Why companies should be hedging their price risk?

The pandemic and its aftermath have had a unique impact on commodity prices. While oversupply conditions resulted when the lockdowns were imposed world over, the recovery that is being witnessed in the western economies and China has unleashed a bull run in commodities, one which has never been witnessed before. We have seen prices of agri commodities, fuel and metals increase sharply which is a boost to the commodity market. The World Bank is seeing an increase in prices of almost all products in 2021 after which there would be stability, as during the pick-up phase of growth there is always a tendency for prices to increase.

Important question

This raises an important question: Are corporates hedging their price risk? This question was almost forgotten when the global economy had gone into a phase of stagnation with countries still struggling to maintain the nominal rate of 2-3 per cent as monetary authorities have been trying their best to stimulate them. But things are different now and this is why hedging is important.

Hedging commodity risk is very important especially for raw material intensive industries and this holds more in the agricultural space where price volatility can upset the profit margins of companies. If one looks even at the recent CPI numbers in India the food basket which has shown nasty signs are pulses, edible oils, and spices besides the perishables which would be more seasonal in nature. Indian agriculture has two cropping seasons, and the peculiar thing is that most crops are grown once a year and have to be stored and sold through the year. As the year comes to an end there is a tendency for prices to move up until the next crop comes in. Any news on monsoon being weak in regions can cause a spike in prices.

Oil seed processors encounter this risk every year as we are net importers and price takers, with 2021 being quite singular. There are market driven derivative instruments like futures and options in goods on commodity exchanges that are liquid and efficient tools to hedge price risk. Ideally any value chain participant exposed to price risk should be hedging their raw material risk as a ratio to turnover which would range between 40-70 per cent. The same holds for processors of pulses where high prices can upset their businesses. Processed food manufacturers use oils, pulses, spices, sugar, etc. in large quantities and should be hedging at least a part of their price risk.

Market-driven tools

Exchanges such as NCDEX offer market driven tools like futures and options, that can be used by corporates to hedge price risk . Hedging should be done keeping in mind the company’s position in the physical market. Once the price is hedged by taking an equal and opposite position in the futures market compared with the physical market, the margins get fixed and the company becomes more or less immune to the price movements. An edible oils manufacturer sees the price of soybean at ₹5,230 (NCDEX) for an October contract and locks in this price as this is when the crop enters the market. The only risk the processor needs to assume is the basis risk which may arise due to location based premium & discount. However, the larger part of the price risk is on raw materials which is hedged using commodity derivatives.

The oil processor may hedge in the derivative contract directly in October when the crop arrives in the physical market or buy the current month futures contract and rolling over the same. Hedging will equip him to offset the losses in one market with the gains in the other, thereby protecting his margins. This idea has to catch on for all commodity-based companies to ensure that there are no awkward price shocks. SEBI has already made it mandatory for listed companies to disclose the hedging strategies in the annual report in the corporate governance section. This has to be taken seriously by companies and more importantly shareholders need to evaluate the same. Companies which do not hedge their commodity price risk are actually taking a big chance which can affect their financials that finally gets reflected in prices.

Investors hence have a role to play here and just like how companies which are environment conscious(ESG) get higher valuations, the same should hold for companies which have strong risk policies covering price risk hedging. In fact, the former which is well accepted today is a long run consequence while price risk affects companies immediately. We should have stock experts talk more on this when they evaluate company prospects.

The author is a Chief Economist, CARE Ratings and author of: Hits & Misses: The Indian Banking Story. Views are personal.

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