to hedge or not to hedge: commoditycontracts and supply chains

Panos Kouvelis and Danko TurcicSeptember 24, 2015

Olin Business School, Washington University in St. Louis

Introduction

Many Industrial Firms are Exposed to Commodity Prices

Example

Food Company Kellogg’s is Exposed to Price Risks From:

∙ Corn, soybeans, sugar and cocoa that are used in its products

∙ Paper and plastics used in its packaging materials

∙ Natural gas used as energy in its manufacturing facilities

∙ Diesel fuel for transportation in its distribution network; and fromenergy consumed in its offices and distribution centers

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Prices of Commodities Vary Over Time

Commodities are goods that are not differentiated in themarketplace such as metals, energy, and agricultural products

Commodity prices are influenced by supply and demand as well asby trading and speculation; thus, they can be highly volatile

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Volatility Wheel

PwC

Volatility Wheel

Source: Commerzbank

Major commodities across agriculture, energy and metals have witnessed continued price volatility over the last few years making Commodity Price Risk Management (CPRM) a key priority for companies.

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How Should Firms React?

Firm Respond to Price Volatility as Follows:

∙ Do nothing and absorb it

∙ Pass it onto their consumers (e.g., remember fuel surcharge in U.S.taxi cabs)

∙ Build inventories can protect against price fluctuations

∙ Hedge using futures contracts

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What is Hedging?

https://www.youtube.com/watch?v=kBtrxAjtG04

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why should firms hedge?

Existing Thinking about Hedging

∙ The key to corporate value is making good investments

∙ The key to making good investments is generating enough cashinternally to fund these investments

∙ Cash flow can often be disrupted by movements in external factors(exchange rates, commodity prices)

∙ Disruptions may be hard to overcome with borrowing if firms facefrictions (taxes, bankruptcy costs, etc.)

A Goal of a Risk Management Program

Ensure that a company has the cash available to make valueenhancing investments

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Existing Thinking about Hedging

∙ The key to corporate value is making good investments

∙ The key to making good investments is generating enough cashinternally to fund these investments

∙ Cash flow can often be disrupted by movements in external factors(exchange rates, commodity prices)

∙ Disruptions may be hard to overcome with borrowing if firms facefrictions (taxes, bankruptcy costs, etc.)

A Goal of a Risk Management Program

Ensure that a company has the cash available to make valueenhancing investments

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Existing Thinking about Hedging

∙ The key to corporate value is making good investments

∙ The key to making good investments is generating enough cashinternally to fund these investments

∙ Cash flow can often be disrupted by movements in external factors(exchange rates, commodity prices)

∙ Disruptions may be hard to overcome with borrowing if firms facefrictions (taxes, bankruptcy costs, etc.)

A Goal of a Risk Management Program

Ensure that a company has the cash available to make valueenhancing investments

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Existing Thinking about Hedging

∙ The key to corporate value is making good investments

∙ The key to making good investments is generating enough cashinternally to fund these investments

∙ Cash flow can often be disrupted by movements in external factors(exchange rates, commodity prices)

∙ Disruptions may be hard to overcome with borrowing if firms facefrictions (taxes, bankruptcy costs, etc.)

A Goal of a Risk Management Program

Ensure that a company has the cash available to make valueenhancing investments

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Existing Thinking about Hedging

∙ The key to corporate value is making good investments

∙ The key to making good investments is generating enough cashinternally to fund these investments

∙ Cash flow can often be disrupted by movements in external factors(exchange rates, commodity prices)

∙ Disruptions may be hard to overcome with borrowing if firms facefrictions (taxes, bankruptcy costs, etc.)

A Goal of a Risk Management Program

Ensure that a company has the cash available to make valueenhancing investments

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Why Hedge?

Example: Omega Drug, a hypothetical multinational pharmaceuticalcompany

26JOURNAL OF APPLIED CORPORATE FINANCE

financial risk. What neither the company nor thebankers have is a well-articulated view of the role ofrisk management.

The starting point for our analysis is understand-ing the link between Omega’s cash flows and itsstrategic investments, principally its R&D program.R&D is the key to success in the pharmaceuticalbusiness, and its importance has grown dramaticallyduring the last two decades. Twenty years ago,Omega was spending 8% of sales on R&D; now it isspending 12% of sales on R&D.

Last year, Omega’s R&D budget was $180million. In the coming year, the company would liketo spend $200 million. Omega arrived at this figureby first forecasting the increase in patentable prod-ucts that would result from a particular level of R&D.As a second step, managers valued the increasedcash flows through a discounted-cash-flow analysis.Such an approach could generate only rough esti-mates of the value of R&D because of the uncertaintyinherent in the R&D process, but it was the bestOmega could do. Specifically, the company’s calcu-lations indicated that an R&D budget of $200 millionwould generate a net present value of $90 million,compared with $60 million of R&D budgets of $100million and $300 million. (See Table 1, “Payoffs fromOmega Drug’s R&D Investment.”)

The company took comfort in the knowledgethat the $200 million budget was, on a relative basis,roughly in line with the budgets of its principalcompetitors.

Given its comparatively high leverage and lim-ited collateral, Omega is not in a position to borrowany funds to finance its R&D program. It is alsoreluctant to issue equity. That leaves internallygenerated cash as the only funding source thatOmega’s managers are prepared to tap for the R&D

program. Therefore, fluctuations in the dollar’s ex-change rate can be critical. If the dollar appreciates,Omega will have a cash flow of only $100 million toallocate to its R&D program—well below the desired$200 million budget. A stable dollar will generateenough cash flow for the program, while a depreci-ating dollar will generate an excess of $100 million.(See Table 2, “The Effect of Hedging on OmegaDrug’s R&D Investment and Value.”)

Will Omega be better off if it hedges? SupposeOmega tells its bankers to trade on its behalf so thatthe company’s cash flows are completely insulatedfrom foreign-exchange risk. If the dollar appreci-ates, the trades will generate a $100 million gain; ifthe dollar depreciates, they’ll post a $100 millionloss. The trades will generate no gain or loss if thedollar remains at its current level. Effectively, thehedging program locks in net cash flows of $200million for Omega—the cash flows that the com-pany would receive at prevailing exchange rates.Whatever the exchange rate turns out to be, Omegawill have $200 million available for R&D—just theright amount.

If Omega doesn’t hedge, it will be able to investonly $100 million in R&D if the dollar appreciates. Byhedging, Omega is able to add $100 million of R&Din this scenario, increasing discounted future cashflows by $130 million (from $160 million to $290million). On the other hand, if the dollar depreciates,Omega will lose $100 million on its foreign-ex-change transactions. However, the $130 million gainclearly outweighs the $100 million loss. Overall,Omega is better off if it hedges.

Although this example is highly stylized, itillustrates a basic principle. In general, the supply ofinternally generated funds does not equal the invest-ment demand for funds. Sometimes there is an

TABLE 1PAYOFFS FROM OMEGADRUG’S R&D INVESTMENT(IN MILLIONS OF DOLLARS)

TABLE 2THE EFFECT OF HEDGINGON OMEGA DRUG’S R&DINVESTMENT AND VALUE(IN MILLIONS OF DOLLARS)

R&D without Hedge Additional R&D Value fromThe Dollar Internal Funds Hedging Proceeds from Hedging Hedging

Appreciation 100 100 +100 100 +130Stable 200 200 0 0 0Depreciation 300 200 -100 0 -100

R&D Level Discounted Cash Flows Net Present Value

100 160 60200 290 90300 360 60

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Why Hedge? (Continued)

Risk management lets companies transfer funds from situation inwhich they have an excess supply to situations in which they haveshortage … borrow from themselves

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Existing Theory Does not Necessarily Explain Data

Empirical Studies

Either do surveys of hedging behavior or test extant theories.

Empirical Findings

∙ Firms may hedge when they do not face the obvious frictionsfrictions (taxes, bankruptcy costs, etc.) and vice versa

∙ Firms may hedge in situations when hedging reduces theirexpected profit

Factors not considered in the existing theories may driving firms’hedging decisions.

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supply chain perspective of hedging

Commodities in Industrial Products

Panos&Kouvelis&- Emerson(Distinguished(Professor(of(Operations(&(Manufacturing(ManagementSupply(Chain(Hedging

Model

e.g.&supply&chain&for&electric&motors

Supplier Manufacturer Uncertain/Demand

Steel/price

Figure: Electric Motors at Emerson Electric

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Commodities in Industrial Products

Practices at Emerson Electric

∙ Sufficiently long lead times⇒ price risk matters

∙ Contracts: price only and index contracts

∙ Financial hedging at the contract level, but not always

∙ Hedging behavior on the supply chain: Emerson hedges rawmaterials for its garbage disposals that it sells to Home Depot(thin margins)

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Commodities in Industrial Products

Practices at Emerson Electric

∙ Sufficiently long lead times⇒ price risk matters

∙ Contracts: price only and index contracts

∙ Financial hedging at the contract level, but not always

∙ Hedging behavior on the supply chain: Emerson hedges rawmaterials for its garbage disposals that it sells to Home Depot(thin margins)

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Commodities in Industrial Products

Practices at Emerson Electric

∙ Sufficiently long lead times⇒ price risk matters

∙ Contracts: price only and index contracts

∙ Financial hedging at the contract level, but not always

∙ Hedging behavior on the supply chain: Emerson hedges rawmaterials for its garbage disposals that it sells to Home Depot(thin margins)

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Commodities in Industrial Products

Practices at Emerson Electric

∙ Sufficiently long lead times⇒ price risk matters

∙ Contracts: price only and index contracts

∙ Financial hedging at the contract level, but not always

∙ Hedging behavior on the supply chain: Emerson hedges rawmaterials for its garbage disposals that it sells to Home Depot(thin margins)

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Commodities in Auto Parts

Practices at BMW

∙ Index contracts (some indexes have long reset periods, > 1 year.)

∙ Rules vary by commodity (steel, plastic, leather, etc.) and bysupplier

∙ Financial hedging (at the firm level)

∙ No hedging at the contract level⇒ BMW intentionallyconsolidates the price risk downstream

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Main Issues That We Address

∙ In addition to direct purchases, commodities are embedded inparts, components, products, and services purchased fromsuppliers

∙ If commodity prices significantly increase∙ the upstream supplier may not be able to fulfill contractualrequirements⇒ risk for the buyer

∙ the downstream buyer may cancel orders⇒ risk for the supplier

Questions we Ask

∙ Can hedging improve supply chain performance?

∙ When would firms want to hedge?

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Main Issues That We Address

∙ In addition to direct purchases, commodities are embedded inparts, components, products, and services purchased fromsuppliers

∙ If commodity prices significantly increase∙ the upstream supplier may not be able to fulfill contractualrequirements⇒ risk for the buyer

∙ the downstream buyer may cancel orders⇒ risk for the supplier

Questions we Ask

∙ Can hedging improve supply chain performance?

∙ When would firms want to hedge?

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model

Model

Global Supply Chain Finance

Panos KouvelisEmerson Distinguished Professor of

Operations & Manufacturing Management

The Basic Setup

Figure: Supply Chain with Raw Material Procurement

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Key Assumptions

(i) Any default on the underlying supply contract is costly; neitherfirm, however, stands to unusually profit from a default of itssupply chain partner.

(ii) Availability of futures contracts

(iii) To hedge means to buy n futures contracts for the underlyingcommodity

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how should firms hedge?

SC Performance with no Hedging

Figure 3: Supply Chain with no Hedging

..

SC Breaks Down

.

SC Performs

.

S1

.

S2

.

(0, 0)

Figure 4: Supply Chain with Incorrect Hedging

..

SC Breaks

Down

.

SC Performs

.

S1

.

S2

.

(0, 0)

6

Without hedging firms may be unable to produce when input costsare too high

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SC with Insufficient Hedging

Figure 3: Supply Chain with no Hedging

..

SC Breaks Down

.

SC Performs

.

S1

.

S2

.

(0, 0)

Figure 4: Downstream Manufacturer did not buy Enough Forward Contracts

..

SC Performs

.

Downstream Firm Breaks the

Contract Because it Cannot

Profitably Produce due to

High Input Costs

.

S1

.

S2

.

(0, 0)

6

Supplier is hedged, but the buyer is not21 / 31

SC with Insufficient Hedging

Figure 5: Downstream Manufacturer Bought too Many Forward Contracts

..

Downstream Firm Breaks the

Contract Because it Looses

Money on the Futures Con-

tracts and Cannot Cover

Production Costs.

SC Performs

.

S1

.

S2

.

(0, 0)

Figure 6: Supply Chain with Correct Hedging

..

SC Performs

.

S1

.

S2

.

(0, 0)

7

Supplier is hedged, but buyer bought too many forward contracts22 / 31

Correctly Hedged Supply ChainFigure 5: Supply Chain with Correct Hedging

..

SC Performs

.

S1

.

S2

.

(0, 0)

7

Both firms are hedged ⇒ hedging by going it alone does not work inSC

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should hedging be expected in equilibrium?

Equilibrium: Assembler’s Expected Payoffs

Wholesale Prices with Hedging are Lower

A rational supplier gives a discount to a reliable buyer.

Downstream Firm’s Payoffs with Hedging are Higher

A hedged assembler pays a lower wholesale price and receives aguarantees supply – provided that both firms manage risk (hedge)

Conclusion

Assembler always prefers to hedge.

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Equilibrium: Supplier’s Expected Payoffs

Uptream Firm’s Payoffs with Hedging are Higher – but onlysometimes...

(i) Downstream firm’s market power exceeds some criticalthreshold⇒ supplier may be forced into hedging

(ii) Downstream firm serves a large market while operating on asmall margin⇒ hedging can be product dependent

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Guidelines for Managers

∙ Hedging depends on distribution of market power: Companiesshould not necessarily adopt the same hedging strategy whendealing with different supply chain partners

∙ If market power is concentrated at the supply chain downstream,our model predicts hedging

∙ For hedging to be effective, costly breakdown is required

∙ Companies should pay close attention to the hedging strategy oftheir supply chain partners: For hedging to be effective, all SCmust be actively managing risk

∙ Supply Chain matters: It is possible for firms to hedge in a(decentralized) supply chain and not hedge in a centralized supplychain

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Guidelines for Managers

∙ Hedging depends on distribution of market power: Companiesshould not necessarily adopt the same hedging strategy whendealing with different supply chain partners

∙ If market power is concentrated at the supply chain downstream,our model predicts hedging

∙ For hedging to be effective, costly breakdown is required

∙ Companies should pay close attention to the hedging strategy oftheir supply chain partners: For hedging to be effective, all SCmust be actively managing risk

∙ Supply Chain matters: It is possible for firms to hedge in a(decentralized) supply chain and not hedge in a centralized supplychain

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Guidelines for Managers

∙ Hedging depends on distribution of market power: Companiesshould not necessarily adopt the same hedging strategy whendealing with different supply chain partners

∙ If market power is concentrated at the supply chain downstream,our model predicts hedging

∙ For hedging to be effective, costly breakdown is required

∙ Companies should pay close attention to the hedging strategy oftheir supply chain partners: For hedging to be effective, all SCmust be actively managing risk

∙ Supply Chain matters: It is possible for firms to hedge in a(decentralized) supply chain and not hedge in a centralized supplychain

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Guidelines for Managers

∙ Hedging depends on distribution of market power: Companiesshould not necessarily adopt the same hedging strategy whendealing with different supply chain partners

∙ If market power is concentrated at the supply chain downstream,our model predicts hedging

∙ For hedging to be effective, costly breakdown is required

∙ Companies should pay close attention to the hedging strategy oftheir supply chain partners: For hedging to be effective, all SCmust be actively managing risk

∙ Supply Chain matters: It is possible for firms to hedge in a(decentralized) supply chain and not hedge in a centralized supplychain

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Guidelines for Managers

∙ Hedging depends on distribution of market power: Companiesshould not necessarily adopt the same hedging strategy whendealing with different supply chain partners

∙ If market power is concentrated at the supply chain downstream,our model predicts hedging

∙ For hedging to be effective, costly breakdown is required

∙ Companies should pay close attention to the hedging strategy oftheir supply chain partners: For hedging to be effective, all SCmust be actively managing risk

∙ Supply Chain matters: It is possible for firms to hedge in a(decentralized) supply chain and not hedge in a centralized supplychain

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example: where do our result apply?

Commodities in Auto Parts

“Steel price increases creepinto supply chains,” WSJ, June28, 2011

Hedging by going it aloneinsufficient:

∙ Firms often become exposedto commodity price riskthrough their suppliers

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Questions?

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Summary

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github.com/matze/mtheme

The theme itself is licensed under a Creative CommonsAttribution-ShareAlike 4.0 International License.

cba

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