier option acts exactly the same as a conventional put option.
Barrier options are popular for commodities (and sometimes for currencies) because of the tendency for commodity prices to trend. However, there is a danger of being whipsawed. For instance, in the example above, the price of corn could fall below $3.00, knocking out the cereal producer’s option, and then subsequently the price of corn could soar to well over the original strike price of $3.50 and the cereal producer would be left fully exposed to corn prices. Generally, to protect against being whipsawed, hedgers will buy another option once one has been knocked out. However, if corn prices do fall below $3.00, then the cost of a call option with a strike price of $3.50 will be much less expensive than it was originally because of the new lower price of corn.
Prudently handled, barrier options provide an effective and low-cost derivative hedging tactic for certain commodities whose price changes have a tendency to trend.
Weather derivatives are a relatively new financial markets innovation, where contract payouts are linked to measurements of weather variables. The particular variables range from temperatures, to wind speeds, to the number of days of precipitation at a particular location. Really, any measurable weather variable can be used in these contracts. Let us explore the specific example of a heating degree day (HDD) swap to help understand the concept. Although the actual calculation is a little more complicated, HDDs are, at their essence, a measurement of how cold a location is—the higher the number of HDDs, the colder a location is. Two companies could enter a swap contract where each month the fixed price payer will pay an amount equal to $1,000 multiplied by 500 and the floating price payer will pay $1,000 multiplied by the actual number of HDDs in New York. The $1,000 could be any number based on how small or large the companies want the contract to be. Here, 500 is roughly the monthly average of HDD in New York State, and would be agreed to by the companies as part of their negotiations. If the actual number of HDDs in a month is 600, the fixed price payer pays $500,000 ($1,000 × 500) and the floating price payer pays $600,000 ($1,000 × 600). In practice, only the net difference between the fixed and floating payments would change hands, so the floating price payer would make a payment of $100,000 to the fixed price payer. If the actual number of HDDs in the month is 400, the fixed price payer will make a net payment of $100,000 to the floating price payer.
The question is who would be interested in entering into a weather derivative like this? If you are a gas distribution company, your profits tend to be very highly correlated to the amount of natural gas you sell to your customers, and they tend to buy a lot more gas when it is cold as it takes more energy for them to heat their homes and businesses. In this case, the company may be worried that if a winter is unusually warm, their sales and therefore their profits will be below expectations. They will look to enter a contract where they benefit if winter temperatures are warm (i.e., there is a lower number of HDDs) to hedge their risk of lower sales and profits. By entering into an HDD swap as the floating price payer, if temperatures are warmer than normal, they receive a net payment from the floating price payer and if temperatures are lower than normal, they will make a net payment to the floating price payer. The company has reduced its exposure to variable temperatures, helping reduce volatility in its earnings.
Energy companies are natural market participants in weather derivatives since energy usage for certain sectors is so closely tied to weather. As renewable energy generation continues to increase, there will be more interest in weather derivatives tied to the amount of sunshine so solar producers can hedge their generation output, or average wind speed so wind producers can similarly hedge their output. Beyond energy companies, who else might be interested in weather derivatives? Revenue at a ski resort is likely to be significantly impacted by the amount of snow—people tend to prefer the white stuff to skiing on grass and rocks. As the resort owner, you could pray to a divine being for snowfall, or you could enter into a weather derivative that pays you if snowfall is below normal to mitigate the impact of lost revenues in a snowless winter. The following Corney & Barrow case study describes one quirky example of a corporation using weather derivatives to hedge their operating revenues.
Corney & Barrow
Corney & Barrow as part of their business own a chain of wine bars in London, and in 2000 entered into a weather derivatives contract. At first blush, you may not think of bars as natural market participants in the world of weather derivatives, but there is an undeniable logic to their thought process. At six of Corney & Barrow’s locations, there were outdoor seating areas, and fully one-fifth of their summer profits were attributable to customers who came out to enjoy London’s fleeting warm sunny days. A cool dreary summer would reduce Corney & Barrow’s profits; so to hedge this risk they entered a contract that would see them receive payments up to £15,000 on each Thursday and Friday between June and September when temperatures failed to reach 24° C (75°F) to a maximum of £100,000 over the course of the summer. The contract was option-like in that Corney & Barrow would make a fixed payment regardless of the weather outcome, receive a payment if the summer was cool, but not make a further payment if temperatures were warm. They were effectively buying an option contract to protect them from one side of the risk equation (lower profits driven by cool weather) while fully benefiting, less the fixed payment, from higher revenues if it turned out to be a warm summer. Other contracts (cooling degree day or temperature swaps, for example) could have been used to eliminate exposure to both higher and lower temperatures. Interestingly, the party on the other end of Corney & Barrow’s contract was Enron, a major energy company that was confident in its ability to integrate the contract into its broad portfolio.4
Commodity price risk has some unique characteristics that also create unique challenges for managing it. The main characteristic of commodities is their physical nature. A large number of trading in commodities are done by producers of the commodities or users of the commodities. In the other areas of financial risk that we have discussed, there are a large number of traders who are trading for speculative gain—that is not as much the case for commodities. The physical nature also means that basis risk is more important, as differences in quality of the underlying, transportation of the underlying, or geographical location of the underlying can make a significant difference in value. It is a lot easier to trade exchange rates digitally than it is to deal with a trainload of corn.
Despite the challenges in managing commodity price risk, it is important to remember that as long as consumers buy physical assets, commodity risk management will be a very important part of business risk management.
2V. Basov. March, 2017. “World’s top 10 Gold Mining Companies—2016.” http://www.mining.com/update-worlds-top-10-gold-producers
3A. Hoffman. September, 2009. “Why Barrick Reversed Its Gold-Hedging Strategy.” https://www.theglobeandmail.com/globe-investor/investment-ideas/why-barrick-reversed-its-gold-hedging-strategy/article4287614