“The most important fundamental determining fact in connection with organization is the meeting of uncertainty. The responsible decisions in organized economic life are price decisions; others can be reduced to routine…”

Frank Knight, “Risk, Uncertainty and Profit”

Extreme price events represent the most significant source of external risk for commodity related businesses. Effective management of this risk could also be the most powerful driver of value creation. Managers in such firms should take active steps to explore strategically sound solutions to respond to the changing market conditions in ways that can enhance their firms’ profitability and resilience.

Such steps should take two related problem areas into consideration: (1) the ability to nimbly respond to market price fluctuations and (2) organizational adjustments to integrate price risk management with the firm’s core activities in a robust and transparent way. We discuss each problem domain in turn.

Responding to price fluctuations

This is perhaps the most difficult problem matter for any firm to master because ultimately it involves price speculation. Over the years I’ve spoken to many industry executives about this problem. While most of these managers had a keen interest in the problem of hedging, very few were comfortable to actually tackle it head-on. The refrain I kept hearing was, “yes, but we do not wish to speculate.” What the managers usually wanted was some way to sidestep this risk by removing the possibility of adverse events while keeping some exposure to favorable price changes. While this is technically achievable, the cost of this type of headache-free hedging can be prohibitively high and ultimately unfeasible.

Managers’ reluctance to get their hands dirty with hedging was the result of the skill gap between what is required to run a business operation and what is needed to speculate in commodity markets. Operating firms select for skills that support its core operations like production, marketing, sales or finance. By contrast, hedging requires a totally different set of skills related to market speculation, and these are not normally cultivated in operative businesses. As a result, managers often regard hedging with reserve and firms tend to manage their commodity price risk either passively or in some crude form[1]. Given all that can go wrong in speculation, this cautious stance is not entirely without merit. At the very least, it can keep the firm safe from self-inflicted risk-related disruptions and enable it to perform broadly in line with its rivals. That, however, is all that it will do.

The passive approach will not enable outperformance or competitive edge that could be achieved through a suitable solution to the problem of commodity price risk and uncertainty. As Thomas Aquinas put it, “If the highest aim of a captain were to preserve his ship, he would keep it in port forever.” Of course, people do not build ships just to preserve them. Likewise, managers should not run their businesses just to avoid risk, especially where risk – if adequately managed – has strong profit potential. This is clearly the case with the hedging of commodity price risk. Given what we’ve seen so far about the relationship between commodity price and business profitability, it follows that such potential should at the very least be made a priority issue to explore at any commodity related firm.

Hedging and competitive advantage

Skillful hedging can facilitate significant competitive advantages: for instance, if the prices of key inputs are rising, a company can secure a lower cost of material by buying adequate quantities for future delivery. Conversely, if the selling prices for its products are declining, it can fix higher prices by taking short positions in the futures markets. In this way, hedging can significantly improve operating profits.

Based on the income statement of an average S&P 1500 company (and assuming constant sales volumes), a 1% improvement in the selling price would generate an 8% increase in operating profits. Conversely, a 1% drop in the cost of goods sold would lead to a 5.36% increase in operating profits. This impact is more than double that of a 1% increase in sales volume. (Marn, Roegner, & Zawada, 2003) For commodity businesses where operating margins are typically very low, hedging can have a much greater impact on profitability. It can also provide the most powerful means for a firm to differentiate itself from competitors and gain a difficult to match advantage over them.

Consider for example the U.S. petroleum wholesale industry where the operating margins average at about 0.8%[2]. At a cost of around $800 per metric ton of heating oil, a typical wholesaler could hope to earn a margin of about $6.40 per ton of heating oil sold. But suppose a wholesaler were able to reduce their cost of merchandise by an average of 1%[3]. That improvement would add $8 per metric ton to the firm’s profit margin, raising it from $6.40 to $14.40 – a 125% improvement in operating profits. Given such dramatic value creation potential, managers at commodity firms should not undiscerningly proscribe all speculation. After all, taking risks is what firms must do to generate profits.

Of course, the question remains whether achieving and sustaining this kind of competitive advantage is realistic. In all likelihood, it is notrealistic to expect that hedging can achieve either permanently reduced cost of goods sold, or permanently higher selling prices. But at times when commodity prices undergo significant changes and form major trends, gaining a definite and significant price advantage through hedging is entirely realistic. The next question then is, how should firms go about exploring this potential advantage?

Quality answers, I believe, would not fail to emerge through a systematic approach to problem solving and some organizational engineering. This isn’t rocket science and observing SIX KEY PRINCIPLES of best practices in price risk management should go a long way in ensuring quality solutions are developed and implemented.

[1] Active hedging also carries extra career risk. A manager who assumes an active role in hedging may not get rewarded if the results turn out good. But if they disappoint, he is likely to be accused of speculating recklessly, and his career will suffer as a result. For this reason, many managers see little upside from taking an active approach to hedging.

[2] This is based on a 2003 FirstResearch survey of 13,828 companies engaged in the petroleum wholesale business. Since then, margins may have shrunk still further.

[3] An oil wholesaler could use hedging to its advantage by buying forward quantities of heating oil when the prices are advancing and keeping their position unhedged when they are declining.