Companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. For example, energy intensive manufacturers and transportation companies can be sensitive to the price of gas. Food product companies can be sensitive to fluctuations in the price of certain agricultural commodities. Futures contracts on commodities can mitigate a portion of this type of risk.
Futures contracts are sometimes confused with forward contracts. While similar, they are not at all the same. A forward contract is an agreement between two parties (such as a wheat farmer and a cereal manufacturer) in which the seller (the farmer) agrees to deliver to the buyer (cereal manufacturer) a specified quantity and quality of wheat at a specified future date at an agreed-upon price. It is a privately negotiated contract that is not conducted in an organized marketplace or exchange.
Futures contracts, while similar to forward contracts, have certain features that make them more useful for risk management. Futures contracts have standardized terms established by the exchange. These include the volume of the commodity, delivery months, delivery location and accepted qualities and grades. The contract specifications differ depending on the commodity in question, but this is the general idea:
A flour miller is concerned about the risk of wheat price increases for wheat to be purchased in November. Wheat futures for December delivery are currently trading at $4.20/Bu, and the typical basis at the miller’s location is $0.15 over futures. The miller hedges this risk by taking a long position (buying) the December wheat future at $4.20. In November, the futures price has increased to $4.40, and wheat is selling locally for $4.55. The miller lifts the hedge by selling back the futures position at $4.40, resulting in a profit of $0.20/Bu. This profit is then applied to the cash purchase cost of $4.55/Bu, resulting in a net cost of $4.35, which is the price expected when the hedge was placed.
For companies sensitive to raw material prices, raw material price variances should be isolated and included in your KPI reporting. Implementing an effective commodity hedge strategy can minimize these price variances, and the effectiveness of your hedge strategy should be measured and included in the reporting
This concludes the 3 part series explaining how middle market companies can hedge their risks with derivatives. Happy hedging!