Executive Briefings

Consider Various Hedging Strategies for Managing the Risks in Supply Pricing

One CPG company has a sophisticated hedging strategy for managing supply price risks for a wide variety of commodities such as natural gas, coffee, electricity, pulp/paper, etc. They use a combination of traditional approaches-knowing supply markets well and tracking the fundamentals-along with treasury instruments for mitigating currency and interest rates. They have a four-person organization with expertise in treasury to manage currency risk, and in procurement to understand what is going on with the commodities across the company and manage that risk. There is synergy in combining these two disciplines. Having treasury and purchasing working together instead of arguing about who should call the shots is a good practice.

The firm has preferred ways of hedging. Their priorities provide some examples and insight into the basic approaches available:

1.    Customer surcharges-Their first choice is to have contracts with their customers that enable them to pass on the commodity price fluctuations. However, some retailers, Walmart for example, refuse to accept that risk.

2.    Supplier Price Guarantees-If the customer will not agree to a surcharge, their second choice is to get price protection or price guarantees in the supply contract. But it is important in that case to ensure that the suppliers can support those price guarantees.

3.    Hedging Instruments-When price guarantees are not possible or adequate, their third choice is buying hedging instruments on the financial markets. For agricultural commodities such as coffee and bean oil, they can use normal futures options. If necessary, they will negotiate an over-the-counter instrument.

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One CPG company has a sophisticated hedging strategy for managing supply price risks for a wide variety of commodities such as natural gas, coffee, electricity, pulp/paper, etc. They use a combination of traditional approaches-knowing supply markets well and tracking the fundamentals-along with treasury instruments for mitigating currency and interest rates. They have a four-person organization with expertise in treasury to manage currency risk, and in procurement to understand what is going on with the commodities across the company and manage that risk. There is synergy in combining these two disciplines. Having treasury and purchasing working together instead of arguing about who should call the shots is a good practice.

The firm has preferred ways of hedging. Their priorities provide some examples and insight into the basic approaches available:

1.    Customer surcharges-Their first choice is to have contracts with their customers that enable them to pass on the commodity price fluctuations. However, some retailers, Walmart for example, refuse to accept that risk.

2.    Supplier Price Guarantees-If the customer will not agree to a surcharge, their second choice is to get price protection or price guarantees in the supply contract. But it is important in that case to ensure that the suppliers can support those price guarantees.

3.    Hedging Instruments-When price guarantees are not possible or adequate, their third choice is buying hedging instruments on the financial markets. For agricultural commodities such as coffee and bean oil, they can use normal futures options. If necessary, they will negotiate an over-the-counter instrument.

Read Full Article