Hedging risk with a Commodity futures hedging strategy

Welcome to the wonderful world of Commodity trading! This paper highlights basic fundamentals, which are important and integral parts of commodity hedging and hedging risk associated with commodity a hedging strategy.

This paper also intends to provide those interested in understanding hedging an introduction, and it provides those more advanced in understanding of hedging a refresher in latter part of the articles. Being involved in international commodity physical trading and exchange traded derivatives for several years, I dedicated my career to commodity hedging through various multinational organisations who have pioneered in this sector for many years. I always think 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 international trading. I used various sophisticated financial and technical tools to optimise my hedging portfolio to eliminate exposure to commodity prices in the world futures and options markets.

We live in a business world where there is absolutely no control over price fluctuations and exchange rate volatility. By mastering this concept you could minimise your risk exposures whatever trade one is involved in, internationally.

Hedging was a new buzz-word in Sri Lanka until very recently when the oil derivative project was launched, but commodity hedging goes back many decades, and the modern commodity markets have their roots in the trading of agricultural products. While 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 commodities were added 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. There is always winners and losers in the trade. 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.

Why commodity hedging is important to Sri Lanka
There is no doubt that developing nations are especially vulnerable, 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. Whether you are a large producer or a whole set of consumers, you need to hedge your foreign currency exposures and the respective exchange futures commodities.

The volatility of the world commodity markets has a huge impact both on developing economies and on the people that produce the material. Therefore, it is important to find a way of flattening out the markets' peaks and troughs. In an ideal world it is important to have a hedging mechanism set up to face these challenges. 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.

Sri Lanka should gradually learn this concept in order to stay in control against international risk exposures. Since we are heavily dependent on foreign imports such as for raw materials, essential commodities, fuel, other energy products, it is important that we set up right financial infra-structure as a cushion from wild price shifts in the world futures exchange markets.

Currently the Sri Lankan economy is experiencing a $2 billion oil bill exposure per annum in a $20 billion-worth economy. According to recent market sources, a net oil importer, Sri Lanka's fuel bill climbed up to around to $2.2 billion last year, from $1.6 billion in 2005, which was indeed a huge increase. Petrol prices again increased in 2007 by 17%, the sixth increase in the year alone amid high crude oil costs.

As a direct result, local fuel prices pushed to inconceivable levels, which pushed inflation to a staggeringly 17%. Yes it is true that global oil prices have rallied in recent weeks, but it does not necessarily mean that we have to pass these higher prices back the consumer.

It is also a well-known fact that prices of most commodities have surged in recent years due to many underlying factors. The price hike was not only due to good demand for such commodities but it it seen that investing in commodities is also popular. Most multinational investment banks are switching their investment focus into commodities rather than equities markets while adding commodities into their portfolio. Investment banks always play an essential role in the commodity markets, providing and taking off commodity price risk from producers and consumers. Currently world commodity indexes are outperforming world equities via commodity hedge funds or you may want to call it as managed money. The rationale behind this growth, which originate as a strategic choice, is that it also provides a macroeconomic hedge that can help to simultaneously enhance returns and reduce the volatility of a portfolio.

Above all global economic growth was above 5% last year; the third year in a row that it has expanded above this rate. The current boom 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 countries and the 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 metals and industrial materials. Metal prices like, zinc, copper and lead are over 200% higher than they were in 2005. Crude oil prices behave much as any other commodity with wide price swings in time of shortage or oversupply.

As a country, what we need to anaylse these huge price swings, and take corrective action where possible, rather than being vulnerable to higher prices. It is widely known that crude oil futures moved into uncharted territory lately by topping $89 a barrel, buoyed by ongoing supply concerns over potential storm risks in the Gulf of Mexico, and expectation of a fall in US supplies and the Fed Reserve’s decision to cut interest rates.

There are clear links between these factors and oil prices. As an example, the lower US interest rate makes the US dollar less attractive, and a weaker dollar means you have to pay more dollar to get a barrel of the world’s most exchange traded commodity. Therefore, these factors goes hand in hand, which we need to look very closely.

Hedging
Commodity price risk is simply the potential for adverse movements in commodity prices. For example, a sugar farmer faces the risk of falling sugar prices in the domestic or international market, resulting in a loss of income. 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. You will know that movements in the value of commodity prices can have a significant impact on the cash flow and profitability of your business.

One has to understand that 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.

It is also fair to explain that 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

Principles
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. There could be hedgers on both sides of the market and that hedging is essentially a risk reduction technique more than anything, which allows informed traders and commodity dealers to profit from their intuitive knowledge of future changes in the difference between futures and spot prices.

It is important to understand commodity risk; either you can as a consumer or a producer create customised commodity hedging solutions. 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/USD 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.

When to hedge
By knowing your cost of production, you can determine at what prices you might consider forward pricing a portion of your crop. Thus, it is imperative that a producer knows his/her cost of production when hedging a commodity. Hedging was created not only for novice traders, or hedgers but for the professional as a refresher or to learn an alternative methodology as well. Whether you are just beginning to trade or have been trading for years, it is important to acquire this knowledge of exceptional trading fundamentals and methods and mastering markets. Therefore, it is ever so important for companies involved in international trade to “think globally, act locally”.

Whatever your exposure is, there’s no way to eliminate your risk but you can certainly manage it. Which 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. The primary objective of hedging is to minimize risks and this includes using hedging to minimise losses.