Challenges to Treasury’s role in commodity risk management

Challenges to Treasury’s role in commodity risk management

Defining the challenges that prevent increased Treasury participation in the commodity risk management strategy and operations and proposing a framework to address these challenges.

Recent volatility in commodity and energy markets has increased the attention given to Treasury’s role in mitigating these risks. Building a commodity risk framework that is in-line with the organization’s objectives and unique exposure to different commodity risks is the key function, but it must align with an over-arching holistic risk management approach.

Figure 1: Rising commodity prices present challenges to business (Source: International Monetary Fund (IMF))

The traditional treasury landscape has always recognized commodity risk management as a component of treasury’s overall remit. However, rarely did that translate into a commodity risk management framework that is fully integrated into the treasury operations and strategy of a corporate, particularly in comparison to the common frameworks applied for FX and interest rate risk.

On the surface it seems curious that corporates would have strict guidelines on hedging FX transaction risk, while applying a less stringent set of guidelines when managing material commodity positions. This is especially so when the expectation is often that the risk bearing capacity and risk appetite of a company should be no different when comparing exposure types.

The reality though is that commodity risk management for corporates is far more diverse in nature than other market risks, where the business case, ownership of tasks, and hedging strategy bring new challenges to the treasury environment. To overcome these challenges, we need to address them and understand them better.

Risk management framework

To first identify all the challenges, we need to analyze a typical market risk management framework, encompassing the identification, monitoring and mitigation aspects, in order to find the complexities specifically related to commodity risk management.

Figure 2: Zanders’ Commodity Risk Management Framework

In the typical framework that Zanders’ advocates, the first step is always to gain understanding through:

  • Identification & Measurement: of the commodity exposure profile. By this we identify all possible sources of commodity exposure, classify their likelihood and impact on the organization, and then prioritize them accordingly.
    Risk quantification and measurement refers to the quantitative analysis of the exposure profile, assessing the probability of market events occurring and quantifying the potential impact of the commodity price movements on financial parameters using common techniques such as sensitivity analysis, scenario analysis, or simulation analysis (pertaining to cashflow at risk, value at risk, etcetera).
  • Strategy & Policy: With this understanding of the existing risk profile, the objectives of the risk management framework are developed next, with special consideration and focus given to procurement teams’ specific objectives when defining the strategy & policy. The hedging strategy is then developed in-line with the financial risk management objectives that have been defined.
  • Process & Execution: follows directly on from the hedging strategy, where the toolbox is defined for hedging along with the roles and responsibilities which are clearly allocated.
  • Monitoring & Reporting: Everything should be backed by consistent monitoring and reporting, exception handling capabilities and risk assessments sharing across departments.

We will look into each of these areas next in-depth and start to consider how teams various different skillsets can be combined to provide organizations with a best practice approach to commodity risk management.

Exposure identification & measurement is crucial

One of the greatest challenges in creating a risk management framework for commodities is that there is far more nuance to understanding commodity risk than there is to other more straightforward risks like FX or interest rate exposures.

Where the same categorization of exposures between transaction and economic risk apply to commodities (see boxout), there are additional layers of categorization that should be considered, especially in regard to transaction risk.

Transaction and economic risks affect a company’s cash flows. While transaction risk represents the future and known cash flows, Economic risk represents the future (but unknown) cash flows.

Direct exposures: Some risks can be considered as direct exposures, where the commodity is required as an input into the manufacturing supply chain, for instance, and is therefore crucial. In this scenario, the financial pricing is not the only consideration for hedging, but also securing the delivery of the commodity itself to avoid any disruption to operations. While the financial risk component of this scenario sits nicely within the treasury scope of expertise, the physical or delivery component requires the expertise of the procurement team. Cross-departmental cooperation is therefore vital.

Indirect exposures: may be more closely aligned to FX exposures, where the risk is incurred only in a financial capacity, but no consideration is needed of physical delivery aspects. This is commonly experienced explicitly with indexation on the pricing conditions with suppliers, or implicitly with an understanding that the supplier may adjust the fixed price based on market conditions.

As with any market risk, it is important to maintain the relationship with procurement teams to ensure that the exposure identifications and assumptions used remain true

Indirect exposures may provide a little more independence for treasury teams in exercising the hedging decision from an operational perspective, particularly with strong systems support, reporting on and capturing the commodity indexation on the contracts, and analyzing how fixed price contracts are correlating with market movements. However, as with any market risk, it is important to maintain the relationship with procurement teams to ensure that the exposure identifications and assumptions used remain true.

Only once an accurate understanding of the nature and characteristics of the underlying exposures has been achieved can the hedging objectives be defined, leading to the creation of the strategy and policy element in the framework.

Strategy & Policy

Where all the same financial objectives of financial risk management such as ‘predictability’ and ‘stability’ are equally applicable to commodity risk management, additional non-financial objectives may need to be considered for commodities, such as ensuring delivery of commodity materials.

In addition, as the commodity risk is normally incurred as a core element of the operational processes, the objective of the hedging policy may be more closely aligned to creating stability at a product or component level and incorporated into the product costing processes. This is in comparison to FX where the impact from FX risk on operations falls lower in priority and the financial objectives at group or business unit level takes central focus.

The exposure identification for each commodity type may reveal vastly different characteristics, and consequently the strategic objectives of hedging may differ by commodity and even at component level. This will require unique knowledge in each area, further confirming that a partnership approach with procurement teams is needed to adequately create effective strategy and policy guidelines.

Process and Execution

When a strategy is in place, the toolbox of hedging instruments available to the organization must be defined. For commodities, this is not only limited to financial derivatives executed by treasury and offsetting natural hedges. Strategic initiatives to reduce the volume of commodity exposure through manufacturing processes, and negotiations with suppliers to fix commodity prices within the contract are only a small sample of additional tools that should be explored.

Both treasury and procurement expertise is required throughout the commodity risk management Processing and Execution steps. This creates a challenge in defining a set of roles and responsibilities that correctly allocate resources against the tasks where the respective treasury and procurement subject matter experts can best utilize their knowledge.

In best practice, Treasury should be considered the financial market risk experts, and are best placed to fully understand the impact of commodity market movements on financial performance. The function should manage that risk within an over-arching holistic risk approach via the execution of offsetting financial derivatives. Treasurers can use the same skillset and knowledge that they already use to manage FX and IR risks.

Procurement teams on the other hand will always have greater understanding of the true nature of commodity exposures, as well as an understanding of the supplier’s appetite and willingness to support an organizations’ hedging objectives. Apart from procurements understanding of the exposure, they may also face the largest impact from commodity price movements. Importantly, the sourcing and delivery of the actual underlying commodities and ensuring sufficient raw material stock for business operations would also remain the responsibility of procurement teams, as opposed to treasury who will always focus on price risk.

Clearly both stakeholders have a role to play, with neither providing an obvious reason to be the sole owner of tasks operating in isolation of the other. For simplicity purposes, some corporates have distinctly drawn a line between the procurement and treasury processes, often with procurement as the dominant driver. In this common workaround, Treasury is often only used for the hedging execution of derivatives, leaving the exposure identification, impact analysis and strategic decision-making with the procurement team. This allocation of separate responsibilities limits the potential of treasury to add value in the area of their expertise and limits their ability to innovate and create an improved end-to-end process. Operating in isolation also segregates commodity risk from a greater holistic risk framework approach, which the treasury may be trying to achieve for the organization.

One alternative to allocating tasks departmentally and distinctly would be to find a bridge between the stakeholders in the form of a specialized commodity and procurement risk team with treasury and procurement acting together in partnership. Through this specialized team, procurement objectives and exposure analysis may be combined with treasury risk management knowledge to ensure the most appropriate resources perform each task in-line with the objectives. This may not always be possible with the available resources, but variations of this blended approach are possible with less intrusive changes to the organizational structure.

Conclusion

With treasury trends in 2022 pointing towards adopting a holistic view of risk management, together with a backdrop of increasing commodity prices and volatility, it may be time to face the challenges limiting Treasury’s role in commodity risk management, and set up a framework that addresses these challenges. Treasury’s closer involvement should best utilize the talent in an organization, gain transparency to the exposures and risk profile in times of uncertainty and enable agile end-to-end decision-making with improved coordination between teams.

In an era of high prices and volatility these benefits may prove to be highly rewarding.