Hedge accounting of hedges for commodity risks

Hedge accounting of hedges for commodity risks – Under the old rules of IAS 39, hedge accounting could be difficult to achieve in relation to commodity exposures. This was largely due to the fact that IAS 39 did not permit hedging of specific risk components of non-financial items (with the exception of FX risk). Hedge accounting of hedges for commodity risks

For example, a company with a known diesel purchase requirement over the next two to three years may wish to hedge its exposure using a diesel swap. Even though the swap is designed to be a valid economic hedge of the wholesale diesel price risk, the company would not be able to define the hedged risk specifically as such. Instead, the swap would have to be designated as a hedge of the ‘all-in’ purchase price as illustrated below. Hedge accounting of hedges for commodity risks

Due to this restriction, the hedged item is sensitive not only to changes in the wholesale diesel price, but also to changes in other components of the purchase price – e.g. fuel duty, supplier margin, etc. As a result, it may not be possible to apply hedge accounting, either because hedge effectiveness cannot be reliably measured due to the ‘un-hedgeable’ risks included within the hedged item, or because the company cannot show that it expects hedge effectiveness to fall within the required 80% – 125% limits of IAS 39. This issue has often resulted in companies making accounting-driven decisions not to hedge commodity exposures due to the risk of incurring P&L volatility. Hedge accounting of hedges for commodity risks

The change of IFRS 9 to allow specific risk components of non-financial items to be designated for hedge accounting should largely alleviate this problem; it will allow hedge accounting to be applied to many more hedges of commodity exposures and could significantly reduce P&L volatility on existing hedge relationships. Hedge accounting of hedges for commodity risks

In order to be eligible for separate designation, the risk component must be separately identifiable and reliably measurable. This is the case if the risk component is either:

  • Contractually specified in the underlying purchase agreement – e.g. a fuel purchase agreement may include a pricing formula which uses a specific wholesale fuel price reference; or
  • Implicit in the pricing structure of the exposure – e.g. for fuel purchases made without a supply agreement (e.g. ‘petrol pump’ purchases), the wholesale fuel price may be an implicit component of the total purchase price. Hedge accounting of hedges for commodity risks

Where the risk of income statement volatility was previously considered a limiting factor to hedging commodity risks, companies have now reviewed their material commodity exposures and determined how the IFRS 9 hedge accounting rules have benefited them. Hedge accounting of hedges for commodity risks

Hedge accounting of hedges for commodity risks

Farming hedges

The easiest example to associate to a hedger is a farmer. A farmer grows crops, soybeans for example, and has the risk that the price of soybeans will decline by the time he harvests his crops in the fall. Therefore, he would want to hedge his risk by selling soybean futures, which locks in a price for his crops early in the growing season.

Let us assume the price of soybeans is currently trading at $13 a bushel. If the farmer knows he can turn a profit at $10, it might be wise to lock in the $13 price by selling (shorting) the futures contracts. The risk is that the price of soybeans could fall below $10 by the time he harvests and is able to sell his crops at the local market.Trading futures on exchanges is an efficient process. It, however, requires large volumes as the fixed cost of setting up and operating an exchange is high.

“A rice producer wants to hedge price risk, he/she can enter into a forwards contract to sell rice at $500/ton in 3 months’ time. A smart contract regulates the agreement between the parties. Each party also locks up an amount of collateral into a multi-signature smart contract. This is equivalent to the initial margin in a futures contract.

Each day, the amount of collateral is recalculated and any shortfall is covered by a margin call (equivalent to variation margin). The daily spot price of the commodity is fed to the margin smart contract by an oracle. At the end of the 3 month’s period, the spot price of a ton of rice is, say, $450 the producer will be paid: $500 — $450 = $50 per ton under the forwards contract. He/she sells the rice on a spot market and gets $450 per ton. So the price he/she gets is $450 + $50 = $500/ton.”.

Case study – Commodity risk from the production and sales of washing detergent Hedge accounting of hedges for commodity risks

A fast moving consumer goods manufacturing and marketing company produces washing detergent and sell it to customers. Linear alkyl benzene (‘LAB’) is the main feed-stock of the final product. The price of LAB is (mainly) driven by the price of Benzene and Kerosene (oil products). The list price for sales is fixed periodically and the period differs per region.

Fixed price sounds good but….

  • Limited transparency of price drivers Hedge accounting of hedges for commodity risks
  • Limited bargaining power Hedge accounting of hedges for commodity risks
  • Paying higher margins due hedging by supplier Hedge accounting of hedges for commodity risks
  • Margin volatility due a lack of flexibility

How this company solved this issue?

Central procurement company made responsible for the physical flow. Purchases at variable prices with Benzene and Kerosene components specified in the contracts. Hedging is performed centrally by a commodity risk management team. Steps taken:

  1. Centralise – Are volumes and pricing conditions of both sales and purchases known?
  2. Standardise – Contractual terms, including pricing formulas, should be harmonised across the business.
  3. Risk appetite – Desired level of exposure. What are competitors doing? Is the use of derivatives approved and understood?
  4. Hedge – Are derivatives available and is the market liquid? Determine required length of hedges.

By decoupling the physical flow from the hedging of price risks, companies can reduce the volatility of their gross margin and ultimately improve margins.

Naming comparisons

Liquidity Commodity
Currency Commodity
Bank Supplier / Trader
FX Forwards Commodity Forwards
Payment Settlement
Invoice (amount) Contract (amount)
Cash Flow Forecasting Commodity exposure
Bank account Warehouse

Hedge accounting of hedges for commodity risks 

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