Asiamoney Commodities Hedging Roundtable: The crucial balancing act
Economic historians looking back at the last few years will be sure to pay close attention to the interest rate environment, the changing banking landscape, and the gradual rise of the offshore renminbi — but they will also be forced to encounter the evidence of wild swings in commodities prices. It may come as a surprise, in this context, that many companies in Asia are still choosing to leave their commodities exposure unhedged, despite the ever-improved ability of their bankers to help them navigate the choppy waters of the global commodities markets. Asiamoney sat down with one of the leading commodities banks in Asia, as well as with two prominent executives with experience of the commodity hedging markets, to size up just how deep those options are at the moment, as well as to ask what changes still need to be made to convince more companies that hedging is the right step.
Chai Eamsiri, vice president, petroleum, corporate insurance and aviation environmental department, Thai Airways
Jacqueline Tan, head of global institutional and derivatives sales, CIMB
Marcus Tan Yam Ngee, general manager, portfolio management, PacificLight Power
Thomas Tan Kok Kiong, head of global sales, FX and transaction banking, CIMB
Yap Chun Kiat, director, commodities trading and structuring, CIMB
Moderator: Matthew Thomas, contributing editor, Asiamoney
Asiamoney (AM): What is the major commodities exposure that you face today – and how are you dealing with the risks?
Marcus Tan, PacificLight Power: PacificLight operates in the power markets. We trade what we call spark spreads: we sell power and pay fuel costs. We need to hedge our costs, which are referenced to certain oil indices for forward power contracts that are in various pricing schemes to secure the company’s profit margin, and clearly this is the major exposure that we face. But we also have some currency exposures that are important for us to address, because while the majority of our revenues received from the power contracts with consumers and spot trading are in Singapore dollars, we're paying our fuel supplier in US dollars.
Chai Eamsiri, Thai Airways: Fuel costs have in the past represented around 40% of our overall costs. The majority of our exposure is jet fuel in Singapore, and we use Mean of Platts Singapore [MOPS] contracts for this. That covers about 85% of our overall fuel cost exposure and in the rest of the world, while it does depend on the market to a certain extent, we know that our fuel costs tend to be strongly-correlated with the MOPS contracts. We leave those fuel costs outside of Singapore open, so we end up hedging around 85% of our exposure to the price of fuel.
We have long had concerns about the right hedging level. What is the right percentage of exposure that companies should leave unhedged? In my view, it is important the answer to this question is not too systematic. There needs to be some flexibility.
We have controls in place stating that different levels of hedging must be passed by management at different levels of the company. At my level, there are certain limits. If I want to hedge more, I will need to go to the risk management committee. If I want to hedge a bit more than that, I have to go up to the board. It works the same way for hedging less. But this does not mean we have to stick to an exact level without getting approval from the board or the risk management committee. There always needs to be flexibility.
Marcus Tan, PacificLight Power: We take the approach that in order to execute a trade in fuel derivatives and foreign currency, we must have an underlying power contract. As we operate in the power markets and do not know the future spot price of power which is subjected to physical supply and demand fundamentals, the aim is to hedge around 90% of the power generation forward with long term power contracts. Hence, we need to effectively hedge the relevant fuel cost so that we are largely secured in profit margin.
One of the problems we face is that the physical fuel supply contracts we reference for pricing are not current month in which the fuel is delivered, they are on prior months basis. That makes matters more complicated. Hence, we needed to develop a very effective fuel hedging strategy.
AM: It would be interesting to dwell on the exact percentage companies tend to hedge for a moment. There seems to be as much art as there is science when it comes to finding the right hedging level. What is the usual hedging percentage that you see from your clients?
Jacqueline Tan, CIMB: We tend to see clients that either hedge 100%, or don't hedge at all. Those positions are really the same position. They are both poor ways to go about managing your risk. There is no magical level when it comes to the percentage of exposures that should be hedged. It depends to a certain extent on how much of your exposure you can pass on to your clients. It also depends how much risk your suppliers expect you to take. You need to work out a level that is, say, 50% in normal times, but then goes higher in extreme times. That is the important thing. The numbers themselves do not matter so much as the fact that companies remain flexible.
Larger corporations can be much slower to adapt their hedging approach as the market changes. They take much longer to adjust their way of thinking, and it is tough to convince them in this regard. Smaller companies are, perhaps unsurprisingly, a lot more nimble, especially when the chief executive is very hands-on. They tend to take more confident views when prices are at historic highs or historic lows. For example, they will increase their hedge level when prices are at extreme lows and shorten the duration of their hedge when prices are at extreme highs.
Volatility is very good in good times, and very bad in bad times. For corporations, volatility should be minimised as much as possible, if only because excess volatility is not something banks are comfortable with. In good times, all banks are close to you. But in bad times, it really makes a difference whether or not you have taken care of tail risk. Those companies that manage risks better than their competitors will have much stronger relationships with banks, and they will have much more reliable credit lines.
Thomas Tan, CIMB: It is interesting to look at this from a historical perspective. Twenty years ago, hardly any airlines hedged. But as more and more airlines started to hedge, many of the newer airlines were forced to hedge as soon as they were created. They adapted to the competition. Their hedging strategies were a direct reflection of what was happening at their competitors. Now, the airlines are among the most advanced companies in the world when it comes to hedging, because so much of their costs come from the fuel price.
There were hardly any agricultural companies hedging five years [ago], but today a lot more companies are starting to hedge. We are seeing the same thing we saw in the airline industry before, in that this change is creating a cycle. Agriculture companies are seeing their rivals start to hedge and are considering hedging themselves. At the same time, banks are starting to provide more solutions that are directly applicable to the sector and that make it more enticing for agricultural companies to start to hedge. This is how the use of hedging grows from being just one or two companies in a sector to being widespread across the sector.
AM: Should the choice of hedging tools be mainly driven by the sector a company operates in, given the difference in liquidity between different asset classes? Or do most companies you deal with have, roughly speaking, the same range of options available to them?
Yap Chun Kiat, CIMB: It varies from client to client and sector to sector. There is not one formula that suits all. Everyone behaves differently. Everyone has businesses that function differently, as well. The solutions are really driven by the clients, because they are the ones that understand their business the best. They approach banks like us and tell us what problems they're facing, and only then do our ideas on solutions really start to form. They often need something that is beyond the usual bucket of products banks can offer, but we can tailor solutions to fit their needs.
Eamsiri, Thai Airways: We certainly have a range of hedging alternatives available, but right now most of our strategy relies on options for hedging. We rarely use swaps, because that tends to create another source of risk; that is, counterparty risk. It is important to choose the best tools to reduce volatility.
AM: Has the move towards more hedging been driven by bank lenders or equity investors, or has it really been an independent assessment by directors that it made sense to move in that direction?
Jacqueline Tan, CIMB: That's a very good question. If you take a look at a bank like CIMB, which is very keen to promote soft commodities derivatives at the moment — we are already lending to corporates who are in the food and agricultural business. It makes sense for us to expand our commodities derivatives business anyway, but there is also a strong argument that we need to give our borrowers an easy way to hedge their business exposures. By lending to these corporates, we have the same exposures to the commodities markets that our borrowers do. When we lend them money, and we tell them we need them to hedge their exposure, they often turn around and tell us they have no way to hedge them. By expanding our capabilities to soft commodities derivatives, we are able to provide our own corporate clients with relevant risk management solutions.
Increasingly in bank lending documents you see covenants requiring corporates to hedge. That may be commodities exposure. It may be foreign exchange exposure. But banks are more and more insisting that their corporate clients have some hedging programme in place before they can really access the lending opportunities that banks would offer them. How these corporates manage their risks can impact the size of their loans or the margins that these corporates can get.
Thomas Tan, CIMB: That's absolutely right. The drive is certainly towards more risk mitigation. Let's say a company does greenfield financing of a coal mine in Indonesia. There is likely to be a very long lead time from when the financing needs to be in place to when the banks actually start to get paid. The risks are very high and the sensitivity of the payback is highly dependent on the value of the underlying commodity. The viability of the project can vary greatly depending on where coal is trading. This is one reason why banks would put hedging conditions into a bank loan. It can ensure that a project remains viable even as prices fall.
Banks may also ask clients to hedge in extreme scenarios. There are situations where hedging is not triggered until some point. That trigger could be a disaster level for insurance purposes. The mine could break even at $100 per ounce and the current price is $150; perhaps you put the trigger at $110. This is one of the ways that banks try to mitigate risks in the project they are financing, and the willingness of clients to do that certainly improves their ability to access loans at the best possible price.
Marcus Tan, PacificLight Power: Banks want to lend to borrowers that have some certainty of payback. It is very important for borrowers to understand how the risks of a business will be mitigated, and that is increasingly being written in the documentation. But this should be very important for companies too. More than 70% of the cost of power generation is the fuel cost, so it is certainly important for us to make sure that there is strong risk mitigation in place so we can service our loans on a timely basis. Sometimes management needs to be educated on hedging because it is not something they face everyday, but once management starts to understand the benefits they get from hedging – and qualifying for hedge accounting – they will get greater access to the bank lending market.
Eamsiri, Thai Airways: I don't directly deal with loans bankers, but from time to time we have met with various analysts and bankers, especially when we were looking to issue bonds. Some analysts asked us at our most recent quarterly meeting: why did you not hedge less? This is because the price was going down. But in the past, they have asked us: why do you not hedge more? It is important that we take a nimble approach to hedging, but when you are looking at relatively short-term movements in prices, it is best not to answer these questions. You need to stand firm and stick to your policy.
AM: That is an interesting point. Given how volatile commodity prices are, how much sense does it make sense for companies to adjust their hedging approach as the market environment changes? Is there some minimum time-frame below which market volatility should be seen as little more then noise?
Eamsiri, Thai Airways: In theory, those hedging their exposure should not take a view. But in practice, we always do. You always have a feeling about the direction of the market. You always have a feeling about whether you have too much or too little hedging in place. This is why you need minimum and maximum hedging levels. They make sure that you are always staying within some range even as the market view changes.
There should be no difference between hedging and not hedging in the very long-term. It should even out over that period. But how many companies can wait that long, or have shareholders that are willing to wait that long?
Marcus Tan, PacificLight Power: You must have discipline once you have put the company's hedging policies in place. There is still going to be some residual basis risk after the hedges are applied, for instance, in the markets you operate in. The important thing is to actively monitor the risk exposures and hedge efficiently through a portfolio of trading books.
AM: How many companies hedge their commodities exposure by focusing on a trading range, rather than fixing the price they will receive at an exact level?
Jacqueline Tan, CIMB: A lot of our clients do use options strategies because taking a fixed-price with a swap is actually taking a very active view. Using options still allows them to take a view, but it is a view on what sort of range prices are likely to be trading within. It is much more sensible for those companies that have a view on where prices are likely to be, but do not feel any certainty about the exact price the commodity will be at in the future.
For listed corporations, hedge accounting is very important. Accountants are thankfully catching up now, because structured options can now be qualified as a hedge. This makes sense because options give a lot more flexibility to clients. Those who have locked prices in place with swaps can be hurt for many years in the future, depending on how long the swap was put in place for.
AM: How does one judge whether a hedging strategy was a good one?
Eamsiri, Thai Airways: This is a question I have been trying to get an answer to for many years, but no-one has really been able to answer it adequately for me. We have come up with our own solution. The most obvious starting point? We have to benchmark against something. We are an airline, and we put hedges in place, so we need to benchmark against our peers. We cannot benchmark ourselves against an unhedged airline.
There is not one answer to this question. There should be some criteria to meet when answering the question. How did we compare to other companies we can benchmark ourselves against? What was their approach? How would dummy trades have done over the same period? We put dummy strategies in place to examine this question, so that is one thing that helps us.
Jacqueline Tan, CIMB: The proof really is in how the share price is doing, how investors are responding to you, how bank lenders are responding to you, and how your P&L is performing. The real test of a hedging strategy comes in bad times. In good times a lot of decisions look wise, but in bad times, those that have put a sensible hedging programme in place will be rewarded by their investors.
AM: Foreign exchange risk is generally expected to be fully-hedged by companies around the world, but there has long been a lot more freedom to leave commodities risk unhedged. Is commodities hedging starting to get closer to FX in terms of investors' expectations over how much companies will hedge?
Thomas Tan, CIMB: I certainly hope so, and that is the trend that I see. I have been drawing attention to this point for the last 20 years. There are some treasury departments that have 10 people, all managing the currency risk. They have progressed to managing interest rate risk, and they have big teams for that, too. But for a lot of companies, FX and interest risk accounts for only around 20% of their overall market exposure. Their exposure to the commodities market is much, much larger, yet they often leave this exposure entirely unhedged.
Interest rates and currencies are also much less volatile than commodities prices. Commodities are historically two or three times more volatile than currencies, sometimes much more. It does not make sense that corporate treasurers spend so much time managing the FX risk, while the commodities risk is sitting with the purchasing department or someone else. We meet with companies sometimes and, after taking a look at their performance, it is very clear that the swings in their P&L are down to swings in commodities prices. But when you ask who is managing that risk, the treasurer tells you: 'no, that is not my mandate'.
We are starting to move towards a realisation that commodities price movements need to be at least partially hedged. More instruments have become available over time to meet this need, and banks can certainly help this trend by continuing to offer more hedging solutions to companies facing heavy exposures from commodities prices. This is particularly useful for small-and-medium enterprises. They cannot afford to have a hedging department, but if we can make contract sizes small enough, we can really help them move towards more commodities hedging.
Marcus Tan, PacificLight Power: The majority of our currency requirement is arising from fuel, so when we hedge the fuel price we have US dollar notional exposure and we have to secure the US dollars in the forward market to fix the fuel cost. FX and commodities risk are so related for us that everything really has to be well-hedged.
Yap, CIMB: Commodities businesses do face a lot of currency risk by their nature. If there are settlement currencies that require us to manage the currency risk for our clients, we are able to facilitate this because we are already in the business of managing foreign exchange risk. This is not a hurdle for us. It is about finding the right product that will suit the underlying exposure.
Thomas Tan, CIMB: I'd like to give an example of what CK is saying. In the context of the ASEAN region, one of the biggest-produced commodities is CPO [crude palm oil] and one of the biggest derivatives markets for this commodity is MDEX, the Malaysian derivatives exchange. The contracts are quoted in Malaysian ringgit and this, of course, is not a major issue for Malaysian companies. But for Indonesian producers, or Thai producers, when they come to hedge CPO risk on the MDEX, they also have the residual risk of what happens to the USD/MYR exchange rate. These non-Malaysian producers are forced to manage that risk, and we try to simplify that for them by quoting them CPO contracts in US dollars.
AM: How much do companies shop around for commodities hedging solutions between different banks? Is it increasingly important for companies to treat commodities hedging as part of a wider integrated approach to working capital?
Marcus Tan, PacificLight Power: Because we need to compete with other generating companies in the power market, we need to make sure we have a panel of banks that are able to offer very competitive commodity pricing. The pricing of contracts is clearly of major importance to us but after the financial crisis and the failure of some banks, it is clear that corporations also need to pay attention to counterparty risk. Most of our trades are on a bilateral basis. They are not cleared with a central clearing house, so it is important we take a close look at the credit rating of our counterparties.
Eamsiri, Thai Airways: We have around 20 counterparties at the moment. Out of those 20, perhaps 10 or 12 are active counterparties. The more banks that we have, the more liquid we are, and the more chance we can get a better deal. It is important to plan for extreme scenarios. Perhaps one day, a company will need to turn to all of its counterparties. The risks that each bank can absorb are quite different; some are more comfortable with commodities risk than others; some do not accept all of the hedging tools we want to use.
We have a minimum rating requirement of single-A for banks that we have as counterparties. Credit ratings are not real-time, however, so we also pay attention to credit default swap [CDS] prices to check on the perceived credit quality of the banks we deal with.
Marcus Tan, PacificLight Power: We have a credit risk management framework to manage the risk we face with individual counterparties. We determine our internal limits with them based on their financial standing. In the event of any adverse change in their financials, we will lower the limit to them or move more of our business to other banks on our panel. This is one way we can manage our risks.
AM: How many Asian corporations are taking an imperfect approach to hedging by using products other than the ones they are exposed to, but presumably those with a high degree of correlation, to hedge their underlying exposure?
Yap, CIMB: It is incredibly common in the commodities world for corporations to do these types of imperfect hedges. The quality of fuel can vary widely, which is one reason that people find themselves unable to perfectly hedge their exposure. But people also have preferences in the exchanges they are going to trade on, or the currencies they want to trade in, and that does not always match perfectly with their underlying exposure. Liquidity is, of course, a major issue.
There are two ways we can work with clients to help them get around these problems. The first is to assure them that fundamentally, the product they are using to hedge moves in line with the commodity they are really exposed to. There must be a fundamental reason, not just simply basis on, for instance, a five-year correlation. There needs to be a fundamental and a statistical rationale that we can explain to them. The other way we can help them is to make sure that the timing of the pricing of their hedging instrument works in the best way possible for them, perhaps even to the extent of offering them an average price to reduce day-to-day pricing risk.
AM: Are most Asian companies hedging using exchange-traded products at the moment, or are you seeing over-the-counter trading becoming more popular?
Yap, CIMB: It actually varies quite a lot between different asset classes. In the energy sector, you have the crude index, of course, which is exchange-traded. But generally speaking, most energy products are traded over-the-counter. Agricultural commodities tend to be more exchange traded. There are different hedging requirements in different sectors, and those historical pressures have led to wildly different use of the markets and, as a result, different levels of exchange access for different commodities.
AM: We have seen some foreign banks scaling back in southeast Asia. Have you seen much impact on the willingness of foreign banks to not only lend in this region but also provide commodities hedging solutions as well?
Marcus Tan, PacificLight Power: Yes. We have seen that reduced in this region. There was historically a strong mix of foreign banks and Asian banks, but quite a number of European banks have closed down their trading desks over here. That has made Asian banks more important in terms of providing liquidity, but thankfully the Asian banks are stepping up.
I don't think European banks will have a lot of credit available to their Asian clients in the future, so the growth of banks in the region is very important. But more than that, Asian banks have moved from just providing lending towards providing more widespread solutions to their clients in the commodities markets.
Eamsiri, Thai Airways: The number of European banks in this region broadly remains the same. But they are not as active as they were before, partly because of regulations and partly because they do not have as much money to lend. There are pros and cons of Asian banks when compared to foreign banks. Asian banks know the culture of the ASEAN region. They are more flexible. They are more responsive. But foreign banks are still strong when it comes to trading and research. We still need them in this region.
Thomas Tan, CIMB: Asian banks are more than ready to take the place of foreign banks. If you talk about the domestic currency business: in ringgit, CIMB's balance sheet is much bigger than all the foreign banks; in Indonesian rupiah, CIMB Niaga's balance sheet is much bigger than all the foreign banks; the same is true in Thailand. We can stand way above the foreign banks when it comes to the domestic currency business. There may be some disadvantage for us when it comes to US dollar lending, but that disadvantage is more in terms of pricing than credit appetite. We have a much stronger credit appetite.
Jacqueline Tan, CIMB: Asian banks will not replace foreign banks in terms of commodities risk management tools or capabilities. Foreign banks have invested many more years than Asian banks. They have reached critical mass. They have the IT infrastructure. They have cleared some very high barriers to growing in this market, and it is going to take a lot of time before a lot of Asian banks get to that level. Asian banks and foreign banks should not be looking at their growth in this market as competitive or mutually exclusive.We have the credit risk appetite. They have the market risk skills.
Thomas Tan, CIMB: I have to say I disagree. Technology is relatively cheap today, and Asian banks can hire from foreign banks to get that knowledge base. The technology transfer and the knowledge transfer is something that takes time. But it is certainly not impossible and it is happening much, much faster now than it did a decade ago.
Marcus Tan, PacificLight Power: There are some specific things that Asian banks are not doing as well as European banks used to. There is a determination period to fix the price of certain contracts. There used to be a lot of European counterparties that provide structured trades that allowed us to pass on that risk. They would manage the risk for us during the fixing period, but since the financial crisis they have pulled back from providing these solutions to us. This is something I would like to see Asian banks offer more.
AUDIENCE MEMBER: I would like to ask Khun Chai a question. You mentioned before that you decided to use options for hedging. How did you come to this decision and why did you decide this was the right approach for you?
Eamsiri, Thai Airways: We had a view that the market would be range-bound, between around $90 to around $105. That made it quite risky to use a swap, because the market could stray as much as $15 away from where we locked our swap price in. We did not need to hedge at a definite level. That was not necessary, so we came up with the approach of using options strategies to improve the cost of our hedging and to give us a bit more flexibility.
Airlines are not cash-rich companies. We cannot spend a lot of money to put options strategies in place, which makes it logical to use a combination of swaps and options strategies. But generally speaking, it made sense for us to protect our profits within a certain range rather than picking one swap price that we would lock-in for the future. That still seems the best approach to me.
AUDIENCE MEMBER: The commodities market is, from my point of view, strongly influenced by hedge funds. They have billions of dollars available, and they can move the market easily. How can we monitor what the hedge funds are doing?
Yap, CIMB: This is something that was raised last time I was in Jakarta. One of the refiners said they want a fair playing field. They want to know that price is reflective of fundamentals. They want to be able to manage their risk with the comfort that the market is reflective of true value. This is starting to be reflected in regulations, though. MDEX has a limit to the positions that individual traders can have, which limits the influence of speculators on the market. We have also seen moves in the US and Europe to make sure that the interests of the real end-users of these instruments are being safe-guarded.
Having said that, hedge funds, if with the right intentions, have an important role to play in the commodities markets, simply because they increase liquidity. In the jet fuel market, for instance, there could be limited participants especially at the back end of the curve. There are some airlines and there are some refineries. These players are not enough to generate sufficient liquidity, but once the hedge funds come in, it is a lot easier to create products that allow companies to hedge their positions. It is not all bad when it comes to the role of hedge funds in the commodities market.