On the Chicago Mercantile Exchange early this summer, the price of block cheddar cheese was up 79 percent from a year earlier. In central Illinois, No. 2 yellow corn was up 68 percent from a year ago. And down in Texas, natural gas at the Henry Hub was up 15 percent from a year earlier and a dramatic 63 percent from its 52-week low.
Those are volatile pricing trends for corporate purchasing agents to manage. Increasingly, however, they don’t have to — at least not alone. Instead, companies are asking their treasury departments to export to their commodity-buying operations the same risk-management expertise they have long exercised in foreign-exchange and interest-rate markets.
“Treasury [managers] have gained a lot of knowledge in providing risk-management execution in those other areas,” says Robert J. Baldoni, leader of the global treasury advisory service for Big Four accounting firm Ernst & Young. “They’re the keepers of the tools and strategies. It is a natural progression for them to be moving down the risk spectrum to what is, at many companies, the next major risk.”
Darrell Thomas, assistant treasurer for capital markets at $35.1 billion beverage and foods company PepsiCo Inc., says he and his staff began working with his company’s global procurement and accounting teams about three years ago to better manage the company’s exposure to commodity risk. A big buyer of corn sweeteners, flour, potatoes, sugar, wheat, and other food staples, PepsiCo also consumes vast quantities of natural gas and fuel to produce and deliver its products. In addition to relying on productivity initiatives and global purchasing programs to manage the price risk, it also uses derivatives contracts.
By getting involved in protecting the company against commodity-price risk, Thomas says, treasury also provides senior executives with better visibility into PepsiCo’s hedging program.
Better visibility into any sort of financing activity has itself become a prized commodity since the Sarbanes-Oxley Act of 2002 began requiring public-company CEOs and CFOs to formally sign off on the accuracy of financial statements. It is especially important for hedging transactions, because hedge accounting can be treacherous. In 2001, the Financial Accounting Standards Board began requiring companies to mark their derivatives contracts to market, with gains or losses flowing through the income statement, except under very tightly prescribed circumstances in which the contracts qualify as hedges rather than speculative transactions.
Plenty of companies have had problems hewing to the new derivatives accounting standard, commonly known as FAS 133 (see “Lost in the Maze,” May 2006). The consequences can be harsh. If a company’s hedge accounting fails to pass muster, the company must restate its financial results in both current and, where applicable, prior earnings periods to reflect mark-to-market accounting. And hedge accounting can be surprisingly easy to mess up, especially with commodities hedges.
Say you’re importing wheat from Mexico and paying your Mexican supplier in dollars under a contract that requires you to pay a kicker if the peso rises by 5 percent or more against the dollar. “That’s a common practice among purchasing people, who don’t like sourcing in local currency and don’t know how to manage currency risk very well,” says a Fortune 50 treasury executive who asked not to be identified. Unfortunately, he adds, that price kicker could be considered an embedded currency option under FAS 133, which would require mark-to-market treatment. Examples like that, he says, show why companies would be foolish not to get treasury involved in managing their commodity risks.
“Hedge accounting for commodities is ugly, and almost always beyond the ability of the purchasing department,” agrees consultant Jeff Wallace, managing partner of Greenwich Treasury Advisors LLC.
Burgers and Chips
The point, of course, is not to disparage procurement specialists. “These folks have generally done a good job,” Baldoni says. “But while price is an issue for them, physical delivery is a bigger issue.” That doesn’t help the growing ranks of companies, he says, that are unwilling to withstand the stress of earnings volatility and are increasingly interested in finding ways to lock in their costs.
Nor does it help those who find rising commodity prices eating into their margins. When Moody’s Investors Service lowered ratings on fast-food restaurateur Wendy’s International Inc. and its securities in June, it cited, among other things, commodity cost pressures. In its latest annual 10-K filing with the Securities & Exchange Commission, Wendy’s says it has not used financial instruments to hedge commodity prices, relying instead on purchasing and pricing contract techniques such as setting fixed prices with suppliers, generally for a year in advance; buying forward (setting future pricing in advance); and using unit pricing based on an average of commodity prices over time.
Tom Linton, vice president and chief procurement officer for Freescale Semiconductor Inc., a $6.4 billion chip maker that was recently taken private, says his colleagues in treasury get involved in helping manage that company’s exposure to price risk for some commodities, such as the silver and gold it uses on its circuit boards. “We are applying to commodities some of the risk-management techniques that treasury developed for other areas,” Linton says. “The reason is predictability.”
Rodney Malcolm, a managing director in Citi’s commodity derivatives origination business, suggests that treasury’s growing involvement in managing commodity risk is as much a product of marketplace developments as it is of changes in accounting and corporate-governance rules. For starters, commodities markets have become more mature over the past 10 to 15 years, featuring a wider array of hedging tools and more-transparent pricing. At the same time, many commodity markets have become more volatile, forcing companies to pay greater attention to their pricing risk.
Around the beginning of this decade, for example, prices for natural gas jumped from about $2 per million BTUs to more than $6. Suddenly, a big price move wasn’t a dime per unit, but a dollar. “With the increase in volatility and absolute expense, a fair bit of the flow business — the daily trading activity — moved from procurement to treasury,” Malcolm says. “Or it was still being managed in procurement, but with limits put on by treasury.”
In some cases, companies put treasury on the commodities beat only after spectacular failures drove home the risk of doing otherwise. In January 2002, automaker Ford Motor Co. took a $1 billion write-off on its inventories of precious metals, primarily palladium, a key component of the catalytic converters that minimize auto-exhaust fumes. Fearing tight supplies and rising prices, Ford had loaded up on the metal via long-term supply contracts only to see prices plummet as new technologies lessened demand for the material.
Ford’s CFO at the time, Martin Inglis, later said the car company had left the job of buying palladium to its purchasing department, which had plenty of experience buying large quantities of steel, copper, and other commodities with relatively stable pricing, but not much background with rarer commodities such as palladium, nor with options or other sophisticated financial tools that Ford’s treasury department routinely used to hedge interest-rate and foreign-exchange risk. After the write-off, Inglis said Ford implemented procedures that would involve treasury in major commodities purchases.
The Future of Futures
To be sure, not everyone is sending finance to the front lines of the commodity wars. Bob Gold, CFO of United Plastics Group, a privately held Oak Brook, Illinois, contract manufacturer and injection molder, says his finance organization doesn’t get involved in the company’s day-to-day purchasing of plastic resin, although from a working-capital standpoint he might suggest building up some inventory if a price increase seemed imminent. In part, he says, the hands-off approach stems from a reliance on an effective supply-chain-management group that negotiates contract pricing, and also from a lack of appropriate hedging tools for plastic-resin purchasing. “I’ve been in the industry quite a while,” he explains, “and I don’t know how to hedge plastic buying. If I did know how, I would find the resources — if I believed it was worth it.”
Still, Citi’s Malcolm says that treasury departments have become increasingly involved over the past several years in managing commodity risk, using a wide array of options and futures strategies. Most of that business takes place in the over-the-counter market, but since the late 1990s companies also have had the ability to trade a growing array of commodities contracts online via electronic exchanges, which are bringing even more pricing transparency to the marketplace.
Enron launched the first electronic commodity exchange, Enron Online, in November 1999, but it collapsed a few years later when the scandal-ridden company imploded into bankruptcy. Since then, one of Enron Online’s early competitors, the Intercontinental Exchange, or ICE, has stepped into the breach. Primarily an energy exchange at its founding in 2000, ICE acquired the New York Board of Trade in January of this year and now offers electronic trading in the NYBOT’s benchmark agricultural products, too.
One day, such exchanges will probably allow companies like United Plastics Group, and plenty of others, to manage commodity price risks for which there are currently no effective hedges. For example, the Dubai Gold & Commodities Exchange in Dubai, which started operations in November 2005, recently announced that it plans to launch a portfolio of four plastics futures contract products during the third quarter of this year.
Randy Myers is a contributing editor of CFO.