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...".
Prohibition against traders trading the same products you (or your customer) trade - please do something about it
There was another fine this week by the CME (the notice is here) where an employee was trading their own account to the detriment of a customer. In this instance, it was a brokerage firm employee trading against customer accounts orders in Treasury options for their own personal account. The notice does indicate the company "failed to adequately monitor the employee’s personal trading account despite permitting the employee to trade the personal account while working customer orders. Although (the company) conducted an internal investigation, (The company) failed to detect the employee trading opposite customer orders for one year, both before and after the internal investigation."
This has several points to it:
Trade compliance is only one thing we cover, supply chain risk for commodities is something different we do
In the post-COVID world, supply chain "resilience" is something that everyone is talking about. But supply chain resilience - shortening supply chain lines, increasing transport options, and diversifying suppliers comes with an increasing need to look at what DCM calls the "static/variable supply chain distinction". It is something we have developed after a number of years working with energy buyers, food products and feed suppliers, agricultural products traders, and even major manufacturing companies.
The static side of the equation is that portion of direct (and indirect) spend dollars that can be easily forecasted on a unit cost for one, two or even three years. This is things like staff labor costs per person - you won't be changing their pay during the budget year by an impactful amount outside budgeted numbers. Similarly, your some of your external supplier costs - cost of paper supplies or computers is not likely to drastically change. These products are very amenable to standard strategic sourcing and resilience normative models.
The other side, the variable side, is much more problematic. This would supplies of items like natural gas, diesel fuel, aluminum, interest rate products or corn or wheat. These product may fluctuate dramatically on a daily - even hourly - basis. The measure of that risk of fluctuation is the volatility of prices. Procurement departments that don't look forward to at least observe the markets' expectation of potential fluctuations can be caught in an noncompetitive position by a sudden increase in supply (or decrease in output) prices that were not managed.
So, when you begin to restructure or even reexamine your procurement function in the post-COVID world, first identify the static and variable components. Determine how much impact the potential movement that the market is expecting and gauge the EPS impact of a change that decreases your margin (supply cost up or output side down). If you want to get deeper into the issue, look at the correlation between the supply and output variations and see how likely a negative impact from both sides is to occur.
Redesigning your supply chain just to unknowingly increase the potential negative impacts of procurement of variable components of your supply chain can just install a new set of problems to replace those uncovered by COVID.
If you have questions about how to looks at these issues, feel free to send us an email or call us. The information is on our Contact page.We are happy to chat and see if we can help.
There is a difference between the US and Europe futures markets' disciplinary actions - you should take that into account
When DCM does trade compliance training for non-US firms trading US markets there is often that moment when the client realizes that thinking trading US futures has the same risk as trading EU futures may be very, very wrong. This doesn't have to do with the basic understanding that markets trade differently or that liquidity pools my differ but rather the understanding that the traders - and their supervisors - may have much more direct contact with and risk from US exchange and regulatory enforcement staff.
Let's just take one small example. Since June 1, 2020, ICE Futures Europe has issued 3 disciplinary circulars. All three dealt with brokers ("Members" in ICE Europe parlance) and failures of their procedures for handling customer business. CME, on the other hand, has issued 30 disciplinary or summary action notices in the same period. Of those, 13 were summary action notices - minor infractions by brokers that were even less impactful than the ICE Europe circulars. The other 17, however, only four were for brokers - for fines from $35K to $60K. Of the other 13, eight were actions against individuals four individuals with eight notices total). In three cases, they were individuals being disciplined for actions within their employment (either as brokers or traders) and the fines ranged from $15K to $200K with associated suspension from privileges to act on customers behalf or to trade the market ranging from 32 years to a permanent bar from ever entering a customer order to the exchange. The other individual trading their own account had a $20K fine and a 30 bar from the exchange.
This is a significant departure between operating environments. One has a more collaborative regulatory structure with a rule book oriented toward the Member (broker) being the entity with responsibility. The other environment is one where the individual logging into the trading screen had personal responsibility for trading activity and violations with the firm having strict liability for any action of their employee when trading the screen.
DCM suggests you take that into account when considering how different your oversight and training should be when trading global markets.