Hedging for companies that buy or sell commodities helps protect a company’s cost of goods sold or top line revenue. It allows a company to lock-in the price of a particular commodity for a certain period of time to limit exposure to unexpected price swings that could negatively impact budgets and bottom lines.
“Good candidates for hedging are midsize companies, especially those buying a lot of fuel, metals or agricultural products, for instance,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “It also applies to businesses that bring in specific commodities, value-add such base-metals like aluminum or copper and move them out, which means they’ve got to inventory their price risk. Anyone directly purchasing commodities should have a hedging strategy. If commodities are a big cost component, companies should use every tool or strategy available to de-risk their purchases by stabilizing pricing.”
Smart Business spoke with Altman about commodities hedging, how it works and what companies that purchase commodities should consider to mitigate their price risk.
Hedging can help protect gross margins from wild or inconsistent swings in prices. How does this work?
Financial hedging to reduce price risk means decoupling the physical commodity from the price component, which tends to fluctuate. How a company buys the physical materials doesn’t change. It’s about the financial hedge reaching a settlement that gets them back to a price that’s stable and reliable.
When hedging, companies buy a commodity at a locked-in rate over a defined period of time. At the end of each month, there’s a gain or loss versus where commodity index settled. If the company is a buyer of a commodity and the price goes higher than the set rate, a settlement comes back to the company. If there’s a loss on the hedge the company can still realize a gain in the physical buy — there’s a settlement in the market that’s offset by the lower prices.
Midsize companies are typically worried about a spike in diesel prices that they can’t pass on to clients. Some of these companies may burn 100,000 gallons per month, so they don’t want to risk a spike of 50 cents. Putting a financial hedge on that commodity offsets any price change on the diesel index.
What do those interested in commodities hedging need to understand or consider before they participate?
Companies must understand their price risk. In transportation, companies buy diesel but may or may not be able to pass on or surcharge their customers for any swing in prices. What’s important is defining the price risk the company will bear — that which it cannot pass on to customers — then setting up a strategy to hedge that risk.
It’s a gut-check question. Companies should recall the last time gas went up to $4 per gallon and how that affected them. Those costs likely couldn’t be passed along to customers.
Be honest about how much of an increase the company could absorb. Define what part of that increase the company might be able to pass along. Are margins being protected? Taking price variability off the table will help set the strategy for the hedge price and how long it should be hedged for.
What are the factors that determine a company’s hedging strategy?
Many companies don’t understand they have exposure until it’s too late — for instance, after a price run up. That’s why it’s important for companies to understand their exposure.
Those that are worried about their budget in 2017 should set a budget for their commodity purchases in the third quarter and then hedge the cost. It’s a best practice to have a hedging strategy that reaches out 24 to 36 months, which allows the company to average out the dollar cost and mitigate the volatility in commodity pricing. A company could decide to be 75 percent hedged at first then taper down as time moves on. But don’t quit hedging.
Do an annual review. Check to make sure nothing has changed in the exposure. Check to see if contracts and risks are the same, if line items have changed and that the strategy is in line with exposure.
Hedging is good insurance. It also helps companies be more thoughtful about their exposure, and determine a strategy to reduce that risk.
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