Supply chain and procurement for commodity products - market price risks don't just come from the unhedged supply
When the principals at DCM have worked with supply chain and procurement teams (not just at DCM but in other lives too), we have found that there is often a misconception of how market price is created, transformed, and mitigated. COVID has brought some of those issues to light for some companies but we thought it would be appropriate to revisit a couple scenarios as examples.
One that became abundantly evident to some firms is that market price risk can be caused by failure of demand or collapse of your sales price. All too often we see management talk about hedging in the accounting framework - transacting to stabilize a cash flow. However, stabilizing your supply cost cash flow while allowing the sale cash flow to fluctuate is not price risk hedging. Instead, it actually creates a price risk for the unhedged sales price.
In COVID, the price risk was created when the sales volume evaporated. Think of hotels where demand for rooms may have dropped 90%. If you had fixed price supply of energy for the hotel you were faced with the need to sell the energy before you used it or, if you have cogen, sell the generated power into the grid. But in this instance (which DCM calls event driven hypervolatility), it is likely everyone else is having to do the same thing and the market price will drop just as you are trying to sell your hedges. Now, you are losing revenue while simultaneously losing money on unwinding your hedges. There are some strategies that can help lessen these impacts but only if:
Both of these scenarios point out what DCM has referred to before as the First Law of Hedging (I know, others have asked for the others and I will get to them - but not in this post) - risk is never destroyed, it is only converted from the risk being hedged to a different risk to be managed.
In the first instance above, the hedging of price risk converts the risk of market price movement into operational and contract risk. As long as your operation continues to work as planned and your sales (whether sales contracts or FP&A projections) occur as planned, you are hedged. But once either of the two assumptions fail to perform as managed, the risk may convert back to market price risk on the supply chain. In the second instance, the market price risk has been converted into credit risk - if the credit risk blows up, you again may find the risk converted back into market price risk.
COVID has illustrated that the assumption that hedging is a "trade and forget" strategy can fall apart rapidly. That is why DCM feels the underlying assumptions always need to be a part of your risk management stress testing. One thing this stress testing does is inform management of the other company actors that can create risks (and potential losses) for the supply chain and hedging activities. Informed management can be a very valuable thing when you are explaining a loss by starting "as we noted in last month's stress tests, if...".