Rabobank: A Clear View On Commodity Risk

With rising prices forcing corporates to rethink their approach to hedging commodity price risk, banking group Rabobank has made specialist commodity products part of its financial services package.

On its own, the continuing volatility of oil prices is enough to affect the cost structure of most businesses. When higher energy costs are coupled with price-spikes in other key raw materials – from copper to corn – the effect on other business sectors is increased.

"Our team provides specialist industry and market knowledge to our clients along the supply chain."

Along with oil prices making the headlines, agricultural commodities have also come into the spotlight this year. Worsening supply conditions have pushed the price of wheat to record highs, and there has been volatility in corn, rice and many other markets. Producers and consumers of these commodities, therefore, have become much more keenly aware of the need to manage these price risks.

‘Corporate clients have noticed the extent of their exposure to rising commodity prices,’ says Louise Derbes, director and dedicated commodity specialist in the Corporate Markets Europe team at Dutch banking group Rabobank.

‘There are many things they can do to mitigate the risk, depending on what they are exposed to and what their risk management strategy is.’

The food and agribusiness sector is the prime focus of Rabobank, which advises many purchasers of agricultural and energy commodities. The bank has become increasingly aware that its portfolio of financial services must include specialist products to hedge commodity exposure, as its corporate customers recognise the need to take a new approach to risk management. As the world’s largest financial institution specialising in the agricultural sector, Rabobank knows it has a vital role to play in helping customers make this transition.

Managing commodity price risk

‘Many companies handle commodity price risk management through their purchasing departments, but now treasurers are seeing the direct impact of commodity prices on profit and loss, so they are looking at it in the same way they might look at interest rate exposure or currency risk,’ says Derbes. ‘It is a cost input,’ adds Alistair Mules, managing director and head of Rabobank Corporate Markets Europe. ‘Commodity risk should be managed by the treasury as a financial risk like any other.’

Putting commodity risk management in the hands of the finance team may be an important first step, but it is just the start of the process of building an effective hedging strategy. For Rabobank, advising on commodity risk is not just about providing products. Its specialist expertise enables it to provide invaluable insight at the early stages of defining a hedging strategy.

‘Our aim is to allow CEOs and CFOs to have a feel for what is happening in the commodity markets and show them how they can protect against or profit from price changes,’ says Mules. ‘There has been exponential growth in companies’ exposure to commodity prices and in their need to hedge. They can clearly see the impact on their need for funding and liquidity.’

A strategy to suit your business

The obvious first step for a corporate looking to mitigate commodity price risk is to consider the use of standardised contracts traded on a futures exchange around the world.

For Rabobank, however, this approach is likely to be too simplistic for many of its clients, who may well need a hedging strategy more closely aligned with their long-term business goals. Furthermore, the unpredictable margin payments required by exchanges can bring unwelcome cost and liquidity implications.

The bank’s team of commodity specialists, therefore, offers clients hedging solutions with greater flexibility. They can not only structure risk management products but can also help clients clarify exactly what they want to achieve through their hedging activities. The objective is to enable clients to take a strategic approach to risk, by helping them determine the scope and objectives of a risk management strategy, identify key risk factors and implement the appropriate financial metrics to evaluate risk exposure.

From there, the bank can help clients determine thresholds set by risk appetite and internal constraints and simulate changes in risk factors. By evaluating the relationship and impact of changes on the agreed metrics the bank’s commodity specialists can determine the expected and worst-case scenarios of each portfolio to articulate a risk profile and, ultimately, evaluate the risk and return of alternative strategies.

Specific risk management strategies

Once the hedging strategy has been defined, the tactical optimisation strategy determines the structure of specific risk management products, which could be ‘over-the-counter’ price swaps to lock in production margins.

"The bank's portfolio of financial services must include specialist products to hedge commodity exposure."

These fixed for floating swaps are cash-settled contracts for difference, where the fixed price and notional amount are established when the trade is executed, and the floating price is set from a pre-agreed index on a future date.

The payoff is the difference between the two prices, multiplied by the notional amount. All hedge contracts are confidential and can be customised to suit each client. All are backed by Rabobank’s AAA (S&P Moody's) rating. By separating the physical transaction from the hedge, a company can diversify its counterparty risk.

‘We can offer long-dated hedging that you can’t get on futures exchanges.’ explains Derbes. ‘We can add liquidity beyond the liquid tenor of the futures curves, and our price hedges do not have to be margined. They are futures lookalikes but their advantage is not just the price of the commodity but also the offer of liquidity.’ ‘The problem with exchange-traded contracts is that they require initial margin payments, plus variation margin as the price of the commodity changes. This cost is unpredictable, so companies may need to have a large pile of cash at hand or the ability to borrow to fund margin calls. Treasurers don’t want unanticipated demands on cash,’ she adds.

Mules makes it clear that Rabobank’s approach is not necessarily about accurately predicting future prices, but rather giving clients with exposure to commodity markets more flexibility in their hedging strategies. Its global network of corporate sales desks support corporate clients in managing their commodity risk.

‘There are a lot of views in the press about what is driving commodity prices,’ Mules says. ‘Some say it is fundamental supply and demand conditions that are determining prices, others say it is fund investment. Our solutions are not so much about our view on prices, they are about offering clients a predictable cost structure.’

Understanding global markets

Although predicting future prices is not the core service Rabobank aims to deliver, its understanding of agricultural commodities relies heavily on its specialist Food and Agribusiness Research and Advisory group (FAR). This global team of analysts is constantly analysing key trends throughout the food supply chain, from production to consumption, including brand strategies and environmental issues.

"There has been exponential growth in companies’ exposure to commodity prices and in their need to hedge."

Through FAR, Rabobank regularly briefs its corporate clients on key issues that may affect their business, and provides hedging strategies to suit the changing markets.

‘There is more demand for our knowledge and advice because of the volatility in the markets over the last two years,’ says Luke Chandler, senior commodity analyst with Rabobank’s FAR group. ‘Risk levels have increased substantially, so we can use our understanding of global and local markets to help our customers manage these risks. ‘Our team provides specialist industry and market knowledge to our clients along the supply chain. We have 70 analysts globally providing our clients with a timely and accurate view on world trends.’

The trends FAR tracks include a diverse range of factors that influence demand and supply, including political issues such as the US Government’s support of biofuels, which is seen to put pressure on the supply side. ‘It is a very interesting time in soft commodities, and the volatility we have seen in the markets over the past couple of seasons isn’t expected to end anytime soon,’ notes Chandler. ‘Stocks of commodities such as wheat, rice, corn and soya beans are tight, but demand is growing as we see more urbanisation, population growth and economic development in countries such as India and China, together with increasing biofuels demand.’

There is limited ability for producers to respond to record high prices, which must be maintained if South America and the region around the Black Sea are to bring new land into the production mix. Skyrocketing fertilizer prices, up by over 300% in the last year-and-a-half, and record fuel costs are placing significant pressure on producer margins.

There is a lot of pressure on the market and it isn’t expected to subside soon.’ Motivated by an understanding of its clients’ growing need for access to informed insight on the diverse forces that drive the price of key commodities, Rabobank’s move to ensure that commodities expertise is a key part of its broader range of financing services will be a major step forward in meeting the needs of its corporate clients.

Alistair Mules managing director and head of Rabobank Corporate Markets Europe and Louise Derbes director and dedicated commodity specialist in the Corporate Markets Europe team.
Luke Chandler, senior commodity analyst with Rabobank’s FAR group.
Diverse forces are driving the price of key commodities like wheat, rice and corn.