What is the right price for cotton, coffee, copper and crude? Not even a soothsayer will try to take a bet on this. Analysts will produce gigabytes of reports and charts, debating whether the market is likely to go up or down and not whether the price is correct or not.
Except for occasional cases, most of the corporates in India do not have commodity hedge plan in place for their manufacturing activities. These large corporates have not been able to come to terms with the fact that they are not the most efficient buyers anymore. Often corporate hedge plans end with an appointment of a consultant who gives a beautiful report which never gets read, let alone be implemented.
Managers resort to statements like “our company policy does not allow hedge programme”. Some of these large companies even arm-twist the government to change trade policies as evident from the recent case of cotton (textile companies) and a few years ago on iron ore exports (steel producers).
The creation of commodity indices and exchange-traded funds saw the amount of asset investment swelling internationally. This has greatly increased the volatility. Increased volatility has lead to riskier strategies. The ripple effect has caused even more volatile commodity prices in India, leading to shorter lead times between the price spike and the price paid by end users.
Some of the manufacturing companies had attempted hedge programmes when the prices were high only to abandon them after a few brain-storming sessions.
Everything goes on a backburner and a flurry of activities recur only when the quarterly numbers are analysed.Somehow, the annual budgeting has become a mere ritual without much understanding of the price behavior of raw material cost and energy cost.
The issue of whether or not to hedge commodity price risk continues to baffle many corporations. At the heart of the confusion are misconceptions about risk, concerns about the cost of hedging and fears about reporting a loss on derivative transactions. A lack of familiarity with hedging tools and strategies compounds this confusion. Corporate risk managers also face the difficult challenge of getting hedging tools (such as derivatives) approved by the company’s board of directors.
A few years ago, when an Indian engineering giant reported losses on the hedge books, the analysts on electronic media went about giving soundbites without the slightest of understanding that the company may have made up by having a lower cost of raw materials on the physical side.
Many companies handle commodity price risk management through their purchasing departments but now treasurers are seeing the direct impact of commodity prices on profit and loss. It is a cost input. They can clearly see the impact on their need for funding and liquidity. Therefore, commodity risk should be managed by the treasury as a financial risk like any other.
Putting commodity risk management in the hands of a finance team may be an important first step but it is just the start of the process of building an effective hedging strategy. There has been an exponential growth in companies’ exposure to commodity prices and therefore the need to hedge is more acute.
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