accenture agribusiness commodity trading risk management

7/23/2019 Accenture Agribusiness Commodity Trading Risk Management

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Achieving High Performancein Agribusiness throughCommodity Trading &Risk Management


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The commodity market faces increased volatility and regulatory scrutiny.

Although many agribusinesses have devoted considerable attention to physical

risks associated with supply chains and producers, commodity trading and risk

management have received scant attention. Where companies have created

commodity trading and risk management programs, they are oftendisconnected from physical risk. Now more than ever, agribusinesses need to

develop a more structured, holistic approach to managing risk and liquidity.

Not only can it assist in mitigating existing risks, but it can help agribusinesses

prepare for the future, seize growth opportunities and outmaneuver

competitors.

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Many companies are feeling the pinch,squeezed between an increasingly tightsupply and demand equation. A growingglobal population and significant dietarychanges in emerging markets have boosteddemand. On the supply side, increasingenergy and freight costs coupled withclimate instability have put downwardpressure on profit margins. To cope withthese changes and other industry trends thatare amplifying market volatility, agribusinesscompanies will need to examine theircommodity trading and risk managementpractices.

In recent years, new players, such asinvestment banks and hedge funds, haveincreased speculation in the commoditymarket, particularly with derivatives tradedthrough exchanges and over the counter.Agribusinesses must take into account theincreased activity of these players whenforecasting prices given the greater potentialfor price volatility. With more sophisticatedinstruments and structures available,agribusinesses need to consider all of thepotential consequences to their businesses in

terms of cash management, debtmanagement and the balance sheet that willallow them to mitigate commodity tradingrisks and seize business opportunities.

Weathering commodity volatility andregulatory changes

Given the recent financial turmoil, manygovernments are looking to regulatespeculation and broaden their risk controlmechanisms beyond the financial markets. Anumber of regulatory changes around theworld are taking shape that will have alasting impact on how agribusinesscompanies manage risk.

In the United States, the Dodd-Frank WallStreet Reform and Consumer Protection Actwill change how any company participatingin the U.S. derivatives market handlesrecordkeeping and reporting. Anotheroutcome of the legislation, which is expected

to be fully implemented by the end of 2013,will be that companies participating in theover-the-counter commodities market willneed to have adequate resources to meettheir financial obligations in case of default.And there are many more requirementsmandated by the legislation. Smart riskmanagement will be essential to plan for andmitigate increased capital requirements. Inthe meantime, several other countries areconsidering the implementation of a similarlaw. 1

In the European Union, reforms to theCommon Agricultural Policy mean thatfarmers will bear greater responsibility formanaging the risks formerly addressed byprice and market support policies, accordingto Deutsche Bank Research. 2

As a result, many agribusiness companieswill need to create more effectivecommodity trading risk managementcapabilities to weather a volatile economicclimate and production environment. Butcommodity trading risk management is morethan just a way to mitigate existing risks. Bydeveloping a more structured approach to

managing risk and liquidity, agribusinessesgain a competitive advantage that can setthem apart from their peers and lead themon the path to high performance. A robust,holistic approach to commodity trading riskmanagement enables companies to stay onestep ahead of the competition by givingthem greater visibility into their overallmarket position. The increased transparencycan help companies make crucial decisionsabout risk that are tied into their overallbusiness strategy, prepare for the future, and

identify and realize growth opportunities.

Figure 1: Factors amplifyingagribusiness market volatility

1 The Dodd-Frank Wall Street Reform Act,Accenture 20112Risk Management in Agriculture, DeutscheBank Research, September 17, 20103Source for both bullets: Basu, Parantap andGavin, William T. What Explains the Growthin Commodity Derivatives? Federal ReserveBank of St. Louis Review, January/February2011, pp 37-48

AgribusinessMarket Volatility

Regulatory Changes

In the EU, Common Agricultural Policy reforms

mean that farmers will bear more responsibilityfor risk;

The Dodd-Frank Wall Street Reform &

Consumer Protection Act in the United States willrequire agribusiness participating in over-the-

counter swaps to comply with new liquidity andreporting requirements, among other mandates;

Many other governments are considering

similar derivative reform legislation.

Enviromental Changes

Extreme weather conditions and temperature

variations will significantly impact productivity;

Today's agriculture uses 70% of all fresh waterwithdrawals globally, and the UN anticipates that

14% extra water will need to be withdrawn for

agricultural purposes over the next 30 years.

Pressure on Land Biofuel growth creates competition with food

producers for the use of land and price volatility

for sugarcane and com; Laws intended to prevent agricultural

encroachment into endangered biomes mean that

producers will have less land to produce a greater

amount of food.

Increased Commodity Speculation' The outstanding notional amount of commodity

derivatives contracts tripled between June 1998

and June 2003 and then rose 19-fold in the nextfive years, peaking at $13 trilion in June 2008.

During this period, trading in commodityderivatives grew to exceed trading in equityderivatives;

Since then, commodity derivatives traded on

organized exchanges have nearly recovered thevolume achieved at the 2008 peak (thoughover-the-counter trades have continued todecline).

Increased Demand Growing middle class BRIC countries mean that

diets are changing, increasing the demand for

meat; By 2030, the United Nations estimates that

demand for agricultural products will be about

60% higher than today;

Population will exceed 8 bilion by 2030.

Rising Input Costs

Commodity boom with Chinese growth has led

to signifant cost increases in major agricultural

inputs like oil and fertilizers; In the next decade, input costs will continue to

rise to levels at or above those of the decadespreceding the 2007/2008 peaks.

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High performance commodity trading andrisk managementIn fact, Accenture research indicates thathaving a sophisticated commodity tradingand risk management approach can helpagribusinesses achieve high performance.Using our proprietary High PerformanceBusiness methodology, Accenture recentlyanalyzed 56 agribusiness companies withannual revenues in excess of US$1 billion todetermine key characteristics of highperformers, defined as companies thatoutstrip their competitors over multipleeconomic, industry and leadership cycles.

As global economic volatility continues tocause huge swings in commodity andresource prices as well as packaging andtransportation costs, financial risk poses agrowing threat to agribusiness companies.While many companies are addressingphysical risks associated with their supplychains or producers to ensure product qualityand safety, financial riskwhether credit,market or liquidity riskis often handledseparately, despite there being an importantconnection to physical risk. However,Accenture research indicates that managingfinancial risk together with physical risk isessential to achieving high performance.

The research revealed that one of the fourdistinctive capabilities of high performingagribusiness companies was effective tradingand risk management. High performerseffectively manage physical, financial andsustainability risk, as well as their revenue.Not only can the capability enablecompanies to mitigate exposure to risk andaid decision-making, but it can also helpthem increase revenue and maximize profits.

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High performing agribusinesscompanies:

Leverage a risk management system tosimulate and evaluate risk, and they usescientific measurements to make fact-based trading and risk managementdecisions.

Minimize financial risk exposure through aprecise hedging strategy andimplementation, market simulation andplanning, and integrated risk managementacross the enterprise.

Having a holistic approach to managingcommodity trading risk not only makesagribusinesses more agile in reacting to oravoiding risk, but the resulting transparencyinto the business enables them to grow andoutmaneuver competitors.

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Developing an integrated approach

Many companies, if they have a riskmanagement program, often apply disparateones to different commodities, functions orbusiness units. The reason is largely systemic:Procurement, sales and trading functions aretraditionally disconnected in agribusinesses.In many cases, each business unit may usedifferent tools, technologies andmethodologies to assess risk.

In contrast, high performers take anintegrated approach to financial and physicalrisk management, leveraging standardizedprocesses to improve their visibility rightacross the enterprise to see how a number of

important risk management functionswhether they are in planning and financialmanagement, hedging and derivatives,contract management or physical tradinginterconnect. Agribusinesses need a clearview of the companys plan, inventory andraw material requirements to hedge prices. Ifthe forecasting is far off the original plan, itcan have serious ramifications for thecompanys costs, trading and tax obligations.

How can companies create an integrated

approach to commodity trading and riskmanagement? There are three dimensions todeveloping a comprehensive capability thatwill help agribusinesses achieve highperformance.

Planning and risk factor analysis

Many agribusinesses operate withmismatched cash flow. They need to pay inadvance to start production and receivepayment many months later when they selltheir product. Despite this intrinsic element

of agribusiness, some companies dont haveefficient funding structures, hedgingstrategies, optimized assets and supplychains in place to ensure liquidity and planfor potential risk factors such as drought.

Furthermore, agribusinesses may be sofocused on production planning that theyoverlook the ways that tactical managementof risk issues can impact their bottom line.For instance, many sugar/ethanol companiesin Brazil grow sugarcane using land leasecontracts tied to sugar and ethanol prices.But in some contracts, the landowners alsoput in soybean options requiring the

company to pay the maximum of sugar,ethanol or soybean prices. In this case, it isimportant for companies to effectivelymanage their contracts and pricing to avoidpotential losses if the cost of soy risessignificantly.

Accenture research indicates that riskmanagement at top-performing companiesis more closely integrated with strategicplanning and is conducted proactively, withan eye on how risk management capabilities

can help a company be successful in newmarkets or pursue other opportunities toenable growth.

To augment production and newinvestments, companies need to examinetheir current risk capabilities and develop aclear view of their existing cost and price riskexposure so they can design hedgingstrategies and goals that are aligned acrossbusiness units. At this stage, a company canalso assess whether it has the right tools andorganizational model to manage financialand physical risk considering marketdynamics.

Forecasting is essential to this process, andprovides an integrated view of a companysbusiness, marketplace risks and the impactthat potential commodity price movementshave on the business. If a company is notable to consider the full picture, hidden riskscould arise at a later date. For instance, anagribusiness company exporting its cropsmay want to hedge risks associated withfluctuating foreign currencies. But they needto view these actions within a singlestrategic framework to identify otherpotential risks, such as liquidity. Not doing socan have drastic consequences. In 2008,many agribusiness companies faced serious

financial and liquidity problems because ofderivatives contracts used to cover theircurrency exposures.

Furthermore, the better the company canforecast its needs, the better it can balanceits physical and financial risks. Companiescan use predictive analytics to forecastoutcomes based on past behaviors as well ascurrent and predicted political, economicand environmental factors, integrating thesewith internal factors to aid decision making.

Agribusinesses can even simulate future costscenarios, leveraging analytical models forprices. With improved forecastingcapabilities, agribusinesses can gain greatervisibility into and control of their financials(both costs and revenues) to use in financialhedging. The ability to predict commodityprice volatility and raw material pricing, forinstance, can help the procurement and salesdepartments make better decisions aboutwhen to buy and sell.

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Governance, policy and limits

Once companies have analyzed their risksand developed a strategy, they need todefine the governance model and put therespective policies in placealigned with thecompanys goalsthat will help to managecommodity trading risks, identify exposurelimits, and pinpoint the potential side effectsof uncontrolled events and positions.

This entails building:

A risk management organization with asolid governance model

Risk policies and operating guidelines

An operating model

Business processes

Metrics and methodologies

Systems and reports

It also involves assigning clear roles andresponsibilities to define what decisions eachgovernance level will make. Furthermore,companies need to organize informationflows and measure performance. This willhelp executives to monitor and measure riskto ensure it is in line with the companys riskappetite, establishing approved financialproducts, trading geographies, counterpartiesand limits.

Building an integrated governance modelmeans that regardless of where a person sitsin the organizationwhether in sales,planning, procurement, financial

management or commodity tradingtheyhave the same view of the companys riskexposure, reports and level of approvals.Establishing a governance policy and limitsfor commodity trading risk management willhelp the companys employees speak thesame language regarding risk matters andlay the foundation for the day-to-dayrunning of this function with clearboundaries for roles, responsibilities andprocesses.

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Commodity and financial trading riskmanagement

With planning and governance in place,agribusinesses can focus on the operationalaspects of establishing a commodity tradingrisk management function and implementingthe changes throughout the business. Usingthe appropriate tools and employee skills,the company can implement its hedgingstrategies, metrics, methodologies, systemsand reports to achieve the desired results.

Technologyspecifically a solutionincorporating sophisticated measuring,

modelling and analyticshas an importantrole to play in ensuring the company tradesaccording to its plan and complies with newand existing regulations. Using advancedmarket simulation and planningtechnologies, agribusinesses can modeldemand forecasts and make refined tradingdecisions based on forecasted as well asunanticipated needs.

For example, companies can use simulations

Forecasting Bears ResultsFor instance, one of the largest producers oforange juice in the world with exports tomore than 60 countries, was highly exposedto market and foreign exchange fluctuations.The company implemented an approach torisk control that included impact analysis ofrisk factors, model set up, scenario building,sensitivity analysis and hedging strategysimulations. This approach enabled thecompany to better forecast results andsimulate potential risk impacts on companyfinancials, as well as improve its hedging

strategy, which increased the EBITDA by 25percent.

to reduce risk in production planning. Asugar manufacturer can plan how muchwhite sugar and how much brown sugar itshould produce based on the market pricesand risks associated with those prices. Giventhat the costs and manufacturing lifecycleprocesses for each sugar differ, companiescan use simulations to determine the mostadvantageous production mix to get the bestprice outcome for the company.

When it comes to reducing financial risk, ourresearch shows that high performers useadvanced tools in market simulation andplanning, which, together with predictive

analytics, can help identify marketopportunities before competitors. Usingthese techniques to build scenarios and setup simulations has helped top performersforecast results more accurately and developmore effective reporting mechanisms.Market leaders combine standardizedbusiness processes and integratedtechnologies in a fully integrated approachto the sourcing, selling, trading and logisticsprocessing of commodities. As a result, they

not only improve visibility into theirenterprise market position at all timesbutthis synthesized capability improves theirdecision-making effectiveness and reducesoperational risk, accelerating their ability tomove in and out of positions asmanufacturing requirements and globalmarket prices dictate. It can also enablethem to take proactive steps to mitigateproblems with producers.

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Lasting Benefits

Structuring an integrated commodity tradingand risk management capability is complex;there are many parts to put into place.Companies need employees with the skillsand knowledge to run the capabilityproperly; a governance model with processes,policies and structure; and the ability tomanage the related systems and IT structure.And all of the pieces need to work togetherin a consistent, harmonious way.

The benefits of doing so are great:Accentures experience indicates thatcompanies heavily exposed to commodityrisk can reduce their exceptional losses by as

much as 50 percent to 80 percent byimproving their market and credit riskmanagement, business intelligence, and riskcontrol capabilities. They can also reduceoperating expenses as much as 10 percent to15 percent through process/platformsimplification and standardization, low-costIT and more efficient back-office services,and automated processing of contracts.

Investing in such a capability can bringlasting benefits to the businessnot just in

avoiding losses or reducing costs but inidentifying new opportunities for growth. Forinstance, by improving talent and knowledgemanagement capabilities, portfoliointegration, pricing and structuring, andtrading and risk management strategy,Accenture estimates that commodity-focused companies can improve profits by 15percent to 40 percent.

Revenue growth

With defined strategic objectives and risktolerance, companies are able to decisivelymanage sales and procurement in a volatilemarket, determining the best moment to buyraw materials or sell products withoutaffecting productionand moving moreswiftly than competitors to capture marketopportunities. Additionally, an integratedcapability will help companies developinvestment strategies given market trendsand the potential benefits or risks for thecompany.

Mitigating price risks also enablesagribusiness to provide stable prices as partof commercial arrangements with clients,enabling increased margins and providing acompetitive advantage.

Improved planning and governance

By developing a clear picture of major riskfactors and how to manage them,agribusiness companies can protectthemselves against price volatility. Trading

and hedging strategies are conducted in linewith a companys defined risk appetite,which can be tracked and evaluated overtime.

With a risk management planning andgovernance framework in place,agribusinesses can more easily comply withregulatory demands and shareholder

disclosure information. Better reporting anddisclosure can boost market confidence(including shareholders, regulators andrating agencies). With better evaluations,companies can raise finance from the marketmore cheaply than competitors, which canbe an essential advantage in meetinginvestment plans.

Agribusinesses can also be more effectiveoperationally, by optimizing contractportfolios on both the buy and sell sideacross the supply chain. With greatervisibility into risks, companies can betterdetermine and prepare for goals, challenges,

investments, marketplace opportunities andregulatory demands.

Increased profits, reduced volatility

Since agribusiness companies have longproduction lifecycles, with often a yearelapsing between account payables andaccount receivables, cash flow can becrucial. And this mismatch can be veryexpensive. A balanced commodity tradingand risk management program will help to

support a balanced cash flow.

With more effective control of cash flow andinsight into the impact on companyfinancials, agribusinesses can implementtheir strategies within the risk managementframework and harness technology to buyinputs like energy or feedstock at alowerprice and sell outputs at a higher price.

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Capital protection

With better visibility into the companysoperational and catastrophic risks, executivescan mitigate any potential negative impacton business liquidity. Using technology andreporting tools, they can manage liquidity ina volatile market while adjusting creditpolicy according to the companys risktolerance. And given recent regulatorychanges, companies operating in certain

jurisdictions may soon be required by law toprove that they have enough capital to covertheir main risks. By considering the majorrisk factors and operational risks,

agribusinesses can determine how muchcapital is required to maintain stableoperations and at what cost, meetingshareholder and regulatory demands.

Increased efficiency

By linking physical and financial trading in aholistic commodity risk managementprogram, agribusinesses can devise the mostcost-effective funding structures, reduce thecost of hedging, identify synergies, and

optimize their assets and supply chains. Itmay even lead to creative solutions toincrease efficiency. For instance, someagribusinesses have set up contracts to tradefertilizer for sugar or grain. For thecompanies selling sugar or grain, instead ofpaying cash in advance for the fertilizer, theycan pay with a portion of the future cropyield, improving cash flow and mitigating

Intrigued?

Accenture is committed to helping its clientsachieve high performance. To find out moreabout how Accenture can help you with yourcommodity trading and risk management,contact:

Latin America/Global LeadEduardo Barros+55 11 9281 [email protected]

North AmericaDarryl Heath+1 [email protected]

Europe and AfricaRob van der Krogt+31 20 593 [email protected]

AsiaBruce Liang+65 6410 [email protected]

price exposure. Similarly, the company sellingfertilizer can optimize its funding structureand reduce its price exposure for sugar orgrain. While some companies are alreadymaking these kinds of connections in theirbusinesses, others have yet to do so. In eithercase, a commodity trading and riskmanagement program can helpagribusinesses identify new or additionalefficiencies to exploit, set up relevantcontracts and manage contract risk.

Preparing for the Future

In an increasingly volatile market, having a

robust, integrated commodity trading riskmanagement capability wont be optionalitwill be essential. With it, companies will bebetter able to react to existing risks andprepare for future ones, whether it meansdeveloping more stringent reportingrequirements to meet new derivativestrading legislation or planning for yield orprice volatility.

Companies can use commodity trading riskmanagement as a mechanism to protect

their capital and liquidity but also transformtheir business by identifying newopportunities and strategies that canincrease efficiency and spur revenue growth.

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About Accenture

Accenture is a global managementconsulting, technology servicesand outsourcing company, withapproximately 244,000 people servingclients in more than 120 countries.Combining unparalleled experience,

comprehensive capabilities across allindustries and business functions, andextensive research on the worlds mostsuccessful companies, Accenturecollaborates with clients to help thembecome high-performance businessesand governments. The companygenerated net revenues of US$ 25.5billion for the fiscal year endedAugust 31, 2011. Its home pageis www.accenture.com

accenture agribusiness commodity trading risk management

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