Hedging Inventory Part One – How, Why and Why Not?
This article originally appeared on the Commodity Risk Control website.
Inventory hedging is the orphan of the commodity price risk management business. The source of more diametrically opposed opinions and different practices than any other topic, it makes us wonder where to begin. At the beginning, of course, but hold onto your hats it is a twisting and rather long ride! We will be following up with a second blog on the more nitty-gritty issues of, variable quotational periods, hedge roll-overs, use of discretion and accounting treatment, so watch this space.
If you start a metals processing business and hedge all your purchases and sales of metal units until you close or sell the business, you will clearly offset all your economic risk from fluctuating metal prices. In contrast, if you are a primary producer or end-consumer, you have either metal revenues or costs, so, in order to cover your economic risk, you only need hedge one or the other for settlement at the time the sale or purchase event takes place. Very straightforward, you would think.
But not so straightforward for our accountant friends. Hedging produces cash flow which is supposed to offset the cash flows from purchases and sales, but inventory does not flow anywhere, it just stays put and accountants insist it gets regularly revalued by marking it to market, with unexpected consequences for stating income. If you keep a purchase hedged after it turns into inventory, the hedge kind of trips over itself on its settlement date and must be rolled forward, while the inventory just stays in place – which, if it is permanent inventory, could be forever. The value of the inventory can be offset easily enough by the opposite valuation of the open forward hedge, so economic neutrality is preserved, but what happens to cash flow?
This is the problem – at this moment commercial, accounting and hedging treatments all part company and give rise to very unpredictable consequences. This is not the moment for a lecture in accounting, but to simplify, you can see that hedges which have to be settled and re-opened at different market prices produce differently timed cash flows and accounting treatment than physical goods which flow through inventory valuation and cost of goods sold into revenue.
In a rapidly falling market this often causes a financial bonanza because hedges are settled at lower prices with positive cash flow occurring earlier than the offsetting negative commercial cash flow of high priced purchases going through inventory into low priced sales. In a rising market the reverse is true and for a low margin, high commodity value processor the negative effect on working capital and income statements can be very nasty indeed. The risks are still economically offset, but you wouldn’t know it from looking at your bank accounts and income statements.
The financial impact of contangos and backwardations on inventory hedge rollovers can be significant too, both negative and beneficial, but that is a story for Part Two.
One simple answer, which ticked all the boxes in the old days, before accountants discovered marked-to-market inventory valuation, was invented by Norddeutsche Affinerie (now Aurubis), which pioneered the asset valuation of “eisenstock” – permanent inventory – at original purchase values as basic equity capital. NA only permitted the hedging of inventory fluctuations that rose above the basic level – which they rightly considered a true cash flow risk.
Even though auditors now don’t generally allow cost-based valuation of permanent commodity inventory components, many companies still follow this principle of only hedging fluctuating, but not basic stocks. Some processors who have fixed price forward sales have even argued successfully with their auditors against the year-end write-downs for permanent inventory, which hit the income statement, because the inventory valuation at high cost is covered by these high priced forward sales. A regular battle with auditors is a consistent by-product of inventory hedging.
Another solution for a cash flow crunch and income statement timing distortion is to aim only to have permanent inventory fully hedged when prices are going down. Wishful thinking you may say, and some companies have blown themselves up doing this by reversing hedges indiscriminately and with too short a time horizon. However, since commodity prices broadly track long-term cyclical patterns, other companies, which followed a disciplined policy of having permanent inventory 25% hedged in the estimated bottom quartile of the cycle up to 75% hedged in the estimated top quartile, have done significantly better than those who blindly have left permanent inventory fully hedged or totally unhedged all the time.
In most of commodity price risk management the principles are simple, and the mechanics are complicated. With inventory hedging the principles are complicated too. There is no universal best practice. To be successful over time, companies must be prepared to separate fluctuating inventory levels, which should be covered as regular cash flow hedges, and permanent hedges, which need a disciplined professional discretionary approach.
Clear hedging policy and consistent hedge accounting procedures supported by a control system with accurate focused reports are mandatory for successfully hedging inventory, together with expert guidance and risk modeling. We have guided many metal inventory hedgers through this maze and we encourage you to contact us with your questions.POSTED: 2017-11-23