Commodity Online
MUMBAI: Commodity risk management operations by Indian companies are not fully geared to protect margins and it lacks focus, according to a survey, “Commodity Price Risk Management Survey 2008” released by Ernst & Young.

More than 50% of the respondents viewed hedging as a tool to lock-in input costs at a target level, some of them still used market views and expectations of future prices as a trigger of decision making. Interestingly, more than 68% of the respondents had a hedging horizon of less than 3 months indicating that the full potential of hedging to protect long-term business cash flows was not being explored.

The survey captures views of senior executives from more that 45 companies across sectors having exposure to a wide range of commodities including non-ferrous metals, oil and petroleum products, precious metals, agro and soft commodities. Responses were compiled from companies across the value chain including producers, processors and end-users.

The survey findings indicate use of standardized exchange traded products by more than 81% of the respondents. Relatively simpler instruments like forward and futures were used by more than 92% of the respondents indicating that customized hedging instruments are yet to gain ground.

Governance of commodity price risk management function is critical to ensure that risk management activities are always consistent with the risk philosophy and risk appetite of the company. As per the survey less than 58% of the respondents reported the existence of an independent oversight function while less than 20% have conducted and external review of the function.

Says Farrokh Tarapore, Partner and Industry Leader, Financial Services, Ernst & Young, “While the concept of commodity price risk management in India has steadily gained ground since the early part of this decade, with the increasing volatility and growth in paper markets, the time is ripe for companies to look at commodity price risk management as an integral part of the strategy to manage the bottom-line.”

He further adds, “Stakeholders are expected to demand clear value add from the function and measurable success in terms of protecting margins. Performance and risk measurement through use of statistical measures like value at risk was noted in less than 15% of the respondents. Use of such risk and performance measures is likely to drive performance assessment.”

The survey points out that hedging program undertaken by companies in India are still generally short-sighted, driven to a large extent by market views and not always aligned with the risk philosophy of companies. Though companies understand the need for hedging and the instruments available, the finer aspects of hedging such as basis risk and timing risk, which can significantly affect hedge cash flows are often ignored.

According to Hemal Shah, Associate Director, Financial Risk Services, Ernst & Young, “Unprecedented volatility in commodity markets has threatened structured margins in fundamental businesses like never before. For the first time price risk management is being seen as an all pervasive function touching every aspect of the business cycle. Commodity price risk management is no longer limited to hedging. It is about managing price risk across the value chain.”

Commodity price risk management in India is at various levels of maturity, depending on the commodity and where the player is positioned in the value chain. The general attitude towards extracting value from this function has however been lackluster. While the pressure to put in place sound risk management practices is omnipresent, views relating to the appropriate strategy and components of an ideal framework have been debatable.

The Reserve Bank of India (RBI) recently relaxing its regulations on hedging in overseas markets has provided companies with a wider range of options relating to price risk management. The RBI has also permitted hedging on international exchanges in the case of certain commodities procured or sold locally. Given internal and external development and the omnipresent shadow of increased volatility, using commodity price risk management as an effective tool is imperative.

Key findings –
1. Maturity of commodity price risk management operations appears to be greater among producers and processors. Consumers are becoming increasingly aware of the importance of commodity price risk management as its impact on the bottom line is being increasingly felt.
2. Hedging programs are still generally short-sighted, driven to a large extent by market views and not always aligned with the risk philosophy of companies.
3. While companies understand the need for hedging and the instruments available, the finer aspects of hedging, such as basis risk and timing risk, which can significantly affect hedge cash flows, are often ignored.
4. The instruments used for hedging tend to be plain vanilla and are generally limited to futures and forwards. Companies do not generally explore the use of customized instruments, depending on their exposure profile.
5. Companies show an appreciation of the need for oversight. However, little is done to enforce sustainable oversight and governance.
6. Cash flows from hedges and underlying exposures are generally viewed in isolation. The definition of position, for the purpose of assessing the underlying exposure, is generally vague. This may prevent holistic performance reporting.
7. Mark to market remains the single most important measure used for performance measurement and reporting.
8. Investment in human resources to manage the function is still fairly low and most commodity price risk management functions are staffed by less than five persons.
9. Operational risk is not perceived as a major issue. This has resulted in less than an optimal level of investment in streamlining operations and putting in place a robust control mechanism.
10. There are continuing concerns relating to the accuracy of reporting and accounting for hedging operations.
(Source: IndiaPRWire)