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Ten Questions Directors Should Ask About Commodity Risk    

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This article is geared toward directors of commodity-based companies or those that have a significant exposure to some form of commodity price risk.  While you may not think of yourselves as a commodity-based business, you may have a significant exposure to commodity risk nonetheless.  For example, an airline with a major exposure to jet fuel prices; a nitrogen fertilizer manufacturer with a major exposure to natural gas prices on the input side and grain prices on the output side; or a food manufacturer with an exposure to ingredient prices such as sugar, cocoa, vegetable oil or wheat flour.

In general, directors should be looking for the assurance that management is aware of the commodity-related risks faced by the company, understands how to quantify these risks and has a well thought out approach to managing these risks.  Bear in mind that risk and opportunity for gain go hand-in-hand and it is seldom the case that the best approach is to try to eliminate risk completely. 

1.  What types of commodity risk does the company face and what steps does management take to manage these risks?  If you are a commodity-based company, such as a grain trader or fertilizer producer, it is likely that discussions about commodity risk are a regular part of your board/management discussions.  If you are not in the commodity business directly, but have an exposure to some form of commodity risk, this is a good warm-up question to initiate a discussion about it.

2.  Of the commodities that impact our business, which ones have a viable hedging instrument available?  Some commodities are “hedgeable”, in the sense that there is a futures contract or other instrument that can be used to hedge or offset the risk associated with the physical commodity.  For example, an energy producer may be able to use the crude oil, heating oil or natural gas futures contracts to help manage their risk.  However, for a hedge to be effective, the prices of the hedging instrument and the physical commodity must be closely related.  If the company is engaged in hedging activities then it is worth asking about what types of tests are performed to measure hedge effectiveness.  If you are not comfortable with the concept of hedging don’t feel bad – most people aren’t.  This is an area where directors often need some additional training and education.

3.  For those commodities that do not have a viable hedging alternative, what does management do to mitigate their risk to the company?  For many commodities there is no viable hedging instrument available.  However, this doesn’t necessarily mean there is no way to manage the commodity risk.  For example, a pulse processor does not have the ability to “hedge” its risk relating to its products (lentils, bean, dry peas, chick peas, etc.), but it can manage its risk by matching its purchases and sales to limit its overall exposure to price changes.  This is often referred to as “back-to-back” trading.  While it is normally not possible to perfectly match purchases and sales, companies should have a policy that sets limits on the size of the long and short positions the traders can take in each commodity. 

Another possible solution for mitigating price risk for an unhedgeable commodity is to transfer some of the risk to other parties through various forms of pricing agreements.  A third possibility is to operate as a toll processor, where the company handles or processes a commodity on behalf of another party for a fee, rather than taking physical ownership of the commodity (and the associated price risk).

4.  Does the company speculate in the commodity markets?  This is a much more complex question than it might seem on the surface.  Your CEO is likely of the view that having an inherent exposure to a commodity by virtue of the business you are in is not speculating and I would agree.  However, choosing not to proactively manage commodity risk when viable hedging alternatives exist is a choice the company is making and management should be able to explain its rationale for doing so.  An example of this would be a company that has a significant exposure to foreign exchange risk as part of its export business, but management chooses to hedge the FX risk at their discretion (i.e., based on their view of where exchanges rates are headed). 

Then there is the case of outright speculating, where the company takes on additional commodity or foreign exchange risk, above and beyond the risks that naturally occur by virtue of the underlying business.  For example, a company decides that since they have a finance department that already deals with Canadian and U.S. dollars, that they will let them start trading other currencies on a speculative basis.  Whenever a company chooses to engage in speculative trading, a whole new range of questions open up for directors to start asking (a topic for another article), but at a minimum - On what basis does management believe that the company can make money speculating?

5.  Does management have systems in place to measure our commodity positions in an accurate and timely fashion?  Over the years, I have been amazed at how often commodity-based companies do not really have a good handle on their positions.  The blame for this is normally assigned to inadequate information systems and/or lags in reporting transactions at their various facilities.  A former colleague of mine was fond of saying that “you can’t manage what you can’t measure” and it is essential that commodity-based companies are able to measure their positions in an accurate and timely fashion.

6.  Is there a clear and effective separation between those that monitor and report the commodity risk, and those that trade the commodity-related positions?  This is one of the most important governance-level questions that directors can ask.  Many of the biggest commodity-related disasters would have been prevented if this simple rule of separation would have been followed.  A fully independent risk control function must be put in place to report on your commodity positions and perform the risk assessments of your commodity trading activities and exposures.  The reasons for this separation of duties should be obvious. 

7.  Are the people in the risk control area (sometimes referred to as the middle office) equipped with the knowledge and support they need to effectively perform their duties?  This is an important follow-up to the previous question.  In order for your risk control group to perform their function effectively they must be equipped with the necessary skills and support from management.  Someone placed in a risk control position without the necessary skills and understanding of the market will easily be intimidated (and often bullied) by the traders.  Ideally, the risk control group is seen as a waypoint to a senior management role such as the CFO.  It is critical that those in risk control have a full understanding of how the markets function and the types of products and trades the company utilizes. 

8.  What is the company’s exposure to foreign exchange risk and what steps does the company take to mitigate these risks?  If you are a commodity-based company or have an exposure to commodity risk then almost invariably you will have an exposure to foreign exchange risk.  Virtually all Canadian commodity-based companies are exposed to the C$/US$ exchange rate, as most commodities are traded in U.S. dollars.  Be aware that even if your company trades only in the domestic market, or trades its products in C$, it is still likely that you are exposed to C$/US$ exchange rate risk, as it is still one of the key drivers of the C$ commodity price.

9.  What types of compensation schemes and incentives are provided to the commodity traders and management?  Understanding the compensation set-up for commodity traders is vitally important.  Many books have been written about the disastrous consequences of having compensation schemes that offer excessive financial rewards with little downside risk to traders.  Bear in mind that companies can also err in the other direction quite easily, by not offering enough incentives to promote a healthy and appropriate performance culture in the organization. 

By the way, boards should also ask themselves whether the types of performance incentives they have in place for their CEO and management (including short and long term incentive programs) are encouraging excessive risk taking or risk aversion.  One of the basic principles of balanced scorecards for performance incentive programs is to find an appropriate balance between risk and profit-seeking behaviour.

10.  Do we understand stakeholder expectations with respect to commodity risk?  This is a question that boards should be asking themselves as well as management.  Do you really understand what your shareholders are expecting of the company when it comes to dealing with large commodity risks?  For example, a dividend paying energy company or utility may have a shareholder base that views the ability to maintain (and hopefully increase) the dividend rate as an extremely important part of the company.  In such a case, commodity hedging strategies that mitigate the risk of a cut in the dividend rate could be an important component of the corporate strategy.  Another classic example is a gold producer that has a shareholder base that views the company, in part, as a play on gold prices, and thus should be wary of hedging strategies that involve capping their participation in price increases.

Commodity risk and hedging can be intimidating concepts for some directors, but don’t be shy about asking questions until you are fully satisfied that management is aware of the risks and is taking appropriate steps to monitor and mitigate these risks.  Judging by the number of failures of large U.S. financial institutions (with highly paid and high profile boards) in recent years, those directors clearly failed in their duty to understand the risks involved in their businesses.

Ron R. Gibson

 

Gibson Capital Inc.
Calgary, Alberta, Canada

Email: info@gibsoncapital.ca


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