Stock charts and percentages superimposed over a wide view of fuel barges
Stock charts and percentages superimposed over a wide view of fuel barges

Commodity Hedging: 4 Key Questions, Answered

The team at Bannockburn Capital Markets, a First Financial Company, answers introductory questions to help consider your financial strategy

Some businesses and industries are especially susceptible to large swings in the price of commodities, which can make it difficult to forecast and manage margins. This becomes particularly true during periods of economic volatility. Commodity hedging can be useful in these situations for creating stability. This approach is sometimes overlooked due to its complexity, so the team at Bannockburn Capital Markets, a First Financial Company, answers a few introductory questions to help determine if you should consider adding commodity hedging to your financial strategy.

What is commodity hedging?

Like foreign exchange and interest rate hedging, commodity hedging mitigates negative price impacts. Interest rate hedging achieves stability by agreeing to a fixed amount and payment; similarly, commodity hedging secures the price of a given commodity through a contract with a lender. Knowing that payments will remain consistent over a predetermined span of time allows a business to better plan their budget and manage their margins.

Customer driven commodity transactions are a common core product extension of capital markets product offerings like foreign exchange and interest rate risk. The commodity hedging risk management team at Bannockburn assists commercial customers with the mitigation of financial price risk of the commodities they consume, produce, or inventory.

How does it work?

The process is very similar to a non-deliverable forward in foreign exchange or interest rate derivative settlements. All hedges are financially settled (USD) with no spot trading or physical delivery of the commodities. Typically, businesses will see one or more monthly average settlements or bullet (single day) settlement over the period of the hedge.

For Bannockburn, customer driven commodity hedges are available in the three main commodity classes: energy, metals, and agriculture. The average book tenor, or lifespan of the trade, of energy trades is in the 18–24-month range, metals average in the 6–8-month range, and agriculture averages within 6 months.

Customers trade under a CEE (Potential Future Exposure) line for commodities and trades are covered under an ISDA agreement. The derivative instruments available for customer transactions are forward swaps, options, collars and combined options.

Should I consider commodity hedging?

Commodity hedging isn’t right for everyone. The decision to pursue cannot be laid out in one article, but general trends can be seen.

  • The strategy is often most impactful for businesses that work in especially volatile commodities, like energy, metals, and agriculture.
  • In the Bannockburn team’s experience, the companies that experience the most benefits are upper middle market to large corporations with indicative credit ratings of BB + and above.
  • Commodity credit exposure can be cross collateralized under an ISDA to the loan collateral or asset / reserves.
  • Unsecured risk can be appropriate for certain counterparties. Risk can be managed through PFE, tenor and CSA limitations (mark to market limit).

How do I get started

To start a commodity hedging strategy, you will want to make an appointment with the commodity hedging team at Bannockburn. They will walk you through key points to consider, and ask you for information like:

  • Has your company been affected financially by commodity prices? (higher or lower)
  • If so, which commodities, and how did it impact your financials (revenue or COGS)
  • What types of commodities do you purchase on a regular basis?
  • Does your cost change daily / monthly / annually? Or does your physical supplier fix your cost for a period? (be sure to decouple physical from financial note)
  • Are there any negative impacts from the cost of transportation, or surcharge capability?
  • Does your company ever benefit from higher prices in commodities, as a producer or inventory holding?

From there, a knowledgeable team will be able to offer recommendations on the most advantageous strategy for your specific needs.

Commodity hedging is not right for everyone. But in a climate of trade turmoil, post-pandemic inflation, and supply change disruptions, it is a valuable strategy to consider. Reach out to your trusted financial team or make an appointment with your banker today to learn what commodity hedging could do for you.