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So everyone is hedging their raw materials, right?

Editorial Team

So everyone is hedging their raw materials, right? Surprisingly, no.

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While commodity price volatility is not a new concept, lately the significant cost fluctuations of raw materials have caused some companies to rethink their current procurement strategies.

But not all companies take advantage of hedging as outlined in an article recently featured in ATEL’s (Association des Trésoriers d’Entreprise à Luxembourg) Treasurer magazine.

Hedging 101

Hedging is a technique used to reduce potential loss should a commodity’s price surge or drop dramatically in the future. The various modes of hedging include:

  1. Futures
  2. Options
  3. Forwards
  4. Swaps

Each presents different trade-offs that need to be in line with your business objectives. Locking in a price to buy or sell a commodity creates certainty for the future because a successful hedge reduces the loss if your underlying exposure loses money.

From the annual INVERTO raw materials survey we’ve learned that though awareness and use of financial hedging increased over the past five years, over 1/3 of companies still do not hedge raw materials at all. Additionally, over half hedge less than 20% of their raw materials exposure.

However, you need to get your hedging strategy right. Back in February of 2015, Ryanair said, “We believe that any growth in profits will be modest as our fuel is hedge at $92 [a barrel], whereas some competitors will be significant beneficiaries of lower oil prices and this may lead to downward pressure on airfares in 2015-16.”*

Luckily, a variety of tools and applications available on Eikon help develop and implement a hedging program appropriate for the strategic, business, financial goals and risk appetite of your company. Making the decision whether to hedge or not has never been easier.

A real-world example

Using the tools available within Eikon outlined in this post, we determine whether or not to hedge using a real and timely example.

Forward Curve Chart (Source: Eikon)

In the above screenshot from the Forward Curve Chart available within Eikon, we see the German Power quarterly contract prices for 31st October 2015 compared to 1st September 2016. In this period, some contracts have shifted significantly while others hardly move.

To figure out whether this would be a good time to hedge and source electricity for Q2 and Q3 2016 contracts, we turn to Eikon. By exploring the fundamental supply/demand drivers and underlying movement in feedstock prices, we begin to understand why a clear drop in price occurs for Q1 2016 and Q4 2016 and whether we expect this trend to continue.

We then turn our attention to the Power Curve application in Eikon, pictured below. This application brings all the contract-relevant informGeneratation on fundamentals and fuel. The intuitive interface allows customers to see live market prices of different trade-able contracts in the market.

Power Curve App (Source: Eikon)

Additionally, users gain access to our analysts’ forecast for the marginal cost of production of power. You learn where we expect the contract to clear after taking into account all factors—supply, demand, and fuel price for instance—related to the contract.

For Q1 2016, analysts have a Power Curve number of €29.24, suggesting a continuation of the current downtrend observed in the two preceding months in the Forward Curve Chart app.

A number of different factors in play at any one time change the current price view presented by our analysts. With Eikon, users stay on top of all the data that drives these changes because the platform lays all these factors out to match workflow requirements.

Need to perform different types of volatility analysis? Not a problem.

Need alerts in place around volatility levels? Also not a problem.

To hedge or not to hedge? That is the question

Looking at the German Power for Q1 2016 example we determine that in this case, holding off on hedging until a later date is our best course of action.

We arrive at this conclusion after discovering that coal and gas are the main fuel types setting the price hourly across this contract using the Power Curve tool. After examining gas price and volatility and noting they are in a downtrend, we choose to wait to hedge.

Knowing when to hedge raw materials and where is highly beneficial to companies. Utilizing hedging appropriately improves risk management and makes cash flow more predictable, ultimately bringing more certainty to a company’s bottom line.

Looking to hedge your raw materials in the coming quarters? The answer is Eikon.

With the help of Eikon and our expert analysis, tremendous opportunity exists to successfully implement an effective hedging program for your raw material needs.

 Read the original article featured in ATEL’s Treasurer magazine.

*Source: Supply Chain Academy

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