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Financial Times: Commodities: the hot topic

EXTRACT: Large resources companies such as BP, Royal Dutch/Shell and RWE are also providing competition by tapping into their first-hand knowledge of the market to offer hedging services to their customers and third parties. “The competition is intense,” says Mr Bryce.


By Kevin Morrison
Published: February 27 2007 01:39 | Last updated: February 27 2007 01:39

Envy the commodities experts for they are almost masters of the universe. The rise in price and volatility of raw materials has moved the subject near the top of the corporate agenda.

In a broad range of industries, including food, manufacturing, packaging, retail and utilities, buying commodities has become so important that responsibility has moved from procurement to the treasury department. Company directors are becoming know-ledgeable about commodity pricing.

They have had little choice in the matter. The doubling of the oil price in the past five years has led to executives becoming more vigilant about their exposure to the price of energy.

Few finance executives can afford to take their eye off the ball for too long. Oil price volatility was more than 35 per cent last year, whereas the volatility of the US dollar was just 7 per cent.

The sea-change has also affected investment banks. Their industrial client business has expanded, as more companies in more industries have hedged their exposure to energy and other commodities.

Benoit de Vitry, head of commodities, emerging markets rates and quantitative analytics at Barclays Capital, has been in the business for 20 years. He says the biggest change has been an increased sophistication of the market, with the bank applying to commodity pricing those solutions formerly used only in foreign exchange and fixed interest.

These techniques include companies using structured notes and specifically tailored commodity indices to hedge their exposure to price risk, in addition to the traditional financial instruments of futures, forward contracts, options and swaps in the over-the-counter market.

Mr de Vitry says that until three years ago, clients who wanted to buy a specific commodity such as heating oil, which is used for homes and small industrial facilities, could hedge for only three years. Now they can take positions for up to 15 years.

He says the deregulation of energy markets in the US, Australia, the UK and parts of Europe and Asia over the past decade, as well as the emergence of the European Union’s emissions markets, has provided more opportunities for managing power, gas, oil and carbon emissions. Even a commodity as old as coal has seen a derivative market evolve in the past three years, when traditionally it was a physical market with consumers and suppliers tied by long-term fixed-price agreements.

The growth in the production and consumption of biofuels has also raised demand for hedging feedstock, including corn, wheat, palm oil, rapeseed and soyabeans.

Nevertheless, Colin Bryce, head of fixed income and commodities at Morgan Stanley, says the concept of hedging against an unwelcome change in the price of energy is still relatively new. The airline industry in 1988-89 was the first big group to limit its exposure to commodity price rises.

Since then, heavy industrial groups such as steel producers, fertiliser and chemical companies, glass manufacturers, cement makers and refiners have all joined the party and chosen to hedge commodity price risk.

Mr de Vitry says corporates now have more flexibility to manage costs for longer and over a broader range of assets. For long-term risk management hedges, this means that corporates are taking a strategic position on long-term commodity prices, and have gone beyond managing their day-to-day exposure.

More experienced consumers such as airlines tend to have the most extensive hedging programmes. Air France-KLM said at its third-quarter results this month it had hedged 73 per cent of its fuel requirements for the year to March 2008 at $59.80 a barrel; 41 per cent of the subsequent financial year at $60 a barrel and 20 per cent of the 2009-10 at between $62 and $63.

A key factor behind the extension of the hedging time horizon is the emergence in the past five years of investors in commodity markets. Their weight of money has provided greater liquidity and depth, which in turn has given industrial clients more flexibility to manage their price risk. But it has also brought more challenges.

“The chase for yield has brought investors into the market, which in turn has distorted some of the pricing patterns, as the influx of more money has added another layer of complexity to price behaviour,” says Mr Bryce.

Market deregulation, higher trading volumes and a broadening of the commodity hedging product range has attracted to commodity trading all the bulge-bracket banks, many of which, such as Lehman Brothers, Credit Suisse and Merrill Lynch, had quit the business in the lean years of the late 1990s and the early part of this decade.

Large resources companies such as BP, Royal Dutch/Shell and RWE are also providing competition by tapping into their first-hand knowledge of the market to offer hedging services to their customers and third parties. “The competition is intense,” says Mr Bryce.

Despite a greater choice of hedging instruments and strategies, big industrial consumers of commodities have so far been very careful in their approach to managing price risk. The $550m loss on jet fuel derivatives by China Aviation Oil in 2004 has been one of the exceptions among industrial consumers this decade.

The greatest losses from commodity hedging have been among producers and hedge funds. Last year, Amaranth and MotherRock both imploded following substantial losses in natural gas. Phelps Dodge, the US copper producer, reported that its 2005 fourth quarter earnings were reduced by $200m because its forward sales of copper were at prices well below the then prevailing price. KGHM, the Polish copper miner, suffered a similar fate.

However, these losses are overshadowed by those from commodity trading in previous decades, when Klöckner and German conglomerate Metallgesellschaft both fought for their corporate survival after massive losses from oil derivatives. Sumitomo also nursed a loss of more than $2.5bn on concealed copper trades in 1996.

Mr Bryce says these producer losses are normally associated with poor internal risk controls – rather than commodity price movements – because traders were allowed to take positions not disclosed to the company.

“Corporate hedgers tend to be more fastidious, they are more conservative and more prudent in their risk management,” he says.

Large losses from derivative trading in the past have led to tighter accountancy rules such as Financial Accounting Standards Board 133 and the International Accounting Standards 39, which stipulate that when reporting their financial results, companies must book any unrealised losses or gains from derivatives in their profit and loss account.

“We do not trade for profit, we do not run a book. We take positions only to manage our risk,” says Paul Gardner, who manages energy risk for Associated British Foods, owner of British Sugar and Primark stores. “Nobody wants to take on excessive risk because we would have a tough job explaining it to our board and shareholders if the trade went the wrong way.”

Peter Ghavami, global head of commodities at UBS, says tighter accountancy rules, together with strong financial discipline, have made corporate treasurers and procurement executives more pragmatic in their approach to risk management.

He says that, even though more corporate customers are hedging over longer periods, there is still much resistance from customers unwilling to extend their risk management programme. This is because they will often have to borrow in the credit markets or put up more collateral.

“Counterparty credit considerations become more acute the larger the transaction and the further out on the curve the hedge goes,” says Mr Ghavami.

Copyright The Financial Times Limited 2007

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