A new day for risk management

by Josh Sosland
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While packaged food companies cannot turn the clock back to commodity prices prevailing two years ago, their ability to manage the risk of input cost swings has not been diminished, according to risk management professionals speaking with Food Business News. Additionally, the heightened risks facing food companies because of extraordinary market volatility have prompted executive management to give increased attention to the importance of procurement.

Wildly volatile markets have created difficulties for food processors (see related story beginning on Page 1) and raised concerns over a host of issues related to hedging, including problems with convergence between cash prices and futures prices and the allegedly disruptive effects of index funds on futures.

Rob Schreck, a customer risk manager at Cargill, Wayzata, Minn., said it was ironic that recent press coverage has suggested the ability of food companies to hedge has been compromised. Cargill is one of a number of processing companies that offer its customers embedded risk management services.

"One Wall Street Journal article discussed anger at the exchanges and that people think the exchanges are broken," Mr. Schreck said. "There is greater opportunity to manage risk in these volatile markets than there ever has been before. There are tools to help people understand, act and capitalize on market conditions.

"In risk management, I couldn’t be more upbeat about what will happen from here. Companies need to partner with people they trust to provide market insight, whatever their risk management program is — whether it’s futures, options, OTCs (over-the-counter derivatives), or embedded risk management tools."

While many companies have actively explored new risk management programs, others have held back, paralyzed by the combination of lack of familiarity with these types of tools together with a reluctance to make changes in the midst of the most volatile markets most ingredient buyers have ever experienced. Mr. Schreck discouraged this kind of passive approach.

"This is a paradigm shift in volatility of the marketplace, and a passive wait-and-see strategy is not a prudent approach to the market. We favor implementing structures to create more ‘knowns’ to the pricing variables."

Ryan Turner, a risk management consultant for FC Stone in Kansas City, said the term "risk management" has reached the radar screen of a growing number of businesses.

"You see more participants seeking help and utilizing some of the tools that are available," he said. "By participants, I mean more people, companies and even industries that never had to use risk management before.

"You’ve also seen some of the tools begin to change. We’ve always used futures as our basic hedging mechanism. You’ve seen more people go to options in conjunction with basic futures and a migration to more structured products, off-exchange, over-the-counter products."

Mr. Turner went on to say the use of risk management tools has been migrating down the food chain, closer to the consumer. While processors historically were the principal users of hedging strategies, he said food service and food processing companies have looked to offset risk.

"The poultry market is a good example," he said. "You now have processors taking price increases across the board, even on contracts. They are basically telling customers, the risk is not going to be ours. You will own the corn risk. You will own the soybean meal risk. We’ll set you up on a formula. You tell us when to buy it."

Mr. Schreck of Cargill offered as an example of creative risk management tools, cap pricing that allows users to capitalize on price declines by repricing contracts using a range of tools. With such programs, flour may be priced in ways that cuts costs further even when the underlying futures market moves higher.

"Or, some of our tools allow users to cap their actual price, but should the futures market return to lower levels, provides the opportunity to capture value as the futures price declines," he said. "With every risk management program, there always are tradeoffs that must be fully understood, but the structures are flexible. Expiration dates, volumes, price ranges and other requirements that emerge in a dynamic market may be adjusted."

Robert C. Lindon, executive vice-president of Connell, Naperville, Ill., described the markets in 2007-08 as a "wakeup call" even for the most seasoned hedgers. Connell is a risk and spend management company.

"Many companies that were doing some form of risk management have discovered that what they had in place was not adequate with the current markets we are in," Mr. Lindon said. "Now they are using some of the same tools, but their business philosophies and risk management programs were not aligned. When you start doubling and tripling prices, many other things begin happening with risk management."

The challenges facing ingredient buyers have been as much about volatility as about price advances. In the case of the Minneapolis May, the $11.95 futures close on May 9 not only was more than double the season’s low of $4.70 set in June 2006, the price also was down more than $7 a bu from the season’s high, set in February 2008.

The ability of the wheat price to hold above $5 per bu for more than just a brief period also represents a break from past history, Mr. Lindon said.

"For the longest period of time, wheat traded between $3 and $5 a bu," he said. "So the range between the high and the low was $2 or maybe $2.50, and probably no more than $1.50 in any given year.

"Now you move into a situation in which the volatility is much greater than anyone has ever experienced, not just for one or two items, but across the board of virtually every major commodity that one could have been buying.

"My point is that companies have had to step back and reanalyze risk management strategies to put them in sync with how markets were trading. It didn’t necessarily mean the tools they used changed, but the perspective of how they used the tools change."

Mr. Lindon encouraged ingredient buyers to step back and more fully understand marketplace risk.

He explained, "Is your risk versus competition? Are you worried you’re going to buy, and the market will go lower? What about not buying currently and facing the risk of the market moving higher? Ultimately, you need to understand your risks and goals, assess those goals and actively manage toward them. Bottom line — you need to have a plan and stick to it."

While the emergence of index funds may have changed wheat futures from a "risk management tool" to an "asset class," Mr. Turner said futures markets remain an effective vehicle for hedging risk. He noted the unique breadth of the market rally.

"No one part of the food industry has been isolated," he said. "It’s been wheat, dairy, the proteins, grains and oilseeds. The root problem, in my view, is energy prices. Between biofuels, and the degree to which they’ve absorbed an increasing percentage of acreage, I would say that if crude were not at $125 a bbl and the price was $50, the situation is very different. The root is the energy crisis.

"I think the one thing I can say with certainty for the next two to three years is that the volatility is not going away. Prices may go up and may go down, but the moves between the high and low will be far wider than we’ve become accustomed to. Swings between high and low have been much wider than expected."

While dramatic day-to-day market swings may make it difficult for ingredient buyers to take the longer view, Mr. Schreck said such long-term thinking is critical if risk management programs are to succeed.

"People can be fortunate and beat the market on a short-term basis, however they are just as likely to miss the opportunities. Ours is a long-term view. Volatility is nothing to be afraid of if you understand how it works and how it can help you."

This article can also be found in the digital edition of Food Business News, May 27, 2008, starting on Page 32. Click here to search that archive.

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