September 15, 2014 | Written by: Abhishek Kaul
Categorized: Industry Insights
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It’s high time for metal producers and consumers to explore new frontiers in risk management strategies due to increased volatility, risk and regulatory compliance. Enterprise wide risk management requires an integrated view of market, credit, operational and Geo-political risk. Managing market risk is vital to managing profitability. There are many factors effecting market risks for metal companies – foreign exchange, interest rate, commodity prices (ore, alloys, finished products, energy etc). An effective risk management policy includes all levers of influence like derivatives trading, hedging; revising contracting-payment terms; pricing policies; capacity utilization & shutdowns; inventory policy etc. In this blog, I focus on market risk specifically commodity cost, price fluctuations effecting producers and consumers.
Due to increased volatility in metal markets prices, both consumers and producers want to secure their profit margins. Volatility is further intensified by demand forecast errors, increased raw material price liquidity, trading arbitrage, shifting customer delivery dates. These effects impact entire supply chain. The degree and maturity in commodity trading varies among consumer and producers. Some execute basic strategies to manage risk exposure and others are deriving profits from trade activities (significant revenue component).
Three key areas where we need to integrate our risk management and commodity trading strategies
1. Derivatives Trading – Multiple exchanges for metal trading, where producers (miners and metal/steel refiners/manufacturers) can hedge risk exposure caused by metal price volatility. Financial instruments used for hedging include forward transactions, futures contracts, warrants, zero cost collar options etc. It is important to monitor open positions (mark to market, net exposure) on physical and financial trades at transaction level. This can be achieved by end to end supply chain integration and visibility.
2. Supply chain integration with end to end transaction visibility & analytics – in order to manage risk, we first need to make visible our risk positions across sales, inventory (raw material, work in progress and finished goods), operations (production, quality, transportation) and procurement. Lets start with sales contract creation. Companies use complex pricing mechanisms based on market, exchange linked prices for quotational periods in provisional offers, final delivery including formulas based on metal characteristics. Further we need to monitor our exposure position based on the open contractual agreements and mark to market values of both physical and traded transactions including movement of physical commodity. This further integrates to production and quality where assay characteristics are used to calculate bonus, penalties for provisional, final invoices. Similar concept extends throughout the supply chain to procurement.
3. Monitoring & Reporting – Regulatory compliance’s for Hedge Accounting, Fair Value Disclosures, Value at risk and monitoring other risk categories linked to credit risk, Geo-political risk and operational risk.
Let us take one case example from stainless steel. Stainless steel requires input (iron ore, coal, alloys –chromium & nickel, energy) to produce finished product. Composition of alloys chromium and nickel varies from 10-30%; 2-10% respectively. Price fluctuations in Nickel which trades around US $14,000-20,000 per ton significantly effects cost of goods sold compared to Chromium which trades at $2300-2500 per ton. In order to manage Nickel fluctuations company is updating their pricing policies, formulas and implementing commodity management solution that provide end to end supply chain visibility to manage risk and profitability at customer order line level.
Conclusion – Enterprise wide risk management needs to support the growth strategy of a company including financial targets. In metals companies, Market risk is seen as a major risk category. In order to effectively manage Market risk we need to go beyond the excel workbook of a day trader and deploy technology solutions that provide end to end supply chain visibility, analytics with real-time integration of sales, planning, production, quality, transportation, inventory and procurement transaction. Further we see metal markets (including steel) are heading towards increased liquidity like oil, gas. In these liquid markets producers can explore opportunities to decouple their supply chain in terms of supply, production and demand. In future risk management and commodity trading will be an integral part of consumers, producer’s strategy influencing entire supply chain for sustainable profitability.
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