CME Group and Informa EconomicsMay 16, 2013

Pan American Grain and Oilseed Conference

2

Contents

Practical Viewpoints on Risk Management

Determining Business Needs Supply Chain Impacts Process Framework Risk Assessment Risk Management Tools Policy & Controls Best Practices

3

What is commodity risk management and why do you do it? In basic terms, it means managing your margins. This could be for sellers (e.g.

farmers) or buyers (e.g. food companies). You project or budget what your costs will be along with your revenue. Hopefully,

that results in a positive margin. You then use hedging tools to lock-in that margin or manage it to remain profitable.

Commodity risk management is also called hedging and is defined as buying or selling futures (or physical) contracts as protection against the risk of loss due to changing prices in the cash markets.

Commodity Risk Management OverviewDetermining Business Needs

Cash Position Futures Position

If you own inventory or expect to sell a product in the future, your risk is falling prices

To protect against falling prices, you sell futures (or physical) contracts that gain if prices fall

If you use inventory or expect to buy a product in the future, your risk is rising prices

To protect against rising prices, you buy futures (or physical) contracts that gain if prices rise

Commodity Risk Management OverviewSupply Chain Impacts

4

Price volatility exists all along the supply chain and hedging is used by each participant to manage the impact from price changes to their business.

FarmRisk from lower prices

for production (e.g. milk)Risk from higher costs

for inputs (e.g. feed, fertilizer, land, etc.)

CooperativeProducer forward

contracts Supply/sales contracts Inventory ownership

Manufacturer/ProcessorRisk from higher prices for

purchased items Inventory ownershipProducer forward

contracts Supply/sales contracts

End UsersRisk from higher prices

for ingredient costsRisk to plans/budget

from price volatility

Commodity Risk Management OverviewProcess Framework

5

Identify Risk

• Identify commodity risk exposures

• Understand the impacts each risk has to the company

Set Risk Strategy

• Assess the effectiveness of hedging tools from an accounting and economic standpoint

• Hedging strategies should be adjusted over time as markets are dynamic

Review and Refine

• Evaluate different hedging alternatives in terms of tool selection

• Choice of strategy should be consistent with policy objectives

Hedging Strategies

• Define the company’s risk tolerance, constraints, and the overall objectives of the hedging program

Quantify Risk

• Quantify the potential impact of market risks on your financial performance

• Determine the overall risk to the company given these underlying risks

Adapted from Citi’s Holistic Risk Management Framework

After understanding why you need to manage commodity price risks, a structured process can be defined to establish and implement a commodity risk management program.

Commodity Risk Management OverviewRisk Assessment

6

Low Medium HighAbility to Pass Through Costs

Nee

d fo

r Risk

Man

agem

ent C

over

age

Low

Med

ium

H

igh• Margin risk depends on the

ability to pass through commodity cost changes to customers

• More coverage should be taken on inputs that cannot pass on cost changes

• Less coverage should be taken for inputs that can pass on cost changes

• Determine what your risk tolerance is. Which is worse for a buyer? Uncovered and market goes

up (margin contraction) Uncovered and market goes

down (margin expansion) Covered and market goes up Covered and market goes

down (covered risk)

Commodity as % of Product

Cost

Commodity- Retail Price

Elasticity

Competitive Response Business Needs

Commodity Risk Management OverviewRisk Management Tools

7

There are a variety of risk management tools available to use. The selection of the proper tool depends on factors such as risk tolerance, financial vs. physical settlement, and cost. Hedging strategies range from fixed price to variable price contracts.

Hedging Tool Advantages DisadvantagesForward Contract • Easy to understand

• Flexible quantity• Locked-in price• Minimizes risk

• Difficult to exit• Must deliver physical product• Opportunity loss if prices rise

Futures Contract • Easy to enter/exit• Minimize risk• Potentially better prices

than forward contracts

• Opportunity loss if prices rise• Commission cost• Performance bond (margin) calls• Set quantities

Options Contract • Price protection• Minimize risk• Benefit if prices rise• Easy to enter/exit

• Premium cost• Set quantities• Commission cost

Commodity Risk Management OverviewPolicy & Controls

8

Given the large amount of financial risk exposure from commodities, hedging activity needs to be governed by robust policies and procedures. A commodity hedging policy can serve as the framework for the definition, measurement, and reporting of price-risks related to commodity hedging activity. Additionally, standard operating procedures are developed for each process step. The commodity hedging policy should contain the following:

1. Scope of Commodity Risk Management Activities2. Commodity Risk Management Oversight3. Commodity Risk Management Strategies4. Commodity Risk Management Tools5. Controls6. Risk Measurement7. Accounting for Commodity Risk Management Activities8. Authorized Commodity Brokers and Trading Advisors

9

A best practice is to establish a risk management philosophy and guiding principles that will help you in your decision making.

Align objectives of risk management with company goals Ensure management understands objectives of risk management Know your cost structure so you can effectively manage your margins Have specific, written risk management strategies Maintain discipline in executing risk management strategies Work with experienced professionals Develop policies, controls, and standard operating procedures Don’t operate in a silo – involve others in the process

Risk management is not speculating and should not be considered a profit center. In fact, not using risk management is speculative.

Commodity Risk Management OverviewBest Practices

10

Commodity Risk Management OverviewSummary

A successful commodity risk management program helps a company manage their margins and reduces the impact from commodity price volatility. Key steps in the commodity risk management process include:

• Determining your business needs• Identifying and quantifying your risk from commodity prices• Developing a structured process for establishing and executing hedging

strategies• Focusing on margin management• Ensuring policies and procedures are robust

Thanks!Mike McCullymike@themccullygroup.comwww.themccullygroup.com