Know Your Market
The Hidden Value in Hedging
Oct 10, 2011
Option premium costs and end-of-year hedge profit-and-loss statements don’t tell the whole story of hedging costs and benefits.
By Will Babler, First Capitol Risk Management, LLC
During the last several months, we have laid out the case for implementing a margin-focused, commodity hedging strategy. We have discussed both hedging fundamentals as well as detailed discussions of important dairy-specific, margin-management issues, including:
· Hedging Philosophy – What we do know and don’t know about markets and what to expect from a hedging program.
· The Right Tool at the Right Time – how to selecting the best available tool for a given market circumstance.
· Creating a Risk Management Plan – key questions that must be answered when devising a risk management policy.
· Revenue Hedging and Milk Basis – understanding your milk basis and the ability to tie down the biggest variable in profitability – milk revenue.
· Feed Hedging with Cash and Futures – controlling prices within a complex ration by coupling corn and meal futures hedges with cash forward contracts.
· Executing the Margin Management Plan – consistency required to run the plan on a day-to-day basis.
The last topic in this series, Hidden Value in Hedging, identifies some of the advantages of engaging in a structured, margin-focused hedging program. In many cases, the pros and cons of engaging in hedging activity can be spelled out clearly in black and white. Daily futures statements, quarterly financials and year-end tax returns will make it quite clear the costs and benefits of a hedging program from a pure profit and loss, or P&L, perspective.
Hedgers realize costs for transferring their risks to the marketplace. These costs include both out-of-pocket option premium expenses and financing costs for marginable futures and options strategies. Given the cyclical nature of commodity markets, in some years there will be costs without any price insurance claims, while in other years the claims may keep your business afloat.
For this reason, it is important to look at the costs and the value of a hedging program over the long term. A multi-year window that spans several market cycles is the only way to provide a fair view of how hedging can benefit your business. It is in this context that we will look at a few of the benefits of hedging that go beyond simple P&L’s.
· Operational Consistency – During severe market downturns, it is common for commodity industry participants to look for any angle they can find to contain costs and generate cash flows. In some cases, there are rational choices that can be made. In other cases, the choices may save money or raise cash today, but come at a great cost to future efficiency and profitability. At times, these decisions are forced by outside parties. In other cases, the damage is self-inflicted because there are no other alternatives. A consistent hedging program can help avoid these tough decisions by always keeping price and margin protection in place to buffer the inevitable downturns. These benefits aren’t easy to quantify when looking at the upfront premium expense of a milk or corn or soybean meal option, but, over the long term, market stability that affords operational stability has proven to be a significant benefit.
· Long-term Planning – Short-run operational consistency and long-term planning are both important to the success of any commodity producer or processor. Hedging programs that smooth out cash flows and provide a safety net on margins can help producers take on long-term facilities, herd, management and expansion programs with greater confidence. Giving up some margin and price peaks to mitigate the valleys can allow for a larger and more efficient operation over the long term. Again, these benefits are difficult to identify up front when putting cash to work in a specific hedging transaction, though over the long term the major decisions that can be entered into with confidence can greatly impact the legacy of an operation.
· Improved Financing – Risk reward tradeoffs must be considered in all hedging transactions. This is also true from the lenders perspective when evaluating the risk/reward of working capital or long-term financing provided to a dairy. If the lender can see a written plan and demonstrated track record of smoothing cash flows through a hedging program, this can result in greater access to financing at potentially more favorable rates. This is a potentially quantifiable benefit to hedging which over time helps reduce the total cost of the hedging program.
· Emotional Clarity – The final intangible of a sound hedging program is ability to remove some of the worry and concern about how unfavorable market conditions may impact your business. Executing on a structured hedging program will mitigate a good deal of downside risk and extend the capacity of any operation to make it through difficult market cycles. It is difficult to measure the monetary benefit of being able to sleep at night, but some hedgers will attest that this is at times the most valuable aspect of a hedging program. When taking the edge of the fear, greed and anxiety that markets can induce, a hedging program can help provide greater clarity of thought and more rational decision-making. This shifts the focus away from outside market events that can’t be controlled to operational and planning decisions on the dairy that can be controlled. It may not be easy to put a price tag on this aspect of hedging, but it certainly helps skew the cost benefit in a favorable direction.