Metal Price Risk Problems? Think Structure.

I live in a 1930 Craftsman-style house and, like older houses, it comes complete with all the old-fashioned inconveniences (small closets, closed vs open spaces, lots of stairs).  In character, renovation brings surprises, some that are fascinating and others…not so much ($$$).  But once started, every builder invariably says, “They don’t build them like this anymore”.  After nearly a century, it underscores the long-term importance of getting structure right.  That’s equally applicable to organizing and equipping business functions too, such as metals price risk management.  

So what is “structure” for price risk management?   It is architecture and principles combined to distill price risk from the jumble of other business noise.  Its purpose is to provide a platform for determining effective risk offsets and a reporting process that yields explainable outcomes.  This can be especially difficult for metal processors.  Virtually every metal processing enterprise, whether it’s a smelter, a refiner or a fabricator, is in fact a trader surrounding a manufacturing engine.  Just like a trader, they work to capture value-added margin through both purchases and sales.  And like a trader, price timing and quantity mismatches between the two may be involved, creating pricing exposures that require recognition and expertise to manage.  

As no two businesses are the same, program architecture must be designed to match the size, nature and goals set by management.   An early decision can be a “centralized vs local”.  We’ve worked with both extremes.   At one end, risk functions run at the local operation level, meeting the needs of strongly independent operations.   Here, the risk function needs dynamic communication with localized commercial, production and accounting functions.  This configuration comes with a high inefficiency cost via multiple systems and complicated central reporting.  Other companies have centralized risk functions, which are especially good for businesses with larger market footprints facing the challenges posed by credit and cash management.   This style is cost-efficient but places higher demands on IT systems.  Depending on the complexity of operations and the frequency of anomalous events, some form of risk management staffing may still be required closer-to-ground.  

The next level of structure is the isolation of risk outcomes from the measurement of operating functions.  Why should the financial impact of early or late pricing by suppliers or customers, or deliberate mismatches in buy/sell timings be reflected in the financial results for production?   Without separation, blended financial results are useless for performance measurement of either manufacturer or trader, and management will draw the wrong conclusions.   A common approach to separation is to have parallel risk reporting streams, with results converging at a centralized point.  If done right, the value added derived from both activities will be transparent.

The final structural element is the isolation of the separate pricing risks themselves.   Often, the same commercial transaction may contain more than one embedded price risk.   An obvious example is metal price and currency, where a transaction involves a metal price referenced in USD but quoted by/to a third party in another currency.  Situations where commodity inputs are bought and sold on different price references (e.g. LME vs CME) are another.  These risks can seem small, but when added up over the many deals, failure to segregate risks and act on them can easily mean the difference between a profit and a loss.   

When creating a processor price risk management function, architecture is critical.   As with my old house, structure shapes utility.  It also shapes a business’s ability and appetite to take risks.   We’ve worked with many companies that have fought through expensive trial and error to develop the right structure for their risk function.  You don’t have to.  Experienced advice from The Metals Risk Team is available and will save you headaches and time.