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Managing commodity volatility

Reducing your risks with effective hedging

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Con

tent

s Managing commodity volatility

Why hedge

About EY

Recent volatility in commodity prices

Driven by supply and demand, logistics, weather, consumer sentiment and geopolitical factors, prices ofcommodities from oil and natural gas to corn and wheat have moved with surprising force and speed.

Energy

$1.00$2.00$3.00$4.00$5.00$6.00$7.00

$20.00$40.00$60.00$80.00

$100.00$120.00

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16Crude oil Natural gas

Grains

Metals US Dollar Index

$3.00$4.00$5.00$6.00$7.00$8.00$9.00

$10.00

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Corn Wheat

$1,000.00

$1,400.00

$1,800.00

$2,200.00

$2,600.00

$4,000.00$5,000.00$6,000.00$7,000.00$8,000.00$9,000.00

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Copper Aluminum

$70.00

$80.00

$90.00

$100.00

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Price

Energy, Grains, Metals and U.S. Dollar Index Futures Charts (2011–2015) — historical futures prices sourced from NYMEX, CME, LME and ICE



1 Oil and Gas Global Capital Confidence Barometer: deal activity to accelerate, EY, October 2015

In a recent EY survey1 of more than 1,600 executivesacross 18 sectors, 34% of respondents believed thatincreased volatility in commodities and currencies isthe greatest economic risk to their businesses overthe next 6 to 12 months.

Impacts of commodity volatilityPotential business implications


Creates uncertainty in earnings per share, causing reporting issuesfor CFOs

Exposure toprice volatility

Creates short-term working capital issues for company treasurersNegativecash flows

Company not able to capture earnings upside due to commodity volatilityLack of marginoptimization

Commodity volatility eats into company’s core earnings, creatingdifferences between company and peer group

Earningscomparability

Unlimited or unmanaged commodity volatility gives public perception thatcompany does not understand business driversHeadline risk

Commodity volatility can cause significant earnings loss due to increasein input costs

Earningsdegradation

How effective is your company at managingcommodity risk?

Self-assessmentDoes commodity volatility affect you?

Have you experienced commodity price volatility in the last three years that has hadan appreciable impact on earnings and cash flows?1

23456

Do you have a strong understanding of key business areas in your company thatare impacted by commodity price volatility?

Do you have clear business objectives for the procurement of commodities andrelated hedging?

Do you have the tools in place for monitoring commodity market risks and reportingrelevant information to management?

Does your technology provide sufficient and timely access to data needed tomeasure and manage risk?

Do you have tools in place to measure and report your specific exposure tocommodity prices?

Managing commodity volatilityWhy hedge


Theprimary

objectives ofhedgingare to:

Reduce price risk andearnings volatility1 Stabilize

procurement costs2 Optimize margins3

Companies in a broad range ofindustries — including airlines,chemicals, consumer products,food products, industrialmanufacturing and utilities —engage in commodity hedgingactivities. Because theyunderstand how difficult it is topredict precisely when commodityprices will rebound after aprecipitous drop, most realize thata low-price environment is a goodtime to consider or revise ahedging program.

► Hedging is an important tool that can help companies in avariety of industries reduce price risk and earnings volatility,maintain a stable supply of raw materials and optimizemargins.

► Hedging programs need to be tailored to the organizationalstrategy, financial goals and risk appetite of the company.

► In determining a hedging program, the organizationshould align its operations to key value drivers thatinclude transaction and credit costs, capital requirements,technology and people investments, and expected valueand timing of returns.

Key takeaways:

Approaches to hedgingWhich approach suits you?

The first step for a company embarking on a hedging program is to determine goals and style for the program andprioritize them. Historically, companies have relied on different hedging strategies, ranging from static programs that lockin prices for a fixed volume to active hedging programs that anticipate trends in price movements. The relevance of eachstrategy is dependent on the overall business objectives, financial goals and risk appetite of the company.

Below are three broad categories of hedging we see as a means of managing risk:


Revenue certainty

The “price fixer”

► Hedges a fixed percentage ofproduction or requirements;limited or no market exposure

► Locks in hedged revenuesand costs for the seasonmechanically; minimal earningsvolatility and price risk

► Low flexibility, no participationin beneficial price moves

A

The “opportunistic hedger”

► Extracts additional margins on thebasis of market volatility; managesmarket exposure

► Adjusts percentage hedged andtiming of trades on the basis ofview of market

► Generally between 40% and 80%of physical hedged

► May win or lose depending onsuccess, but earnings should bewithin a targeted range

B

The “active hedger”

► Takes more directional views

► May or may not hedge at timesdepending on view

► Enters and exits hedge positionsactively

► May have both “hedge” and“opportunistic” portfolios managedseparately

► Needs more sophisticated risk and limitmonitoring, and robust systems andcontrols

► Potential for higher rewards at the costof volatile results

C

Fixed Highly variableRevenue certainty

Which approach to a hedging program is most suited to what you want to accomplish?

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An effective hedging programKey elements


An effective hedging program must be installed within the context of a structured framework supported by well-definedprocesses that cover all aspects of the transaction life cycle and an infrastructure that includes the people, systems anddocumented policies and procedures for risk management and accounting.

Key elements of a well-designed and well-executedrisk management program:

Common challenges of poorly designed orexecuted risk management programs

► Unclear objectives for risk management

► Lack of investment in resources to supportthe risk management function

► Unidentified financial risks

► Inadequate internal controls

► Misapplication of hedge accounting rules

► Lack of meaningful performance measuresto control and manage risks

• Robust processes around governance, forecasting,credit, risk, accounting and treasury should be bolsteredas necessary to address the requirements of thehedging program.

• People with the right experience and skills manage differentaspects of the program.

• Fit-for-purpose policies — from a governance perspective,a risk management policy document is a must that clearlyarticulates the objectives, risks and rewards of the hedgingprogram.

• Program performance — key performance indicators shouldbe established and monitored to aid oversight and improveoverall program performance.

Sample hedging frameworkPrinciples in action across the transaction life cycle


Credit function► Sets up and approves

all counterparties andcredit limits

► Monitors credit exposure

Risk function► Monitors market exposure

► Conducts curve validation

► Performs stress testingand sensitivity analysis

Risk managementcommittee► Oversees all hedging

activities to confirmcompliance with companypolicies, risk appetite andobjectives

Commercial team► Conducts forward and

historic market analytics

► Executes transactions tomanage financial riskwithin the market andcredit limits

Accounting and back office► Performs settlement

of positions

► Prepares and booksjournal entries

► Meets derivativeaccounting rules anddisclosure requirements

► Oversees internal controls

Sample illustration of a framework to support implementing an effective hedging program

Logistics

Settlements

Analytics

New productdevelopment

Businesscontrol

Pre-dealsupport

Dealexecutionand deal

administration

Financialaccounting

Cashmanagementand treasury

Riskmanagement

Effectivehedgingprogram

How can EY help?Our framework and phased approach


Companies that are exposed to commodity prices should carefully consider the impact that price increases and volatilitymay have on the bottom line. Whether to hedge and how much to hedge are questions that companies need to thinkthrough, and companies must carefully evaluate the risks and rewards of hedging. More important, companies mustclearly articulate their objectives and risk tolerance, then align the execution of their hedging program with thatassessment.

EY has a proven approach to advise clients in the development of fit-for-purpose hedge programs that address the keyinfrastructure components.

Illustrative

Key commodity risk management infrastructure components must be linked by design.

Strategies,governanceand policies

Organizationstructure Processes Management

reportsModels and

assumptionsSystemsand data

Process doesnot supportoperations

People cannotperform

processes

Reports do not provideinformation for

effective management

Information is notavailable for analysis

and reporting

Operating modeldoes not support

commercial outcome

Risks occur if linkage is insufficient.

The services we can offer may vary as certain of our services for an audit client and its affiliates may be more limited in order to comply with applicable independence standards.Please reach out to your EY contact for further information.

About EY

FAAS Commodities Markets teamOur service offerings


Commodity price volatility is nothing new, but increasingly companies are actively considering how best to manage therisks and potential opportunities that swings in prices present to operating and financial results.

Whether you are thinking about putting a hedging program in place or would like to enhance your existing approach, EYcan help you proceed strategically and operationally to achieve your goals. At EY Financial Accounting Advisory Services(FAAS) Commodities Markets, we have a global team of commodity professionals who can share their insights andlessons learned through our six service offerings.

Service offeringsBusiness transformation

► Risk management effectiveness,functions, roles and reporting

► Strategy, process analysis, leadingpractices, industry comparisons andindustry training

Internal controls assessment

► Assessment focusing on front- to back-office controls, regulatory compliance,rogue trader risk, Commodity Tradingand Risk Management (CTRM) systemapplication and business readiness, andhedge effectiveness

Regulatory compliance

► Trade surveillance business processand systems

► International, and domesticacquisitions regulatory due diligence

► Global regulatory compliance such asDodd-Frank, European MarketInfrastructure (EMIR)

Quantitative advisory

► Model risk management (including modelvalidation), independent valuation

► Risk measurement (value-at-risk, stresstesting), risk budgeting, performancemeasurement

Technology support

► Technology assessment and strategy

► Technology selection

► Systems development and integration

► Data services — architecture,management, analytic support,reporting tools and cubes

Hedge accounting

► Financial accounting advisory servicesunder both US GAAP and IFRS

► Complex leases, fair value, derivativesaccounting, netting issues

► Accounting training

The services we can offer may vary as certain of our services for an audit client and its affiliates may be more limited in order to comply with applicable independence standards.Please reach out to your EY contact for further information.

FAAS Commodities Markets teamOur global network


Being part of an integrated global organization provides a holistic approach to a hedging program. We can provide insights on globaland regional practices from leading organizations across multiple operating sectors and industries, including areas such as tax,governance, currency, business processes, regulatory compliance and systems. This approach allows us to work closely with other EYservice lines such as Performance Improvement (supply chain and procurement), Risk Assurance, Tax and Valuation.

Houston

Calgary

Rio de Janeiro

San Francisco

Chicago

New York

London

Beijing

Cape Town Perth

Brisbane

Moscow

Geneva

Sydney

Bahrain

SingaporeFAAS Commodities Markets

EY Global Industry CentersVirtual hubs for sharing industry-focused knowledge and experienceAutomotive Life Sciences Private Equity

Consumer Products Media &Entertainment

Real Estate, Hospitality &Construction

Financial Services Mining & Metals Retail & Wholesale

Government & PublicSector

Oil & Gas Technology

US Health Care Power & Utilities Telecommunications

Financial Accounting Advisory ServicesCommodities Markets contacts


Suzie KupiecFAAS Commodities Markets

[email protected]: +1 713 858 9733

Talib DhanjiFAAS Commodities Markets


Andrew WooseyFAAS Commodities Markets


Bryan BonnerFAAS Commodities Markets


Sam PetersonFAAS Commodities Markets


EY | Assurance | Tax | Transactions | Advisory

About EYEY is a global leader in assurance, tax, transaction andadvisory services. The insights and quality services we deliverhelp build trust and confidence in the capital markets and ineconomies the world over. We develop outstanding leaderswho team to deliver on our promises to all of our stakeholders.In so doing, we play a critical role in building a better workingworld for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one ormore, of the member firms of Ernst & Young Global Limited,each of which is a separate legal entity. Ernst & Young GlobalLimited, a UK company limited by guarantee, does not provideservices to clients. For more information about ourorganization, please visit ey.com.

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This material has been prepared for general informational purposes only and is notintended to be relied upon as accounting, tax, or other professional advice. Pleaserefer to your advisors for specific advice.

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