Hedge against every grain of price rise

With the front pages of business and news dailies devoted to the rupee’s movement, one aspect that has escaped attention is the volatility in global commodity prices across board — be it crude oil, coal, copper, precious metals such as gold and silver, or agricultural commodities such as wheat, rubber, cocoa, coffee, cotton and sugar.

The fact that most commodity prices in India are closely linked to their global counterparts further exacerbates the volatility in rupee terms, with the tribulation of the rupee/dollar adding to the price movement in global markets. For example, oil prices have been treading 18-month lows, but the 25 per cent depreciation in the rupee hasn’t allowed Indian consumers to benefit from this downturn.

Similarly, gold prices in India are close to all-time highs, while the dollar-denominated price of gold is almost 20 per cent lower than its 52-week high.

Most Indian corporate houses have shied away from actively hedging their commodity exposures through derivative and financial instruments, in part due to the negative sentiment surrounding the aggressive use of derivatives during 1997-98 and the ensuing financial mess that pushed several corporate bottomlines into the red.

Fear of hedging

Several independent directors and company managers had then vowed themselves away from these ‘instruments of mass destruction’, as Warren Buffet described them.

However, not protecting one’s underlying business from the volatility in input prices critically impacts the underlying business performance. Few directors or senior managers consciously realise that refusing to hedge an exposure is in itself a decision that deliberately exposes the firm to significant market price volatility.

Several leading firms in India are consciously hedging their commodity exposures, and would therefore be better placed to grab market share vis-à-vis others that are forced to react to changes in input costs.

Win-win?

Is commodity hedging beneficial for everyone?

Not necessarily. In general, hedging is advisable if the price for one side of the value chain (either purchase or sale) is fixed while the other is subject to changes. In commodity production industries, prices are usually determined at the time a contract is closed or the commodities delivered.

Therefore, it might be useful to hedge in cases where commodities are sold with the price fixed today but need to be purchased or produced in future. Hedging will then ensure today’s margin between sales and purchase price or manufacturing cost.

Several large firms in the mining and extraction business typically do not hedge their underlying commodity exposures. The assumption is that investors and funds buying equity in these companies are actively seeking the underlying commodity exposure, and would not be interested if the exposures are hedged away.

One thing that a firm should have in place before attempting to actively hedge its underlying commodity exposures is a robust and appropriate risk management and governance framework. Worldwide, a common thread binding most commodity hedging gone wrong is the absence of a strong risk management framework incorporating the firm’s strategy, intent and risk appetite, lack of appropriate monitoring and reporting tools.

As volatility in commodity prices is here to stay, shying away from active hedging is not a long-term option. The companies that choose to proactively embrace it and put in place a robust commodity hedging programme that is supported by risk management processes and oversight will prevail over their reactive competitors.

(Rohit Bammi is Partner, KPMG)

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