When it comes to commodities, companies are concerned about price fluctuations and how those fluctuations affect gross margins and budgets. As companies look to protect their cost structure, buyers worry about prices unexpectedly going up and how those price fluctuations will affect margins.
“Margins are affected by an array of exposures that carry the risk of price fluctuations, which in turn creates changes that affect customer prices, which will need to be adjusted to compensate,” says Sean O’Connor, PA/WVA, Middle Market Group Leader, at Huntington Bank.
Buying commodities brings a consistent exposure and a price risk that can’t always be passed on. Companies, however, can protect their margins and cost structures by hedging their commodity exposures. That’s why it’s critically important for companies to know and understand their exposure.
Smart Business spoke with O’Connor about working with commodities, the importance of understanding exposures and how companies can protect themselves, and their customers, from risk.
How can businesses protect their margins from cyclical commodity price changes?
Companies can hedge to reduce their risk exposure in commodities. Two common ways of doing that include using a swap or optionality. Which to use depends on the nature of the exposure.
Commodity swaps, which trade a floating price for a fixed price over a period of time, is a strategy that works well with a set budget, and when the company knows what the line-item cost is going to be.
Optionality is a strategy that gives a company the option to buy or sell at a certain price. When the concern is that costs will increase, a company can buy a call option to cap the costs while preserving downside participation.
What mistakes do companies tend to make when it comes to buying commodities?
It’s important that companies understand their exposure with any commodity. It sounds simple, but there are many companies that don’t know their exposure and, equally as important, what it means to their business.
Companies that buy commodities should understand how much of their cost structure is exposed and the volatility of the commodities they buy. Commodity volatility affects pricing, which affects existing contract structures. When commodity prices are high, there’s not a lot a company can do to insulate itself because hedging in a high-price environment isn’t effective.
Some companies may know their exposure, but they don’t have a thorough enough understanding about what that exposure really means for them. That could be because the company has always operated in a steady price environment, so it’s never been an issue and not something that’s a priority to track. That’s not just a problem at middle-market companies, it happens at large companies, too.
Companies that don’t pay attention to their commodity exposures can miss budgets and miss their margins, which unfortunately is all too common. That’s why it’s so important for companies to fully understand their exposure and its implications because there are steps companies can take to mitigate those risks.
Who can help companies better understand their exposure?
Some banks can help companies get a sense of their exposure through a sensitivity analysis, which can give companies a better sense of how their margins are affected by certain price changes. This can help companies determine the range of price changes that they can live with, and when they need to hedge to protect themselves.
Companies that are uncertain about their commodities exposures should have a conversation with their bank as soon as they’re able — before they experience an issue. These conversations can take place any time, but it’s a good idea to have them if something in the cost structure has changed or a pricing mechanism has changed.
Buyers that have constant commodities exposure should always have an eye on the market and regularly keep in touch with their bank so they can act when prices are low. Those with seasonal exposures should have these conversations late in the third or early in the fourth quarter when they’re in their budgeting cycles. ●
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