Hedging against price fluctuations of raw materials such as KOH, potassium sulphate, and sodium hydroxide is a critical risk management strategy for manufacturers. By using a combination of futures contracts, options contracts, forward contracts, and swaps, manufacturers can protect themselves against market volatility and lower or minimise the risk of raw material costs.
One example of how raw material prices have fluctuated over time and how a hedging strategy works can be seen in the chemicals industry.
In 2018, the global chemical manufacturer BASF implemented a price hedging strategy for propylene, an important chemical feedstock used in the production of various chemicals and plastics.
BASF utilized financial derivatives to hedge against the potential price volatility of propylene in the market. Specifically, they used futures contracts to lock in prices for future delivery of propylene, effectively creating a fixed cost for this important raw material.
This hedging strategy allowed BASF to protect their profit margins and ensure a stable supply of propylene for their operations, despite potential market fluctuations.
With this in mind, here are some practical steps that manufacturers can take to optimize their hedging strategy for price fluctuations of raw materials:
· Identify the raw materials that are most vulnerable to price fluctuations. Manufacturers should identify the raw materials that are most critical to their business and are most vulnerable to price fluctuations. This will help them to focus their hedging efforts on the most important raw materials.
· Determine the appropriate hedging strategy. Manufacturers should determine the most appropriate hedging strategy for each raw material. This may involve using a combination of futures contracts, options contracts, forward contracts, and swaps, or a more direct ‘locked-in price’ with a trusted supplier.
· Monitor the market. Manufacturers should monitor the market for the raw materials they are hedging against to ensure that their strategy is working effectively. If market conditions change, the hedging strategy may need to be adjusted.
· Understand the market. This includes analysing the supply-demand dynamics, global economic conditions, geopolitical tensions, and other factors that may impact the price of raw materials.
· Set clear hedging objectives. Manufacturers should have clear objectives in place for their strategy. This includes determining the quantity of raw materials to hedge, the desired level of protection, and the time horizon for the hedge.
· Diversify hedging instruments. Where possible, it is important to use a combination of tools against price fluctuations. Diversifying the hedging instruments used can help manufacturers to spread their risk.
· Consider the cost of hedging. Hedging against price fluctuations comes at a cost, which includes fees and commissions charged by brokers and other intermediaries. Manufacturers should carefully evaluate the cost of hedging against the potential benefits. In some cases, it may be more cost-effective to absorb the price fluctuations rather than hedging against them.
· Evaluate timing and liquidity. Manufacturers should also consider the timing and liquidity of the hedging instruments they are using. Futures and options contracts, for example, have expiration dates, which may require manufacturers to roll over their positions.
· Monitor the effectiveness of the hedging strategy. Manufacturers should continuously monitor the effectiveness of their hedging strategy to ensure that it is working as intended. This includes monitoring the performance of their hedging positions, tracking market movements, and adjusting as needed. By regularly evaluating the effectiveness of their hedging strategy, manufacturers can optimize their outcomes and maximize profitability.
Great care should be taken when assessing a price hedging strategy. Those sourcing raw materials should carefully evaluate the cost of hedging and consider the timing, liquidity, and effectiveness of their positions to ensure that goals are met.
One example of a poorly judged hedging strategy can be taken from the oil sector (where hedging is commonplace).
In the early 2000s, oil prices experienced a sharp rise from around $20 per barrel in 2001 to over $140 per barrel in 2008. During this time, some oil companies, such as BP, used price swaps to hedge against the risk of rising oil prices. These hedges allowed BP to lock in a certain price for its oil production and protect its profit margins.
However, the financial crisis of 2008 led to a sharp decline in oil prices, and companies that had hedged against rising prices found themselves locked into higher prices than the market rate. This resulted in large losses for some companies, including BP, which lost around $1 billion in 2008 due to its hedging strategy.
From this it is clear that hedging can provide some protection against price fluctuations, however it is far from a fool proof strategy.
Photo credit: Anita Stachurski from Pixabay, Lorenzo Cafaro, & Miguel Á. Padriñán