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For Commodity Related Firms, Hedging Is Key!

Summary

For firms with significant commodity price risk, hedging can be the most powerful source of profitability and competitive advantage.

Frank Knight hypothesized that the responsible decisions in organized economic life are price decisions - others can be reduced to routine.

90% of managers at commodity related firms agree that price risk is key to competitive advantage.

Lately I got into arguments about the proper role of hedging with some individuslas who, I thought, should know better. Their belief, essentially, is that operative businesses - mining firms, oil&gas producers, airlines... - should always hedge their price exposure and focus on generating value on their operations. In other words, ignore the price of inputs and/or outputs. They insist that it's all the same whether a Palladium producer sells the metal at $600/oz or $1,300/oz, whether gold miner sells gold at $450/oz. or $1,400/oz or whether an oil producer obtains $70/bbl or $50. Their rationale, in a nutshell: management shouldn't speculate, else they may as well just close down their firms and only engage in price speculation.

They are wrong, however. I seldom make such categorical statements, so I'll try to substantiate: rather than being an indiscriminate means to eliminate price risk, hedging can and should be the most powerful source of profits and competitive advantage, at least for commodity-related businesses. Take a recent example: in Q4 2018, oil price fell by 40%. By taking the wrong directional bet on oil prices, China's largest refiner, Sinopec sustained a $690 million loss, reducing their profitability for the year by 90%. When commodity prices fell 50% in 2014/15, U.S. mining industry (this category includes oil and gas producers) sustained losses of $227 billion, erasing fully eight previous years worth of profits.

Indeed, in "Risk, Uncertainty and Profit," Frank Knight wrote that in competitive markets, only true uncertainty can be the basis of a firm’s ability to earn positive economic profits on a sustainable basis. The key aspect of uncertainty Knight was referring to was price, which he regarded as the most important factor determining a firm’s profitability: “the most important fundamental determining fact in connection with organization is the meeting of uncertainty. The responsible decisions in organized economic life are price decisions; others can be reduced to routine…”

To insist that management's choice is either to ignore price fluctuations or to close shop and just focus on price speculation is a pointless caricature of the issue. Hedging should have its rightful place in any firm's business process. Managing commodity price, currency, or interest rate risk should enable a firm to take risks in a controlled and purposeful fashion, accept occasional losses and communicate such losses to its stakeholders openly and transparently, without losing stakeholder confidence in the validity of the firm’s strategic choices or the management’s capability to achieve them. Price speculation need not be reckless risk taking and a magnet for rogue traders. As with any process, there are best practices to observe in implementing hedging operations. I've summarized them here.

In addition to being a potential source of profits, hedging can be a powerful and hard to match source of competitive advantage. For instance, if the prices of key inputs are rising, a company can secure a lower cost of material by buying adequate quantities for future delivery. Conversely, if the selling prices for its products are declining, it can fix higher prices by taking short positions in the futures markets. In this way, hedging can significantly improve operating profits.

Based on the income statement of an average S&P 1500 company (and assuming constant sales volumes), a 1% improvement in the selling price would generate an 8% increase in operating profits. Conversely, a 1% drop in the cost of goods sold would lead to a 5.36% increase in operating profits. This impact is more than double that of a 1% increase in sales volume. For commodity businesses where operating margins are typically very low, hedging can have a much greater impact on profitability.

Consider for example the U.S. petroleum wholesale industry where the operating margins average at about 0.8%[1]. At a cost of around $800 per metric ton of heating oil (ignore the absolute price level for the moment), a typical wholesaler could hope to earn a margin of about $6.40 per ton of heating oil sold. But suppose a wholesaler were able to reduce their cost of merchandise by an average of 1%[2]. That improvement would add $8 per metric ton to the firm’s profit margin, raising it from $6.40 to $14.40 – a 125% improvement in operating profits. Given such dramatic value creation potential, managers at commodity firms should not undiscerningly proscribe all speculation. After all, taking risks is what firms must do to generate profits.

Of course, the question remains whether achieving and sustaining this kind of competitive advantage is realistic. In all likelihood, it is notrealistic to expect that hedging can achieve either permanently reduced cost of goods sold, or permanently higher selling prices. But at times when commodity prices undergo significant changes and form major trends, gaining a definite and significant price advantage through hedging is entirely realistic. The next question then is, how should firms go about exploring this potential advantage? Quality answers, I believe, would not fail to emerge through a systematic approach to problem solving and some organizational engineering.

According to a BCG survey in 2013, 90% of managers in commodity companies thought managing price risk was key to competitive advantage, implicitly agreeing with the above (and with Frank Knight's hypothesis). At the same time, only one third of them thought they had good solutions in place and 25% of them stating their capabilities in this respect are 'low'. here's no question that firms should devote some resources to tackling this problem matter and formulate effective solutions. As Milton Friedman put it, “it is worth discussing radical changes, not in the expectation that they will be adopted promptly but for two other reasons. One is to construct an ideal goal, so that incremental changes can be judged by whether they move the institutional structure toward or away from that ideal. The other reason is… that if a crisis.. does arise, alternatives will be available that have been carefully developed and fully explored.”

[1] This is based on a 2003 FirstResearch survey of 13,828 companies engaged in the petroleum wholesale business. Since then, margins may have shrunk still further.

[2] An oil wholesaler could use hedging to its advantage by buying forward quantities of heating oil when the prices are advancing and keeping their position unhedged when they are declining.