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Managing commodity volatility
Reducing your risks with effective hedging
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Con
tent
s Managing commodity volatility
Why hedge
About EY
Managing commodity volatility
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Recent volatility in commodity prices
Driven by supply and demand, logistics, weather, consumer sentiment and geopolitical factors, prices ofcommodities from oil and natural gas to corn and wheat have moved with surprising force and speed.
Energy
$1.00$2.00$3.00$4.00$5.00$6.00$7.00
$20.00$40.00$60.00$80.00
$100.00$120.00
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16Crude oil Natural gas
Grains
Metals US Dollar Index
$3.00$4.00$5.00$6.00$7.00$8.00$9.00
$10.00
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Corn Wheat
$1,000.00
$1,400.00
$1,800.00
$2,200.00
$2,600.00
$4,000.00$5,000.00$6,000.00$7,000.00$8,000.00$9,000.00
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Copper Aluminum
$70.00
$80.00
$90.00
$100.00
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Price
Energy, Grains, Metals and U.S. Dollar Index Futures Charts (2011–2015) — historical futures prices sourced from NYMEX, CME, LME and ICE
Managing commodity volatility
Page 5 Managing commodity volatility
1 Oil and Gas Global Capital Confidence Barometer: deal activity to accelerate, EY, October 2015
In a recent EY survey1 of more than 1,600 executivesacross 18 sectors, 34% of respondents believed thatincreased volatility in commodities and currencies isthe greatest economic risk to their businesses overthe next 6 to 12 months.
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Impacts of commodity volatilityPotential business implications
Managing commodity volatility
Creates uncertainty in earnings per share, causing reporting issuesfor CFOs
Exposure toprice volatility
Creates short-term working capital issues for company treasurersNegativecash flows
Company not able to capture earnings upside due to commodity volatilityLack of marginoptimization
Commodity volatility eats into company’s core earnings, creatingdifferences between company and peer group
Earningscomparability
Unlimited or unmanaged commodity volatility gives public perception thatcompany does not understand business driversHeadline risk
Commodity volatility can cause significant earnings loss due to increasein input costs
Earningsdegradation
How effective is your company at managingcommodity risk?
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Self-assessmentDoes commodity volatility affect you?
Have you experienced commodity price volatility in the last three years that has hadan appreciable impact on earnings and cash flows?1
23456
Do you have a strong understanding of key business areas in your company thatare impacted by commodity price volatility?
Do you have clear business objectives for the procurement of commodities andrelated hedging?
Do you have the tools in place for monitoring commodity market risks and reportingrelevant information to management?
Does your technology provide sufficient and timely access to data needed tomeasure and manage risk?
Do you have tools in place to measure and report your specific exposure tocommodity prices?
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Managing commodity volatilityWhy hedge
Managing commodity volatility
Theprimary
objectives ofhedgingare to:
Reduce price risk andearnings volatility1 Stabilize
procurement costs2 Optimize margins3
Companies in a broad range ofindustries — including airlines,chemicals, consumer products,food products, industrialmanufacturing and utilities —engage in commodity hedgingactivities. Because theyunderstand how difficult it is topredict precisely when commodityprices will rebound after aprecipitous drop, most realize thata low-price environment is a goodtime to consider or revise ahedging program.
► Hedging is an important tool that can help companies in avariety of industries reduce price risk and earnings volatility,maintain a stable supply of raw materials and optimizemargins.
► Hedging programs need to be tailored to the organizationalstrategy, financial goals and risk appetite of the company.
► In determining a hedging program, the organizationshould align its operations to key value drivers thatinclude transaction and credit costs, capital requirements,technology and people investments, and expected valueand timing of returns.
Key takeaways:
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Approaches to hedgingWhich approach suits you?
The first step for a company embarking on a hedging program is to determine goals and style for the program andprioritize them. Historically, companies have relied on different hedging strategies, ranging from static programs that lockin prices for a fixed volume to active hedging programs that anticipate trends in price movements. The relevance of eachstrategy is dependent on the overall business objectives, financial goals and risk appetite of the company.
Below are three broad categories of hedging we see as a means of managing risk:
Managing commodity volatility
Revenue certainty
The “price fixer”
► Hedges a fixed percentage ofproduction or requirements;limited or no market exposure
► Locks in hedged revenuesand costs for the seasonmechanically; minimal earningsvolatility and price risk
► Low flexibility, no participationin beneficial price moves
A
The “opportunistic hedger”
► Extracts additional margins on thebasis of market volatility; managesmarket exposure
► Adjusts percentage hedged andtiming of trades on the basis ofview of market
► Generally between 40% and 80%of physical hedged
► May win or lose depending onsuccess, but earnings should bewithin a targeted range
B
The “active hedger”
► Takes more directional views
► May or may not hedge at timesdepending on view
► Enters and exits hedge positionsactively
► May have both “hedge” and“opportunistic” portfolios managedseparately
► Needs more sophisticated risk and limitmonitoring, and robust systems andcontrols
► Potential for higher rewards at the costof volatile results
C
Fixed Highly variableRevenue certainty
Which approach to a hedging program is most suited to what you want to accomplish?
Deg
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An effective hedging programKey elements
Managing commodity volatility
An effective hedging program must be installed within the context of a structured framework supported by well-definedprocesses that cover all aspects of the transaction life cycle and an infrastructure that includes the people, systems anddocumented policies and procedures for risk management and accounting.
Key elements of a well-designed and well-executedrisk management program:
Common challenges of poorly designed orexecuted risk management programs
► Unclear objectives for risk management
► Lack of investment in resources to supportthe risk management function
► Unidentified financial risks
► Inadequate internal controls
► Misapplication of hedge accounting rules
► Lack of meaningful performance measuresto control and manage risks
• Robust processes around governance, forecasting,credit, risk, accounting and treasury should be bolsteredas necessary to address the requirements of thehedging program.
• People with the right experience and skills manage differentaspects of the program.
• Fit-for-purpose policies — from a governance perspective,a risk management policy document is a must that clearlyarticulates the objectives, risks and rewards of the hedgingprogram.
• Program performance — key performance indicators shouldbe established and monitored to aid oversight and improveoverall program performance.
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Sample hedging frameworkPrinciples in action across the transaction life cycle
Managing commodity volatility
Credit function► Sets up and approves
all counterparties andcredit limits
► Monitors credit exposure
Risk function► Monitors market exposure
► Conducts curve validation
► Performs stress testingand sensitivity analysis
Risk managementcommittee► Oversees all hedging
activities to confirmcompliance with companypolicies, risk appetite andobjectives
Commercial team► Conducts forward and
historic market analytics
► Executes transactions tomanage financial riskwithin the market andcredit limits
Accounting and back office► Performs settlement
of positions
► Prepares and booksjournal entries
► Meets derivativeaccounting rules anddisclosure requirements
► Oversees internal controls
Sample illustration of a framework to support implementing an effective hedging program
Logistics
Settlements
Analytics
New productdevelopment
Businesscontrol
Pre-dealsupport
Dealexecutionand deal
administration
Financialaccounting
Cashmanagementand treasury
Riskmanagement
Effectivehedgingprogram
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How can EY help?Our framework and phased approach
Managing commodity volatility
Companies that are exposed to commodity prices should carefully consider the impact that price increases and volatilitymay have on the bottom line. Whether to hedge and how much to hedge are questions that companies need to thinkthrough, and companies must carefully evaluate the risks and rewards of hedging. More important, companies mustclearly articulate their objectives and risk tolerance, then align the execution of their hedging program with thatassessment.
EY has a proven approach to advise clients in the development of fit-for-purpose hedge programs that address the keyinfrastructure components.
Illustrative
Key commodity risk management infrastructure components must be linked by design.
Strategies,governanceand policies
Organizationstructure Processes Management
reportsModels and
assumptionsSystemsand data
Process doesnot supportoperations
People cannotperform
processes
Reports do not provideinformation for
effective management
Information is notavailable for analysis
and reporting
Operating modeldoes not support
commercial outcome
Risks occur if linkage is insufficient.
The services we can offer may vary as certain of our services for an audit client and its affiliates may be more limited in order to comply with applicable independence standards.Please reach out to your EY contact for further information.
About EY
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FAAS Commodities Markets teamOur service offerings
Managing commodity volatility
Commodity price volatility is nothing new, but increasingly companies are actively considering how best to manage therisks and potential opportunities that swings in prices present to operating and financial results.
Whether you are thinking about putting a hedging program in place or would like to enhance your existing approach, EYcan help you proceed strategically and operationally to achieve your goals. At EY Financial Accounting Advisory Services(FAAS) Commodities Markets, we have a global team of commodity professionals who can share their insights andlessons learned through our six service offerings.
Service offeringsBusiness transformation
► Risk management effectiveness,functions, roles and reporting
► Strategy, process analysis, leadingpractices, industry comparisons andindustry training
Internal controls assessment
► Assessment focusing on front- to back-office controls, regulatory compliance,rogue trader risk, Commodity Tradingand Risk Management (CTRM) systemapplication and business readiness, andhedge effectiveness
Regulatory compliance
► Trade surveillance business processand systems
► International, and domesticacquisitions regulatory due diligence
► Global regulatory compliance such asDodd-Frank, European MarketInfrastructure (EMIR)
Quantitative advisory
► Model risk management (including modelvalidation), independent valuation
► Risk measurement (value-at-risk, stresstesting), risk budgeting, performancemeasurement
Technology support
► Technology assessment and strategy
► Technology selection
► Systems development and integration
► Data services — architecture,management, analytic support,reporting tools and cubes
Hedge accounting
► Financial accounting advisory servicesunder both US GAAP and IFRS
► Complex leases, fair value, derivativesaccounting, netting issues
► Accounting training
The services we can offer may vary as certain of our services for an audit client and its affiliates may be more limited in order to comply with applicable independence standards.Please reach out to your EY contact for further information.
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FAAS Commodities Markets teamOur global network
Managing commodity volatility
Being part of an integrated global organization provides a holistic approach to a hedging program. We can provide insights on globaland regional practices from leading organizations across multiple operating sectors and industries, including areas such as tax,governance, currency, business processes, regulatory compliance and systems. This approach allows us to work closely with other EYservice lines such as Performance Improvement (supply chain and procurement), Risk Assurance, Tax and Valuation.
Houston
Calgary
Rio de Janeiro
San Francisco
Chicago
New York
London
Beijing
Cape Town Perth
Brisbane
Moscow
Geneva
Sydney
Bahrain
SingaporeFAAS Commodities Markets
EY Global Industry CentersVirtual hubs for sharing industry-focused knowledge and experienceAutomotive Life Sciences Private Equity
Consumer Products Media &Entertainment
Real Estate, Hospitality &Construction
Financial Services Mining & Metals Retail & Wholesale
Government & PublicSector
Oil & Gas Technology
US Health Care Power & Utilities Telecommunications
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Financial Accounting Advisory ServicesCommodities Markets contacts
Managing commodity volatility
Suzie KupiecFAAS Commodities Markets
[email protected]: +1 713 858 9733
Talib DhanjiFAAS Commodities Markets
[email protected]: +1 281 844 8222
Andrew WooseyFAAS Commodities Markets
[email protected]: +44 77 6649 8328
Bryan BonnerFAAS Commodities Markets
[email protected]: +1 713 385 3500
Sam PetersonFAAS Commodities Markets
[email protected]: +1 215 806 8430
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