“Even the greatest was once a beginner. Don’t be afraid to take that first step.” - Muhammad Ali.
In our previous article we discussed a simple scale for assessing your commodity risk management maturity, starting from Naïve, progressing through Novice, Normalized and finally to Natural.
Let me introduce you to John. John runs procurement for Fancy Gizmo Limited. A key component in Gizmo production is copper. Whenever his factory needs some copper John phones his trader friend Joe (Trader Joe get it?) who quotes a price and organizes delivery. The CFO of Fancy Gizmo regularly sends articles about derivative disasters to his direct reports. Six months ago, John purchased a sizable volume of copper at a 2-year price high.
Where would John sit on the commodity risk maturity scale? Clearly he is unaware of the need to manage risk, has no processes, hasn’t learned from past volatility, and has senior management who are fearful of using derivatives. He is clearly a very solid “Naïve”.
At Forge aHedge we want to help companies with commodity and financial risk protect their margins and optimise their risk management processes. Here’s what we recommend as first steps for John.
Firstly, John needs to work out a 12-month forecast for Fancy Gizmo’s copper purchases. He helps creating a risk aware culture by explaining to his sales and production teams that he needs an approximate 12 months sales forecast from which the production team can then use to estimate their copper volume requirements. Understanding your exposure is a vital first step in the risk management process.
John knows there is a lot he can do but wants to get basic risk management in place so he can learn and start Fancy Gizmo’s risk journey. He skills himself up on the basics of hedging and speaks to his banker to help him hedge 50% of the expected annual copper purchase with 12 monthly forwards. He draws up a basic spreadsheet and gets some advice for the accounting journals he needs to post monthly. Each month he tracks the actual copper he purchases and the amount he saves (or loses) for each hedge. As he is not fully hedged he can explain to management that a losing hedge is actually a good outcome for them because the larger actual physical purchase cost is lower. One month the price of copper spikes on a mine fire in Chile but John’s hedge saves considerable cash for the company and they are able to offer their gizmos cheaper than their competitors. Sales increase. The CFO extols the virtues of hedging at that month’s board meeting. John is Naïve no more.
But we don’t want John to stop there! We want him to keep improving Fancy Gizmo’s commodity risk management maturity. We will find out how next article.
Let’s Forge aHedge!
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