record price and volatility levels > need to start hedging your commodity exposures? treasury hot...

Record price and volatility levels > need to start hedging your commodity exposures?

Treasury Hot Topics Seminar

19 February 2009

Agenda

Audience perspectiveA view on the marketsEvolution of Commodity MarketsWhere philosophy meets strategyCRM related issuesWrap up and conclusion

PricewaterhouseCoopers

Audience perspectiveShare your point of view

Audience perspective

Question n°1 – Treasurer’s viewpoint

How would you rank your company’s exposure to commodity risk compared to other financial risks?




Question n°2 – Management awareness

How would you qualify your company’s top management level of awareness to commodity price risk issues?




Question n°3 – Identification and quantification

Does a centralised view of your company’s commodity exposures exist and are these exposures quantified?




Question n°4 – Where is the exposure managed

Where is the commodity price risk managed within your company?




Question n°5 – How is the exposure managed

What type of instrument do you use to manage the commodity price risk?




Question n°6 – Financial instruments type

What type of financial instrument do you use or would you consider using to manage the commodity price risk (multiple answers possible)?

Agenda



Chinese Imports – ICE Brent – LME Copper

A view on the markets

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ICE Brent Chinese imports LME Copper Cash price

Source: Bloomberg data and PwC analysis


ICE Brent & Airlines Filings


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Dates

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Brent

US Airways

United Airlines

Air CanadaUS Airways

Aloha Airlines

Northwest & Delta Airlines

Maxjet Airways

Aloha – ATA – Skybus – Frontier – EOS Airlines

Source: Recession.org and PwC analysis


Brent - From a backwardation to a contango market (1/2)


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ICE Brent 36 Months – ICE Brent Spot

BackwardationContango Back

Contango



Brent - From a backwardation to a contango market (2/2)


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Commodity Markets Volatilities (cont’d)


Volatility Drivers• Political Risk (e.g. oil and gas)• Weather (e.g. temperature levels, hurricanes in the U.S impact electricity

and gas prices)• Storage capacity and availability of Supply help reduce the volatility

(i.e. electricity cannot be stored and is consequently the most volatile commodity).

• Shortage expectations or bottlenecks in production / refining process• Short-end of the price curve is significantly more volatile than the Long-

end.


100-days historical Vol – ICE Brent – LME Copper – LME Zinc


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ICE Brent LME Zinc Cash price LME Copper Cash price



Volatility and contracts maturity


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ICE Brent 100-days historical Volatilities


Agenda



A Bit of History

Evolution of Commodity Markets

From Butter and Cheese…The Butter and Cheese Exchange of New York was founded in 1872..

You may better know its today’s name: NYMEX. Today, the Exchange is the world's leading energy and precious metals market.


A Bit of History… (cont’d)


Today, a high number of market places exist and can be used for hedging or speculating on Commodity Risk

… to a wide range of commodities: from oil, gas, electricity and metals to… Vegetable Oil, Cheese, Eggs, Pork Bellies… CO2 and Weather…


From physical to financial markets (1/2)


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Zeebrugge Hub daily average traded volumes and daily average physical throughput

Source: huberator.com


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Wold oil production (Average KBbl / day) Average of FUT_AGGTE_VOL (KBbl)

From physical to financial markets (2/2)


Average daily World Oil production and Brent traded (Thousand barrels)



Development of New Markets – Weather Derivatives


• Correlation between their business and climate:- Hot summer of 2003, hot winter 2006-2007, rainy summer 2007…- Concerns regarding global climate change and its impact

• Weather fluctuations is a risk against which companies may wish to be hedged

• Slow to take-off of hedging products due to:- Complex relationship between weather and business performance- “Uniqueness” of the relationship between the business and the

weather (creation of basis risk and sub-optimal hedges)- No medium-long term valuation method (due to uncertainty of weather

forecast) and lack of speculators who could add liquidity in the market


Development of New Markets – Weather Derivatives (cont’d)


Example 1: Correlation between temperature and electricity demand in Spain in 1983 and in 1998

Example 2: Influence of T° and rainfalls on the corn yield

Source: Journal of applied meteorology, August 2001, Volume 40, p 1418

Source: WRMA lesson 1a Weather effects on Crop yields, December 2004


Agenda



Would you be Winnie the Pooh or the Tigger

Where philosophy meets strategy

"Don't underestimate the value of Doing Nothing, of just going along, listening to all the things you can't hear, and not bothering.“~ Winnie the Pooh

"True mastery can be gained by letting things go their own way. It can't be gained by interfering." ~ Lao Tseu

Source:http://financialphilosopher.typepad.com/


The call for action


“The market can remain irrational longer than you can remain solvent” ~ Keynes

The basic 4 steps approach:

1. Identify

2. Measure

3. Manage

4. Control


The 4 steps approach (1/5)

1. Identify what the exposure is?• Locate the exposure:

- In which subsidiaries, for which products?- Within purchases, sales, transformation process?

• Identify physical contracts (firm commitments, forecasts) and indexed contracts creating exposure

2. Measure the exposure and your sensitivity• Quantify the exposure (consider netting of exposures, natural hedges,…)• How much does the commodity price represents within my cost structure?• Assess earnings sensitivity to commodity price taking into account

- Commodity price volatility- Volume risk (demand elasticity)




3. Manage the exposure in line with the company’ strategy and objectives (1/4)• Key input from management:

- CFO, Treasurer, Sales Director, Purchase Director, Production Director, Country Managers

• Objectives should be aligned with:- Company business model- Company risk appetite- Shareholders expectations

• Typical objectives:- Zero exposure- Reduce earnings volatility- Lock-in margins and ensure medium term visibility for the business




3. Manage the exposure in line with the company’ strategy and objectives (2/4)How can we manage the risks?• Choice of methodology and instruments:

- Financial hedges- Purchase / sales contracts re-negotiation- Find natural hedges- Process re-organisation

• Centralised V.S. decentralised processes:- Identification of exposures- Reporting process to Group Treasury- Follow-up of forecasts versus actuals- Hedging decision and execution process




3. Manage the exposure in line with the company’ strategy and objectives (3/4)What are the economic and accounting impact of selected strategy?• What are competitors doing? Which are the accounting implications of the

economic choice made,…

How to implement?• Provide training to key stakeholders:

- In which subsidiaries, for which products?- Within purchases, sales, transformation process?

• Customise and automate exposure reporting- Tools, reports,...




3. Manage the exposure in line with the company’ strategy and objectives (4/4)

4. Control the achieved performance• Benchmarking versus

- “No hedge” scenario- Alternative hedging scenario

• Consider whether we achieved our primary objectives- From an economical standpoint (cost effectiveness, competitiveness,

…)- Accounting (do we reflect the economic reality in the accounting?)



The quantification exercise (1/3)

Measuring the exposure• Across the Group

- Netting opportunities- Local monopolistic markets / legal constraints / non-market driven

prices• Natural hedges / price pass-through mechanism

- Working in both ways• Competitive environment / market practice• Client acceptance for price increase in bull market• Client acceptance for no price decrease in bear market

- Time lags between purchases and sales• How does the commodity volatility impact

- Cost structure- EBIT- Other (covenants working capital requirements,…)




Measuring the sensitivity of the cost structure: Air France – Base case HY08


2.972

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0

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Costs Revenues Margin

Employees Aicraft costs Landing fees and end route charges

commercial & distribution costs Handling charges Other

Fuel costs Revenues Margin

Source: AirfranceKLM website



Measuring the sensitivity of the cost structure: Air France simulated costs:

• No hedge – 60% jet fuel increase – 50% pass through via fuel surcharge


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Employees Aicraft costs Landing fees and end route charges commercial & distribution costs

Handling charges Other Fuel costs Base Revenues

Fuel surcharge revenues Margin

Source: AirfranceKLM website and PwC simulations


The need for adequate CRM policies

"Only in quiet waters things mirror themselves undistorted. Only in a quiet mind is adequate perception of the world.“~ Hans Margolius

• Avoid bad timing for decision taking. E.g.- Hedging jet fuel price in July- Clearly sets the rules of the game, the

expectations of the stakeholders• Policies should cover

- Goal- High level strategy- Rationale- Roles & responsibilities- Reporting requirements – KPIs



Choosing the right strategy upfront (1/2)

"When the mind is in a state of uncertainty the smallest impulse directs it to either side.“~ Terence (195/185 - 159 BC)

Avoid asking yourself the right questions at the wrong moment

• Historical comparison of potential strategies• Building simulation tool • Running what-if analysis• Using stress testing• …


Knowing upfront potential impact of Commodity prices should enable you to

react more quickly and more appropriately


Choosing the right strategy upfront (2/2)

Historical simulation of jet fuel hedging strategies


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)

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Comparability periodHedge build-up period

Source: Bloombreg data and PwC analysis


Finding the Best Hedge

Do financial instruments exist for the commodities I am exposed to?• Yes

- Are these OTC or exchange traded derivatives?- Is the price transparent?- Is there enough liquidity? And for which maturity?- What would be the cost / benefit of hedging?

• No => Proxy hedging- Do other financial instruments exist for highly correlated commodities?

(Proxy hedging)- How stable is the correlation across time?- How effective is the hedge relationship?


=> Proxy hedging may be the only efficient solution for hedging but

may create additional complexities on the accounting side.


CRM and the Treasurer

• Commodity Risk Management tends to be placed under the responsibility of the Treasurer when the exposures remain acceptable.- This allows to benefit from the Expertise and the infrastructure of

Treasury.

• This is untrue for companies where Commodity Risk is at the core of the Business (e.g. Utilities, Metal Refining, etc)- Commodity Risk tends to be managed by a distinctive function from

Treasury (need for expert skills and specific systems).

• In the latter case, interaction between Commodity Risk Management and Treasury remains important in order to integrate : - The FX risk dimension (commodities are often USD denominated)- Funding of CRM activities (e.g. margin calls)- Counterparty risk generated by CRM activities (OTC derivatives)



Section five



Managing CRM related issues

CRM related issues

Brent swaps

Crack spread swaps

Managing commodity risk comes along with other “side duties”:

RISKCommodity Risk Management

Operational

Counterparty

Foreign Currency

Liquidity

Accounting


Accounting for Commodity Hedges (1/2)

Specificities for commodities:• Cannot isolate a component of a pricing formula: only the entire change in fair value

of the hedged commodity contract can be hedged- Hedging one component of a price formula would most likely not qualify for

hedge accounting

Proxy hedging - Basis risk• When no exact pricing is available to hedge an exposure, a correlated pricing can

be used which may lead to difference in pricing movement from the hedge item and hedge instrument

Proxy hedging - Quality premium• The quality premium in a pricing formula of a physical contract may not be included

in the pricing formula/index of a financial contract.

CRM related issues

Hedge accounting and effectiveness testing may be difficult to achieve but

solutions do exist.


Accounting for Commodity Hedges (2/2)

Application of hedge accounting to stack-up strategy• De-designation and Re-designation may need to take place if various derivatives

are packaged to synthetically hedge the exact exposure

CRM related issues

Synthetic jet fuel build-up

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Diffs


FX and Operational risks

Majority of commodities are quoted in USD – FX risk• Chosen policy should incorporate a strategic analysis of interdependency of these

two risks- Managed at the same time?- Manage separately (leave room to benefit from potentially favourable market

movements)

Type of operations – Operational risk

• Need to have adequate structure to manage CRM instruments (derivatives)- FO / MO / BO segregation- Set-up risk committee to monitor CRM activities and take strategic orientations- Follow-up of physically VS financially settled transactions- Adequate systems and tools- Knowledgeable teams / training

=> Treasury is the adequate environment to develop this activity

CRM related issues


Liquidity and Counterparty risks

High volatility implies important changes in market values – Liquidity risk• Exchange traded derivatives often require the set-up of margining arrangements

- Daily exchange of the Mark-to-Market (MtM) of open contracts• Limited credit risk• Creates additional administrative burden• Creates additional liquidity requirements that may be significant (asymmetric

margining between physical and financial contracts)

Important market values of derivatives can increase the credit risk

• Positive fair value of OTC derivatives not subject to margining create additional credit risk- Requirement for adequate follow-up of trading counterparties- Need to incorporate credit risk within the CRM policies

CRM related issues


Agenda



The best moment to fix the roof is when the sun is shining

Wrap up and conclusion

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1

ICE Brent LME Zinc Cash price LME Copper Cash price Aluminium Cash price

• Is it the right time to hedge the Commodity price risks?• In any case it is the right time to

- Define your CRM strategy- Start managing your commodity risks

Back to the future!• Brent: Dec 2004• Zinc: Dec 2004• Aluminium: Oct

2002• Copper: May 2005

Between 4 and 7 years of price rise have disappeared!


© 2009 PricewaterhouseCoopers. All rights reserved. “PricewaterhouseCoopers” refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP (US).

Thank you!

Olivier Cattoor [email protected]+32 2 710 4118

Olivier Kaczmarek [email protected]+32 2 710 9624

record price and volatility levels > need to start hedging your commodity exposures? treasury hot...

Documents

agenda audience perspective

conclusion slide

commodity risk

markets source

centralised view

pwc analysis slide

markets ice brent

commodity price risk