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1

Commodity Risk Management

Daniel Hofstad Risk Management Consultant

Building a Risk Management Program

International Assets Holding Corporation | www.intlassets.com

2


Outline of Presentation

I. Introduction to OTCs

a. differences vs. exchange traded

b. Exchange traded futures, how prices are established

c. Contract specifics and margin commitments

II. The Philosophy of Hedging

III. Market Correlation & Basis

a. Black Sea grain correlation to CME

a. Basis

a. Hedging with Basis

IV. Opening a trading account

3


What exactly are they?

– OTC’s are off exchange derivatives of which the value depends on the price of the underlying instrument

– A combination of volatility, strike price, maturity dates, averaging windows and underlying prices make up the prices of OTC options

– Products offered typically reference exchange prices, or cash prices

– Products are designed to match the cash flow requirements of the product being hedged

– Can hedge commodities that are not traded on an exchange, as long as they are priced on a referenced index, (DOE Diesel)

What Are OTCs

4


• Exchange Options

– Options traded on a formal open outcry or electronic means

– Options are traded as American where early exercises are possible

– Electronic options can be European which are financially settled

• Over-the-Counter (OTCs) Options

– Options are traded as European financially settled (end of period) or Asian (average of period)

– OTCs can be tailored to closely match consumers commodity price risks

OTCs vs. Exchange Traded

5


• Provides the needed flexibility for pricing requirements

• Customizes specific hedging strategies

• Easily combines with existing futures and physical positions

• Creates unique risk reward profiles for the client given the

market bias or risk limits in place

• Can cover the exact risk more closely then exchange traded

futures and options

• Can be non contract specific sizes

OTC Summary

6


Who are they traded with?

– OTC’s quotes are obtained through a counterparty

– Trades are initiated with a counter-party through

broker or directly

– Banks, physical players, market makers, trading

companies and re-insurance companies

• Who are they insured with?

– FCStone is one of the few firms in the industry that

have and continue to carry third party insurance

and credit swaps

• Who tracks the trades, tracks margin calls?

– FCStone continually monitors positions, tracking

prices on trades through a third party mark to

market system4

Who Trades and Tracks OTCs

7


• Energy Products

– Average settled swaps on retail fuel price in U.S.

– Coal

– Electricity

• Currencies

– NDF (non deliverable forward) USD/UAH,

USD/RUB

• Agriculture

– Sunoil (6 port price index)

– Palm oil options

– Fertilizer (Urea black sea)

Common OTCs

8


• Domestic or FOB milling wheat

– Domestic swap that settles vs. the average of the monthly reported

IKAR EXW price for 3rd grade wheat (example)

• Sugar

– Domestic swap that settles vs. the average of the monthly IKAR sugar

index

• Sunoil export price

– Swap that settles vs. the FOB port price weighted average of the black

sea export ports or 6 port price

• FX

– NDF’s on UAH/USD and RUB/USD

• More…..

– In general there are many possibilities as long is there are companies

needing to manage the risk and financial brokers willing to provide the

OTC

Potential OTCs in Black Sea Market

9


Reasons for Hedging

• Depending on the type of business

– Better Utilization of Facilities

– Inventory Protection (Risk Transfer)

• Physical or forward price ownership

– Accumulate Inventory (Flexibility)

– Innovative pricing programs

– Manage budgets

– Additional Profit Opportunities

• Increase Margins

• Cap risk, manage volatility

– Opportunity=Risk

– Provides Certainty within your operation

10


Agricultural Producer

• Produces: milling wheat (50,000 MT)

• Planting period: (September/October)

• Harvest period: (June/July)

• Selling Terms: EXW on forward terms for future

delivery after harvest (sell in Feb/May and

deliver the grain in August/September

11


Producer’s Risks

• Risk that wheat price declines before they have

sold it and after they have established costs for

production (lower revenue margin)

• Risk that spot wheat price rises after they have

forward sold on the cash market (opportunity

cost)

• Risk that if they hedge with futures market, the

spot market declines relative to the futures

market before they sell on spot market (basis

risk)

12


Producer’s Hedging Goals

• Reduce risk of falling crop prices and lower

revenue margins

• Fix a portion of the production margin ahead of

harvest

• Maximize production profitability

• Reduce risk of loss on financial hedges

13


Hedging Philosophy

• Identify potential

opportunities to hedge at

higher price levels

• Identify opportunities to

forward sell at higher cash

price levels

• Utilize derivative strategies

that allow for opportunities

to increase margins

• Develop strategies to

improve basis position

• Analyze futures market

seasonal price patterns

and behavior

• Analyze cash market

seasonal price patterns

• Focus on options

strategies that limit risk and

allow of increased margins

on the crop prices

• Analysis of basis patterns

and strategies

14


OCT NOV DEC JAN FEB MAR APR MAY JUN JUL

JAN FEB

Wheat Hedging Example 2013 Production

*Periods of risk for individual crop (lower market risk) in the green bar

*From when forward sale made until wheat is delivered (opportunity cost) in the yellow bar

Wheat 50,000 MT

Costs / Budget

established

Wheat Forward Sold

Wheat Delivered

Wheat 50,000 MT

15


Quantifying Profit Margin Risk

• Accounting Method

Costs: Wheat $150/MT (sunk October)

Revenues: Wheat $200/MT EXW (February Sale)

(Budgeted)

________________________________________________

Gross Profits: Wheat $50/MT ($200-$150)

Risk: As EXW prices decline, Producer is at risk of

reduction in gross profit margin for the period between

October until February.

16


Identify Mechanisms to Hedge

• Futures Exchanges Potentially Suitable

• CME wheat futures

• Instruments

• Futures, options, option combination strategies

• Cost/Benefit Analysis

• Which mechanism works best to manage the firm’s

risk?

• Which mechanism works best within the goals of

company’s management and business? “hedge risk

while limiting risk of loss on financial hedge”

17


Correlation (CME vs. Black Sea Market)

Cross

Hedge

2010 2011 2012

CME SBO /

BS SFO

0.7308 0.6208 0.6538

CME SB /

BS SB

-0.1543 0.5868 0.9441

CME SBO /

BS SFS

0.8000 0.4800 0.6300

MATIF RS /

BS RS

0.8757 0.8866 0.7810

CME SB /

BS SFO

0.4700 0.4400 0.7200

18


CME Corn Correlation

19


CME Wheat Correlation

20


Components of a Crop’s Price and Risk

Basis Component

Reflects local

supply/demand factors,

transportation and

quality differentials,

etc.

80%

20%

Futures Component

Reflects Macro

environment factors

such as

supply/demand and

economic conditions

*Assuming 0.80 R^2 between futures and crop price

$160

$40

$200/MT Total

21


Importance of Basis

FUTURES PRICE

+

BASIS

=

NET EFFECTIVE

PRICE

Uniform and transparent

to all market participants,

Easy to fix/hedge (Same

for everyone)

Varies by each region and

location, is fixed once

cash price for

purchase/sale is made

(different for everyone)

Given that futures can be

easily fixed, the net

effective price becomes a

function of basis position

22


Example of Crop Price (+ and – ) Basis Values

CASH $200/MT Wheat

MARKET: CPT Odessa

(-)

FUTURES $250/MT Wheat

MARKET: CME Sep. Contract

_________________________

=Basis $50.00/MT (Under)

CASH $250/MT Wheat

MARKET: CPT Odessa

(-)

FUTURES $235/MT Wheat

MARKET: CME Sep. Contract

_________________________

=Basis $15.00/MT (Over)

Positive Basis

Negative Basis

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Components of a Crop Production Hedge

Costs of inputs, labor, equipment and

storage that must be covered in order to

make a profit

Production

Cost

Futures

(Hedge) level

Breakeven

Revenue or price level fixed vs. the

futures index, represents a % of the

total crop price subject to correlation

Basis level

Net Cash Market Price

Relationship between futures price and

physical cash market commodity price

(Basis = cash price – futures price).

Can be positive or negative value.

Losses

Pro

fits

or

*Once Futures price and Basis level are fixed via hedging Net Cash Market

Price = Net Hedge Price

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Revenue or price level fixed vs. the

futures index, represents a % of the

total crop price subject to correlation

Relationship between futures price and

physical market commodity price (Basis

= spot price – futures price)

Components of Hedge Price Example

Costs of inputs, labor, equipment and

storage that must be covered in order to

make a profit

Production

Cost

($170/MT)

Futures

(Hedge) level

($239/MT) Breakeven ($170/MT

Basis level

(-$5/MT)

Net Hedge Price (Spot

Price $234/MT)

*If Basis and Futures level are hedged = Profit of $64/MT

or

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$245 $245 $245 $245 $245

Basis Example (Wheat)

April May June July August

FUTURES

EXW

BASIS

Producer has sold Sept. wheat futures at $245/MT to hedge

lower EXW prices at harvest. He has therefore fixed the futures

price component and is now exposed only to basis (difference

of EXW price and Sept. futures) price risk

$230 $235 $240 $245 $250

$-15 $-10 $-5 $0 $5

As we can see, when basis is higher (stronger) it benefits the

producer with a higher EXW price because by selling futures

and owning the wheat he is long basis. So the $20 gain in his

basis position, is the same as the net improvement in his cash

position

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Fixing Basis Example (Wheat)

April May June July

FUTURES MT

PRICE (MTM)

EXW PRICE

BASIS

Producer has sold Sept. wheat futures at $245/MT in April to hedge

lower EXW prices at harvest. Current basis for Sept. delivery of the

wheat is -$15/MT for EXW and he is targeting a basis of +$5/MT or

better and will then fix the basis.

$230 $237 $242 $251

By July the basis level has reached the producers target and therefore

he can fix basis by liquidating the futures hedge (buy Sept. futures)

and selling forward to the exporter at $251/MT

-$15 -$13 -$13 $11

$245 $250 $255 $240

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Fixing Basis Example (wheat) Futures P/L

April May June July NET

FUTURES MTM

PRICE

FUTURES P/L

EXW PRICE

BASIS

When we combine the effect of the profit and loss on the hedge with

the profit and loss on the physical position we can see it is the same

as the profit and loss on the basis.

$0 -$5 -$10 +$5 +$5

NET POSTION CALCULATION = $251 (EXW) + $5 (FUTURES P/L) =

$256 or $26 better than the price in April represented also by a basis

improvement of $26

$230 $237 $242 $251 +$21

$245 $250 $255 $240

-$15 -$13 -$13 $11 +$26

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July 15th Sell at $251 EXW Buy @ $240 +$11

Date

April 1st

Cash EXW

Price = $230

Futures

Sell @ $245

Basis

-$15

+$21 +$5 +$26

Position Ledger for Transaction

May 15th Price = $237 MTM $250 -$13

June 15th Price = $242 MTM $255 -$13

Start Hedge

Liquidate

Hedge

*Notice that the net gain/loss on both futures and cash position is

equal to the final basis position and its gain/loss (+$26/MT)

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Managing the Basis Risk Component

• Basis can be determined at any time as the domestic or destination

cash price for the commodity less the relevant futures market price

(EXW Odessa corn of $251/MT – Sept. corn futures of $240/MT =

basis of +$11/MT)

• Similar to futures market prices, basis price has seasonal tendencies

that can be taken advantage of by producer or consumer

• As a producer of a commodity you are inherently long basis, as such

your physical position increases in value as basis increases once you

have hedged by going short in the futures market

• Even when both futures and cash markets are falling, as long as basis

is increasing, as a hedger who is long basis you are better off

• In some cases, basis can be fixed at the same time as the futures

price level, at a different time as the futures level, or not fixed at all

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FOB Black Sea Basis

Typically we see wheat basis peak during the spring and again in the end of the year. This is

therefore when a producer should try to maximize their basis position

31


Managing the Futures Component

• Futures price can be determined as the futures contract month and

exchange for which you will be hedging your crop, (September

CME 2013 corn).

• Futures markets tend to behave in seasonal patterns, as well as

technical price patterns which can be studied in order to help

determine optimal time of placing the futures price hedge.

• As a producer of a commodity you are long the commodity and

therefore take an opposite position in the futures market to hedge

or a short position (selling futures).

• Futures hedge can be initiated at any time during the course of the

period of risk, however when unhedged you are accepting the

market based price risk of the physical position.

32


Wheat CME Futures

Typically we see wheat futures peak during the most critical period of the U.S. growing season for

winter wheat during Jan - Mar. This year it likely occurred during the summer as the drought in the

US and Russia worsened.

33


A few additional thoughts

• Basis may be negotiable, and when you sell hedged grain, you are

in a position to negotiate

• You have time to wait because flat price risk is protected

• Patience is key to attaining your goals

• A producer/consumer of a commodity must be concerned about flat

price, then basis, with the consideration that he must cover

production costs and make a profit.

• If handlers of grain use futures to protect flat price risk, then basis is

the only ownership to be concerned with

• If both buyer and seller of the commodity hedge using futures, they

may exchange futures positions to eliminate further market slippage.

34


Position Record

A priced grain position record (long & short) which records all purchases, prices and average price

of accumulated inventories, plus all dispositions,

both cash and futures, is ESSENTIAL!

35


For your organization to become successful in your hedging operation, it will be important to follow these guidelines:

– Discipline: You will need to have the discipline to delegate time –

either yours or that of a capable employee – to spend on hedging. Always be a disciplined hedger… don’t speculate!

– Basis History: You must have basis history of the markets in which you are going to be involved and understand how the cash markets relate to your hedge position

– Cash Flow & Credit: You will need to continually examine your credit needs in relation to changing prices. It is necessary that your company be familiar with hedging and understand that margin calls may occur and that a loss in the futures market should correlate with a gain on the physical commodity.

36


Opening a Hedging Account

1. Provide Financial Statements and Other Documents for Due Diligence and

Regulatory Requirements

• These are then reviewed by FCStone credit and risk departments (2-5

Days)

2. FCStone will then establish trading limits and any applicable credit lines

based upon the customers financial review

• This process protects both the company and its customers from

exposure to risky customers (1-2 Days)

3. Customer signs relevant account documents and submits signed originals

to FCStone

• In general there are 3-4 documents which need to be signed by client

depending on the products they wish to trade (1-5 Days)

4. Customer is issued account number and account is opened

• Customer will fund the account with appropriate margin amount required

and commence trading/hedging

37


Hedging Process with FCStone

1. Once account is open, FCStone consultants will advise on appropriate

hedging strategy (for customers who are consulting clients)

2. Customer makes ultimate decision on which strategy to use and when to

implement

3. FCStone consultants will advise clients on price of strategy, margin

requirements if required, and relevant cost/bennefit information.

4. The Order is worked at the desired price, or executed at the current market

price per the customers instructions.

• Customer is given confirmation of order once executed and price of

order

5. Customer receives daily statements with profit/loss information, margin

requirement and open position mark-to-market value.

38


Communication with FCStone

1. Daily Market Updates and Report

• Fundamental analysis

• Technical analysis

• Derivative positions and profit/loss

2. Hedging Strategy Analysis and Recommendations

• As needed based on how the physical market position of the business is

changing

3. Questions and Quotes Anytime

• Phone (desk and mobile)

• IM (yahoo instant messenger)

• Email

• Bloomberg

• Trading systems (Alpha FX, QST, CQG)

COMMUNICATION IS THE MOST IMPORTANT FACTOR IN A

SUCCESSFUL HEDIGNG PROGRAM AND OUR RELATIONSHIP WITH

YOU!!

Спасибо за внимание!

Dan R. Hofstad

+44 (0) 20 3580 6076 Office

+44 (0) 20 7626 6030 Fax

+44 (0) 77 8561 0558Mobile

Yahoo I.M: danhfcstone

Skype: daniel.hofstad

[email protected]


mailto:[email protected]

Disclaimer

The following presentation should be taken in conjunction with the most recent financial statements and notes thereto as well as the most recent Form 10-Q or 10-K filed with the SEC. This presentation may contain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve known and unknown risks and uncertainties, many of which are beyond the Company's control, including adverse changes in economic, political and market conditions, losses from the Company's market-making and trading activities arising from counter-party failures and changes in market conditions, the possible loss of key personnel, the impact of increasing competition, the impact of changes in government regulation, the possibility of liabilities arising from violations of federal and state securities laws and the impact of changes in technology in the securities, foreign exchange and commodities dealing and trading industries. Although the Company believes that its forward-looking statements are based upon reasonable assumptions regarding its business and future market conditions, there can be no assurances that the Company's actual results will not differ materially from any results expressed or implied by the Company's forward-looking statements. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned that any forward-looking statements are not guarantees of future performance.

In this presentation and in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of our Form 10-Q and 10-K filings with the SEC, we present financial information on a non-GAAP basis in order to take into account mark-to-market adjustments in our physical commodities business within our Commodity & Risk Mgmt Services segment. Please note that all financial information provided in this presentation, referred to as an adjusted number, reflects our results adjusted for these mark-to-market adjustments and are non-GAAP numbers. For a reconciliation of these adjusted numbers with their corresponding GAAP numbers, please see the appendix to this presentation.

41


Putting the Strategy Together (2013 new crop)

• New crop corn prices higher than average (CME Sept. futures).

• Current: 245, 2012: 225, 2011: 220, 2010: 167, 2009: 160

• Creates opportunity to hedge higher than average futures price

• Current intentions and Budget

• Plant 50,000 ha of corn

• Projected yield of 4.0 MT/ha

• Total production of 200,000 MT

• Production costs $125/MT

• Budgeted selling price EXW $215/MT

• Hedge 50% of production between February and April 2013

• Develop basis strategy

• Once futures hedge is placed, Mryia becomes long EXW corn basis

• Examine seasonal opportunity to fix high basis value

• EXW basis typically appreciates $20-$50/MT between April and July, to an

average level of approximately $10 - $15 under CME price

• Therefore Mriya will target a $20-$30 basis gain once futures are sold

42


Hedging Strategy Timeline

FEB MAR APR MAY JUN JUL AUG SEP OCT

Planting

Hedge futures price (Sep CME) /

Establish long basis position

Fix basis, target appreciation in basis of

$20/MT

Deliver corn, complete sale.

Liquidate hedge and contract for physical sale

43


Hedging Strategy Simulation (Futures)

*BASIS STRATEGY = Target appreciation (gain) in EXW

basis of $20-30/MT between March and June 2013

*HEDGE VOLUME = 100,000 MT

1st Hedge placed

(50%)

2nd Hedge placed

(75%)

3rd Hedge placed

(100%) or 50% of

total production

50% of hedge

liquidated and

basis fixed

100% of hedge

liquidated and

basis fixed

NET RESULT = $227 EXW price + $6.50 futures P/L = net

corn revenue hedged price of $233.50/MT

Grain

delivered in

Sep/Oct

Basis goal

reached, hedge

liquidated

44


Producer Hedging Strategies (Options)

Put Spread

• Consists of buying a put option and selling a put option of a lower

strike price.

• Creates limited amount of protection from lower prices for a fixed

known cost (premium) similar to insurance

• Does not require margin to be maintained in trading account aside

from premium cost.

3 Way Option Spread

• Consists of buying a put option, selling a put option of a lower strike

price, and selling a call of a higher strike price than the long option

• Creates limited amount of protection from lower prices for a fixed

known cost (premium) which is generally much lower than a put or

put spread cost.

• Requires margin to be maintained in a trading account (due to short

call option)

45


Put Spread Corn Hedge Example

Parameters

• Physical Portfolio

• 200,000 MT, long (production)

• Anticipates to sell by July

• Current price assumption EXW Odessa price, $202/MT

• Hedge 50% of production (100,000MT)

• Put Spread Strategy

• CME Sept. Corn Futures

• Initiate options strategy In April

• Current Futures Price level to fix/protect: $6.25/bu or $246/MT

• Current Basis = -$44.00 EXW

• Target Basis = -$20.00 to -$15.00 vs. Sept. CME

46


Put Spread Risk/Reward Structure

P/L at

Expiration $0

$+

$(-)

Breakeven Futures Level: =

(higher put strike level – net

premium paid for put

spread)

Lower Put Strike Level =

Max Profit Futures Level

Max Loss Futures Level =

Higher Put Strike Level = net

premium paid for put spread

Futures Price

Level at

Expiration

47


Futures

Put Spread Corn Hedge Example(Current Values)

Sep

Bought

Higher

Put

Sold

Lower

Put

Area of increased value

to physical position, no

additional loss on

hedge

Area of increasing

hedge protection (profit)

as market moves lower

Area of decreasing

physical position as

market moves lower,

max hedge profit

Expiration

Futures

Level

$244.00 ($20.86/MT)

$220.00 ($10.63/MT)

$246.00

Net Cost of Put Spread=

$10.23/MT

Option (Put)

Strike Prices

(Levels)

48


Put Spread Hedge Performance at Expiry (Aug 23rd)

Futures

Price Level

Net Grain

Position

P/L ($/MT)

Physical

Corn

(Unhedged)

$+

$(-)

$0

Corn Put

Spread

Net Corn

Position

(Hedged)

$220

(Short Put)

$244

(Long Put)

$300

$170

+$56

+$45.77

-$74

-$60.23

Futures Level (SEP CME)

+$13.77

49


3 Way Option Spread Risk/Reward Structure

P/L at

Expiration $0

$+

$(-)

Breakeven Futures Level: =

(higher put strike level – net

premium paid for put

spread)

Lower Put Strike Level =

Max Profit Futures Level

Max Loss Futures Level =

Potentially unlimited as futures

increases past sold call strike

level

Futures Price

Level at

Expiration

Sold Call Strike Level

Higher Put Strike Level

50


3 Way Option Wheat Hedge Example(Current Values)

Sep

Sold Call

Bought

Higher

Put

Sold

Lower

Put

Futures


to physical position, no

additional loss on

hedge

Area of increasing

hedge protection (profit)

as market moves lower


to physical position, and

additional loss on

hedge position

Area of decreasing

physical position as

market moves lower,

max hedge profit

Expiration

Futures

Level

$275.00 ($7.18/MT)

$244.00 ($20.86)

$220.00 ($10.63/MT)

$246.00

Net Cost=

$3.05/MT

Option Strike

Prices (Levels)

51


3 Way Option Hedge Performance at Expiry

Futures

Price Level

Net Grain

Position

P/L ($/MT)

Physical

Corn

(Unhedged)

$+

$(-)

$0

3 Way Corn

Option

Net Corn

Position

(Hedged)

$220

(Short Put)

$244

(Long Put)

$275

(Short Call)

+$21

$300

$170

-$53

-$74

+$56

52


Futures

Brokerage &

Clearing

Over the

Counter

Brokerage &

Clearing

Physical

Commodity

Brokerage

Mission: To reduce commodity price risk while improving bottom line results for our customers

Products and Services

Risk

Management

Consulting

53


Background

54


GRAINS & OILSEEDS

ENERGIES

METALS

SOFTS

FINANCIALS & FX

LIVESTOCK & DAIRY

FERTILIZER

RENEWABLE FUELS

IB SERVICES, DEBT SERVICING

LUMBER & PULP

Markets and Products Served

55


Development of a Risk Management

System

•Goals & Objectives

•Deliverables

•NDA

•Account Documents

Proposal/Plan

•Program Structure

•Management

•Metrics

•Tools

Policy & Strategy

•Tactical Assessment

•Platform Analysis

•Accounting

Execution

Evaluation

56


Risk Management

Policy/Plan

Goals & Objectives

- Risk Tolerance

- Knowledge

- Financial Situation

- Physical Assets

Data Analysis /Modeling

Industry Intelligence

- Supply, Demand, Weather, Politics

- Customer receives Daily, weekly, monthly, and special reports

- Webinars

Execution & Hedging

• Futures • Options • OTC’s • Cash • Wait

Year End Analysis

Month End Report

Training

IRMP


57


IRMP


58


Matt J. Ammermann

44-(20)3580-6087 Office

44-(20)7626-6030 Fax

44-(0)8561-0551 Mobile

[email protected]

Skype: matt.ammermann

Yahoo IM: m_ammermann

Daniel R. Hofstad

44-(20)3580-6076 Office

44-(20)7626-6030 Fax

44-(0)-77-8561-0558 Mobile

[email protected]

Skype: daniel.hofstad

Yahoo IM: danhfcstone

Contact Information

Thank You!


