Managing Commodity-Linked Costs & Revenues

Managing Commodity-Linked Costs & Revenues Commodity Risk Among the four major types of financial risk (interest rates, currency, credit and commodities), commodity risk is arguably the least common, followed by credit risk. Two categories of commodity risk: 1. Cost risk: the risk of higher costs that a company experiences due to a volatility of commodity prices. An example would be a clothes manufacturer, whose operating costs are linked to cotton prices. 2. Revenue risk: the risk of lower revenues due to a volatility of commodity prices. An example would be an aluminum producer, whose revenues are clearly linked to the price of aluminum. Those companies who have revenue risk on commodities often also have some kind of commodity risk on the cost side, so that they should manage the net exposure. The opposite does not hold true; since there are many companies with purely cost exposures. Commodity vs. currency risk One important difference between the two - is the mean reversion (усреднение) due to the nature of the supply and demand in the commodity sector. When the prices of commodities are high, more producers enter the market and the resulting increase in supply lowers the cost of commodities. When the prices are low, high cost producers reduce the production and the reduced supply pushes prices back up. This causes mean reversion in the commodities markets which is not observed in the currency markets. Is the commodity revenue exposure something that needs to be fixed or should it remain floating? If the cyclicality follows the cycles in the business environment, which in turn follow the cycles in interest rates, then a commodity producer can use this to reduce the net risk by increasing the proportion of the floating rates. Example: See the mining company “Anglo-American” Annual Report 2011: The Group policy is to borrow funds at floating rates of interest as, over the longer term, this is considered by management to give somewhat of a natural hedge against commodity price movements, given the correlation with economic growth (and industrial activity) which in turn shows a high correlation with commodity price. Breakdown of cyclicality (IMF metals price index vs. Federal Reserve funds) In practice, we do not notice that the resulting risk reduction is significant enough to be relied on as a risk management tool. It is easy to see that, even if there was a certain amount of correlation before 1999 (for instance, both curves dip in 1992 and increase in 1999), it almost totally disappears subsequently. This is presumably due to increased speculation and the impact of China as both producer and user of metals as well as other factors. Of course, the picture is different for every company, and for some commodities correlation with interest rates will be stronger than for other. Commodity price risk and working capital Given high commodity prices and increasing need to invest in physical assets, capital needs are set to increase substantially. When commodity prices rises, many companies who used commodities for production may noticed an increase in working capital. This increases the need for debt, and therefore the interest cost rises. Hedging activities On the revenue side….. If the sales contracts are variable in price, the company may decide to fix the price via financial derivatives. If the sales contracts are fixed in price, the company may decide to float it via financial derivatives. Futures contracts Warm-up: Futures contracts Futures - exchange traded promise to buy or sell an asset in the future at a pre-specified price. Futures can be: financial and commodity Settlement price - the average price at which a contract sells at the end of a trading day. This amount specified in the contract or the previous marking-to-market price. Marking-to-market – daily cash settlement of all futures contracts. The spot (cash) price of a commodity or financial asset is the price for immediate delivery. The futures price is the price today for delivery at some future point in time (the maturity date). At expiration, the spot price must equal the futures price because the futures price has become the price today for delivery today, which is the same as the spot. Arbitrage will force the prices to be the same at contract expiration. Why the futures price must be equal the spot price at expiration? Example: Assume, that the contract matures in one minute. Suppose the current spot price of silver is $4.65 and the futures price was $4.70. We could buy the silver at the spot price of $4.65, sell the futures contract, and deliver the silver under the contract at $4.70. Our profit would be $4.70 $4.65 = $0.05. Because the contract matures in one minute, there is virtually no risk to this arbitrage trade. Suppose instead the futures price was $4.61. Now we would buy the futures contract, take delivery of the silver by paying $4.61, and then sell the silver at the spot price of $4.65. Our profit is $4.65 - $4.61 = $0.04. Once again, this is a riskless arbitrage trade. Therefore, in order to prevent arbitrage, the futures price at the maturity of the contract must be equal to the spot price of $4.65. Futures: buyers or sellers Buyer Seller The buyer (long side) of a futures contract is obliged to take a delivery of the commodity or its cash equivalent based on the spot price at expiration and will pay a settlement price. The seller (short side) of a futures contract is obliged to deliver the commodity or its cash equivalent based on the spot price at expiration and will receive a settlement price. Buyers futures are increasing in value Sellers futures are increasing in value when the value of underlying when the value of underlying commodity is increasing in value. commodity is decreasing in value. Long hedges involve buying a futures Short hedges involve selling a futures contract to offset an underlying short contract to offset an underlying long (sold) position. (purchased) position. How to close position? The long side will sell an identical futures contract and the short side will buy an identical futures contract. Hedging with futures Financial futures Permit firms to create hedge position to protect themselves against fluctuating in interest rates, stock process and exchange rates. Long hedges Futures contracts are bought in anticipation of (or guard against) price increases Commodity futures Can be used to hedge against input price increases. Short hedges Futures contracts are sold to guard against price declines Although the futures hedgers are unable to benefit from favorable price changes, they are protected from unfavorable market moves. The Long Hedge Assume, that it is July and you are planning to buy corn in November. The cash market price in July for corn delivered in November is $6.50 per bushel, but you are concerned that by the time you make the purchase, the price may be much higher. To protect yourself against a possible price increase, you buy Dec Corn futures at $6.50 per bushel. What would be the outcome if corn prices increase 50 cents per bushel by November? The higher cost of corn in the cash market was offset by a gain in the futures market. Let’s assume cash and futures prices are identical at $6.50 per bushel. The Long Hedge What would be the outcome if corn prices decrease 50 cents per bushel by November? The lower cost of corn in the cash market would be offset by a loss in the futures market. The net purchase price would still be $6.50 per bushel The Short Hedge Let’s suppose it is May and you are a soybean farmer with a crop in the field; In market terminology, you have a long cash market position. The current cash market price for soybeans to be delivered in October is $12.00 per bushel. If the price goes up between now and October, when you plan to sell, you will gain. On the other hand, if the price goes down during that time, you will have a loss. Let’s assume cash and futures prices are identical at $12.00 per bushel. What happens if prices decline by $1.00 per bushel? The Short Hedge What happens if prices increase by $1.00 per bushel? The net selling price would have been $12.00 per bushel, as a $1.00 per bushel loss on the short futures position would be offset by a $1.00 per bushel gain on the long cash position Basis: The Link Between Cash and Futures Prices All of the examples just presented assumed identical cash and futures prices. But, if you are in a business that involves buying or selling grain or oilseeds, you know the cash price in your area or what your supplier quotes for a given commodity usually differs from the price quoted in the futures market. Basis risk = Cash (spot) price – Futures price Basis and the Short Hedger The July Wheat futures price is $6.50 per bushel, and the cash price in your area in mid-June is normally about 35 under the July futures price. The approximate price you can establish by hedging is $6.15 per bushel ($6.50 – $.35) What if the futures price will decline to $6.00 by June and cash market decline to $ 5.65? Basis and the Short Hedger Suppose, that the basis in mid-June had turned out to be 40 under rather than the expected 35 under. Then the net selling price would be $6.10, rather than $6.15. This example illustrates how a weaker-thanexpected basis reduces net selling price and if the cash price will be lower, then $5.65 – selling prices will increase! Short hedgers benefit from a strengthening basis ! Basis and the Long Hedger Let’s look first at a livestock feeder who in October is planning to buy soybean meal in April. May Soybean Meal futures are $350 per ton and the local basis in April is typically $20 over the May futures price, for an expected purchase price of $370 per ton ($350 +$20). If the futures price increases to $380 by April and the basis is $20 over, the net purchase price remains at $370 per ton What if the basis strengthens (more positive) and instead of the expected $20 per ton over, it is actually $40 per ton over in April? Then the net purchase price increases by $20 to $390. If the basis weakens, moving from $20 over to $10 over, the net purchase price drops to $360 per ton ($350 + $10) Long hedgers benefit from a weakening basis – just the opposite of a short hedger. Importance of Historical Basis Although it is true that basis risk is relatively less than the risk associated with either cash market prices or futures market prices, it is still a market risk. Buyers and sellers of commodities can do something to manage their basis risk. Since agricultural basis tends to follow historical and seasonal patterns, it makes sense to keep good historical basis records. The table below is a sample of a basis record. Although there are numerous formats available, the content should include: date, cash market price, futures market price (specify contract month), basis and market factors for that date. Concerns when using futures contracts Basis risk – the possibility of unanticipated changes in the difference between the futures price and the spot price Cross-hedging - the underlying securities in a futures contract and the assets being hedged have different characteristics Tailing the hedge – purchasing enough future contracts to hedge risk exposure, but not so many as to cause overhedging. Examples of exchange-traded futures contracts Grains and oilseeds EXCHANGE FACE AMOUNT Corn Chicago Board of Trade 5000 bushels Corn Euronext LIFFE 50 tons Oats Chicago Board of Trade 5000 bushels Wheat Chicago Board of Trade 5000 bushels Canola Winnipeg Commodity Exchange 20 metric tons Euronext LIFFE 50 metric tons Rapeseed Livestock and meat EXCHANGE FACE AMOUNT Cattle - feeder Chicago Mercantile Exchange 50 000 lbs Cattle - live Chicago Mercantile Exchange 40 000 lbs Pork bellies Chicago Mercantile Exchange 40 000 lbs Food and fibre EXCHANGE FACE AMOUNT Cocoa Coffee, Sugar & Cocoa Exchange, New York 10 metric tons Cocoa Euronext LIFFE 10 metric tons Coffee Coffee, Sugar & Cocoa Exchange, New York 37 500 lbs Euronext LIFFE 10 tons Coffee, Sugar & Cocoa Exchange, 112 000 lbs Coffee, robusta Sugar-world Examples of exchange-traded futures contracts Metals and petroleum EXCHANGE FACE AMOUNT Copper Comex, New York Mercantile Exchange 25 000 lbs Gold Comex, New York Mercantile Exchange 100 troy oz New York Mercantile Exchange 50 troy oz Comex, New York Mercantile Exchange 5000 troy oz Crude oil New York Mercantile Exchange 1000 bbls Natural gas New York Mercantile Exchange 10 000 MMBtu Copper London Metal Exchange 1000 kg Aluminium London Metal Exchange 1000 kg Platinum Silver Interest rate EXCHANGE FACE AMOUNT Treasury bonds Chicago Board of Trade $100 000 5-year Treasury notes Chicago Board of Trade $100 000 30-day federal funds Chicago Board of Trade LIBOR Chicago Mercantile Exchange $5 million $3 million Examples of exchange-traded futures contracts Index Dow Jones Industrial Average EXCHANGE FACE AMOUNT Chicago Board of Trade $10 x average S&P 500 Chicago Mercantile Exchange $250 X average Nikkei 225 Chicago Mercantile Exchange $5 x average FTSE100 Euronext LIFFE £10 x average MSCI Euro Index Euronext LIFFE €20 x average Currency EXCHANGE FACE AMOUNT Japanese yen (¥) Chicago Mercantile Exchange ¥ 12:5 million British pound (BP) Chicago Mercantile Exchange £ 62 500 Swiss franc [SF] Chicago Mercantile Exchange SF 125 000 Euronext LIFFE € 20 000 Euro (€) Futures valuation Commodity futures value Any costs associated with storing or holding the asset will increase the futures price because it is costly to buy, store, and deliver the asset. Many commodities have storage costs (e.g., corn, live cattle, and gold). There also is risk of loss from spoilage (corn), disease (cattle), and fire (oil or gas). Insuring or bearing these risks adds to the cost of holding these assets. There may also be non-monetary benefits from holding an asset in short supply. For a manufacturing firm, for example, this may be the benefit of having a ready supply so that a temporary shortage of their primary input will not disrupt their operations. The return from these non-monetary benefits is called the convenience yield. Futures price  Spot price (1 + Rf) + Storage cost – Convenience yield Rf – the period’s short-term risk free interest rate Storage costs (“the cost of carry”) - amount for storage costs of the underlying commodity over the life of the contract. Convenience yield – Buyer of the futures contract does not have immediate access to the commodity but will receive it in the future. The buyer has given up the convenience of having physical possession of the commodity and having it immediately available for use. The futures price is adjusted for the loss of convenience; the convenience yield is subtracted to arrive at the futures price. Contango and Backwardation Futures prices may be higher or lower than spot prices depending upon the convenience yield. When futures prices are higher than the spot price, the commodity forward curve is upward sloping, and the prices are referred to as being in contango. Contango occurs when there is little or no convenience yield. When futures prices are lower than the spot price, the commodity forward curve is downward sloping, and the prices are referred to as being in backwardation. Backwardation occurs when the convenience yield is high. There must be a significant benefit to holding the asset and these benefits offset the opportunity cost of holding the asset (the risk free rate) and additional net holding costs. Hedging strategies at contango and backwardation markets Futures price Spot price Backwardation market Contango market Arbitrage opportunities Arbitrage opportunities would exist if the futures price differs from the spot price compounded at risk free rate. For example, if the spot price of commodity = 100 Rf = 5% 1 year futures price is 107 (as opposed to 105) Arbitrageur can buy the commodity for 100 and sell a futures contract for 107 Assuming no storage costs, when the commodity is delivered for 107, the arbitrageur earns 2 in excess of the earned investing in the risk-free asset. However, commodities typically incur a storage costs. The buyer of a futures contract, in effect, gains access to the commodity in the future without buying it now and incurring the storage costs. Futures prices are affected by the monetary costs and benefits of holding the underlying asset Storage and insurance are costs, while any cash flows from the asset are a benefit. If we define the net cost of holding the asset as the costs net of any non-monetary benefits, we have: Net costs (NC) = storage costs convenience yield The generalized no-arbitrage futures price is now: Positive net costs of holding the asset increase the futures price. When the asset generates cash flows, the net costs are negative (a net benefit), and the futures price is decreased. We can define the net benefit of holding an asset as: Net Benefits = yield on the asset + convenience yield In that case, the no-arbitrage futures price is: where: FV (NB) = future value, at contract expiration, of the net benefits of holding the asset Sources of return for commodity futures contract  Roll Yield  Collateral Yield  Spot Prices (The primary determinant of spot (or current) prices is the relationship between current supply and demand. This is simply the change in the spot price of the commodity. As the spot price increases, a long position in a futures contract will increase in value and a short position will decrease in value; as the spot decreases, a long position will decrease in value and a short position will increase in value. Spot yield is also earned by investors in physical commodities, as well as investors in forward contracts) Roll yield An investor who wants to invest in commodities for a period longer than the longest available futures contract will have to enter into a new futures contract when the original contract expires; this is known as rolling the contract forward. Because the futures price on the new contract will likely differ from the futures contract on the expiring contract, a gain or loss will occur when the contract is rolled forward; this gain or loss is known as the roll yield. The roll yield will be negative if the new futures price is higher than the expiring futures price, and will be positive if the new futures price is lower than the expiring futures price. Markets for which the futures price is lower than the spot price (and farther-term futures prices are lower than nearer-term futures prices) are said to be in backwardation. For example, suppose the spot price of oil is $58 and the market is inverted because inventories are relatively low. This means the first futures price might be at $57 and the next contract at $56. You go long the front contract as described above. Now suppose a few weeks pass and nothing happens to the spot price. The futures contract you own moves toward the spot price as delivery approaches, and we can assume the spread between the futures stays at a dollar. You sell your maturing futures near the $58 spot price and buy the next future for around $57. Note that in an inverted market you make money from the roll yield even if commodity prices remain unchanged. Collateral Yield Commodities exchanges require investors to post a margin. Although this can be in cash, most exchanges allow (and most investors prefer) to post risk-free securities, such as US Treasury Bills. This allows the margin account to earn interest; this interest is the collateral yield. The collateral yield component of the commodity index returns is the interest earned on the collateral (plus invested cash up to the value of the underlying asset) posted as a good-faith deposit for the futures contracts. Collateral yield can be earned by investors in forward contracts (if the parties agree to having a margin posted, and allow that margin to be funded with interest-bearing securities), but this is not common. Collateral yield is not earned by investors in physical commodities (as there is no margin account). In measuring this component of return, index managers typically assume that futures contracts are fully collateralized and that the collateral is invested in risk-free assets. Thus, the returns on a passive investment in commodity futures are expected to equal the return on the collateral plus a risk premium (i.e., the hedging pressure hypothesis) or the convenience yield net of storage costs (i.e., the theory of storage).