Commodity Risk Management: Where to Start

Amol Dhargalkar:  A first step that we’ve seen work really well in practice is making sure the CFO and other executives understand what the exposure is and how big of an impact the exposure might have on the company. The answer might be that the commodity risk is not actually a very big deal and treasury shouldn’t spend time thinking about it. But treasury won’t know that without a thorough analysis of the risk.

To start, the treasury team needs to gather data from multiple parts of the organization. They should engage senior stakeholders to kick off a data collection and analysis project. They should make sure people throughout the company understand why they’re doing that analysis, why they need to get their arms around commodity risk.

Then, as they gather the necessary data, they need to help guide the conversation toward a conclusion about whether the commodity risk matters. If it does—i.e., if senior executives believe the company has too much risk and they want to do something about it—then treasury should make recommendations of how to manage and mitigate that risk.

And the third step is implementation of the risk management program. I don’t want to oversimplify things, but if everyone is looking at the same data and the organization’s executives have decided that risk management is important, then implementation will go a lot easier.

T&R:  What data should treasury be looking at to facilitate the analyses of commodity risks?

AD:  That depends on the type of business they’re in. Companies that are heavily exposed to a specific commodity—such as an airline’s exposure to fuel prices—might have a better handle on those exposures, versus a company for which the commodity is an ancillary expense.

The best data to evaluate is forecast data. An airline, for example, should have a forecast that shows how much fuel it expects to require over a specific time frame. But forecasting spend can be hard, especially for commodities that are not central to the business. For treasury teams that don’t have a solid forecast, the easiest place to start is with historical spend data. Then they can work their way backwards, do some math to figure out how much they spent and how many gallons of diesel they used, for example.

Getting access to this data will probably mean working with finance and procurement, among other groups. Treasury may be able to pull this information out of a forecasting platform or ERP [enterprise resource planning] system, but pulling it all together will probably require some effort for treasury teams that don’t already have a commodity risk management program in place.

T&R:  How should the treasurer determine which commodities to focus on?

AD:  Well, the conversation about which commodities require risk management might be expansive in scope. The best way to start is for executives who know the business well to use their intuition. The commodity they start with might not turn out to be the one that the company has the most meaningful exposure to. But unless it’s super obvious which should be the number-one priority, they should use their intuition. That intuition may be confirmed, or they may be surprised when they get the data. But they have to start somewhere.

It’s important to remember in this process that a company may face exposure to commodities that it is not buying directly. It might be buying a component that a supplier is delivering, and the price of that component may reflect the price of silver or copper or some other commodity. When we dive into the data, sometimes we’ll see that the component price moves in lockstep with the price of the underlying commodity, and sometimes we’ll see that it does not.

So maybe in that situation, the treasury team would need to have a conversation with suppliers, asking them to disaggregate the price of their components into a commodity price, which the organization can hedge against, and a value-added price based on what the supplier is doing with that commodity.

T&R:  Is this something you think every company should be doing?

AD:  It depends on the business. Manufacturers tend to have the biggest challenges associated with commodity risk. Treasury may have trouble getting access to all the necessary data, but they will likely find that doing so is highly rewarding because they will be able to generate a lot of insights and value from analyzing it.

Really, any industrial manufacturing firm is a prime candidate for analyzing commodity risk. But the larger an organization is, the more likely it is to already be doing this. To put a finer point on it, midmarket industrial manufacturing companies are the most likely to see outsized benefits from shifting to a proactive approach to commodity risk management.

T&R:  If the commodity risk analysis results in the organization putting in place a risk management program, how should the treasury team sustain commodity risk management over time?

AD:  Once the risk management program is in place, the best practice for managing it on an ongoing basis is to put in place a risk committee. The commodity risk committee might comprise individuals from treasury, finance, procurement, and the business units. Basically, the determination of who should be on it depends on how widespread the risk is and how central to the organization it is. But the commodity risk committee should be an executive team that focuses on making decisions annually, quarterly, or on whatever timeline makes sense.

Note that this best practice is in stark contrast to the reactive approach of just responding whenever an executive realizes ‘Oh no, we’re getting crushed by copper.’ Establishing a risk management program overseen by a risk committee is a more planful, measured approach, which helps treasury come up with an aligned vision of what the company should do.