Commodity EDGE: The Basics — Risk Management and Hedging Strategies for Procurement (Dispatch 1)

Today and tomorrow, we are live blogging from the Spend Matters/MetalMiner conference: Commodity EDGE. Today's presentations are being recorded and will likely appear in one form or another on our sites in the future. However, we did not want you to have to wait. We'll be covering live -- or as close to live -- as much as possible. First up are Tom Hronis and Damon Pavlatos of FuturePath Trading, who have started to give a rousing intro to understanding the basics (and some more advanced techniques) for commodity risk management and procurement. For those who don't know the commodity-trading scene, these folks tend to be much more animated than the typical geeks (myself included) that live in the procurement and supply chain software and consulting worlds. After all, someone is buying all those martinis as part of the infamous "liquid lunches" down by the Chicago Merc (better known to outsiders as the CME).

Yet for traders, and increasingly procurement organizations, commodity risk management and hedging is serious business. But what is it, really? Tom and Damon started their talk by discussing how futures represent obligations to buy or sell something "at a certain price, on a certain date, in the future." This is nothing new. The market for futures in the US began to trade in the mid-1800's, they note, in the wheat markets when buyers and sellers got together in "centralized venues" to trade both intermediate and forward wheat contracts. Ultimately, formalized exchange came into play as means to create standards and specific connections between individual parties, driving price stability and risk management as the primary objectives.

These exchanges enabled what became known as "hedging," which Tom and Damon simply define as an "investment position intended to offset any potential loss that may be incurred by a companion investment." Hedging exists outside of exchanges, however. The duo provided a few examples: forever stamps from the US postal service, the ability to refinance a mortgage and lock in rates (and the cost associated with additional rate locks if prices decrease further) and, in the most morbid of "futures" markets, death. After all, Tom and Damon note that locking in prices for cemetery plots years or decades in advance of one's death is a form of hedging.

Today in the commodity markets and procurement, the best-known example of hedging come from the airline industry, as many carriers have hedged jet fuel for years (we can thank Southwest as the poster child of this strategy, which saved the company a small fortune when prices increased and the legacy airlines dipped into their balance sheets to offset prices while Southwest was largely covered). But beyond jet fuel, Tom and Damon note that companies are increasingly hedging other categories, including a wide range of agricultural commodities (e.g., wheat, corn, sugar, etc., metals -- copper, aluminum, steel/hot rolled coil -- and energy/transportation (e.g., oil). In addition, organizations hedge foreign currency exposure for both buying and selling to and from local markets. Examples in this regard of major traded currency contracts include Euro/US dollar, US dollar/Australian dollar, GBP/US dollar and DX (dollar vs. a basket of currencies).

Generally speaking, there are two types of hedgers: long and short. A long hedger "doesn't own the commodity and wants to buy ahead of time to lock in a price for later delivery." Consider the case of a company that buys aluminum as input into the products it produces -- this is an example of a long hedger. As is "a construction company needing material goods such as copper or lumber [who] goes to the futures market to 'buy' goods needed ahead of time." In contrast, a short hedger "typically owns a commodity and tries to lock in a sale price in advance to guarantee gross profit" such as a "metals manufacturer who wants to sell metals in advance on the open market before he's done producing the metal" or a "producer of wheat who wants to pre-sell next quarter's crop."

Stay tuned as we get into how hedging works in practice.

- Jason Busch

Discuss this:

Your email address will not be published. Required fields are marked *