SAP Commodity Management Overview - Business Foundation



Commodities impact each of us every day - from the price we pay for gas for our cars at the cost of bread at the cost of our houses. The commodity business is a broad based market including many diverse participants ranging from the companies that produce commodities to those who use them in their manufacturing and production processes ending up with those who consume the commodity in their daily life. Surrounding the primary cycles of production and consumption are the commodity markets containing traders, banks, and intermediaries who provide liquidity to the market, establish certain levels of commodity trading and allow the market to support arbitrage opportunities.


Different Market Segments of Commodity Management Customers

Risk Mitigator

• Core business is in Manufacturing or Production
• Focus is to minimize procurement commodity price risk
• Commodity function is in Procurement or Sales
• Risk management function is in Treasury
• Simple relationship between paper and physical contracts
• Simple reporting requirements
• Limited number of paper trades

Market Optimizer

• Trading and asset optimisation is part of core business
• Focus is to maximize profits by leveraging market arbitrage
• Trading functions are in Front Office
• Logistics and Risk are in Mid Office
• Complex physical and paper trades
• Complex relationships between paper Contract and underlying physical contract
• Complex reporting requirements
• High number of physical and paper trades

Commodity Management Customer Segments

The complexity of commodity business and risk management is driven by unique business characteristics such as commodities, currencies, the complexity of business process and transactions, number of locations, etc.
This is not a maturity slide progression from one segment to another does not automatically happen based on growth or time. It requires a shift in a company’s perspective of the market, their market positioning along with their view of commodity risk and specific risk appetite.

Commodity Management Industries

Commodity Producer



Industry Examples

• Oil
• Mining
• Agriculture ### Commodity Converts



• Chemicals
• Metal Mill products
• Oil & Gas Refining
• Utilities

Commodities Consumers



• Automative
• Consumer Products
• High Tech
• Aerospace
• Industrial Machinery and Components
• Travel & Logistics.

Commodity Management cover multiple industries a few of which are listed above. It is almost impossible to find a customer who is not impacted by commodity prices on their infrastructure.

Company Risk Profiles

Each customer has its own hedging or trading strategy based on its unique risk profile.
Core company issues revolve around the unique risk profile of a company. The risk profile of a company is generated based on the following factors:


• What to hedge?
• How to hedge?
• What open positions (buy vs. sell) is the Company willing to tolerate?
• How much price risk are they willing to take (price risk means matching of fixed vs. floating)?
• How does the term structure (what is the forward period they want to hedge) impact the hedging?
• What types of commodities will they trade?
• What type of instruments will they use?*

These decisions are made by the senior levels of a company and usually contained in Risk Policy which impacts all areas of a business including but not limited to Trading & Marketing, Commodity Sales, and Purchasing, IT, Risk, Accounting, Credit, Settlements, Logistics, and Operations.

Company Risk Profiles and Hedging Approaches

As noted, each company has a core risk profile stating what types of, how much of and the term structure of the risk they are willing to tolerate on a corporate basis. One of the risks identified at the business level is what type of price risk they are ready to take fixed price or floating price risk. The company’s determination of price risk tolerance is usually based on company size, capital structure (debt plus equity). core business (producer, procurer, trader, manufacturer, etc.), geography and overall risk tolerance.

Depending on a company price risk appetite and the business operate in, there are multiple approaches to hedge their commodity price risk.

• Floating Price Risk Profile
• Fixed Price Risk Profile
• Combined Floating and Fixed Price Risk Profile



Floating Price Risk Profile



Company is willing to accept the risks of commodity price volatility

• Usually companies with little debt

• Company could have the ability to pass the changes in the commodity pricesalong to their customers

• Purchases and sales are denominated in floating prices wherever possible(customer or vendor dependent)

• Fixed Price transactions (purchases and sales) where possible are converted to floatingprices by use of swaps or futures

• End result is price risk is matched

Examples:

• Trading Companies
• Copper smelter
• Cable producer
• Refineries, Commodity producers Note that if prices fall too low, a company will convert to fixed price contracts to cover the costs of operations ### Fixed Price Risk Profile

Company is not willing to accept the risks of commodity price volatility

Usually companies with medium to large amounts of debt -need to fix cashflows to cover debt payments and operating costs

Companies that buy commodities on a floating basis, but sell final products atfixed (not floating) prices -sales prices are inelastic

Purchases and sales are denominated in fixed prices wherever possible(customer or vendor dependent)

Floating Price transactions (purchases and sales) where possible are converted to fixedprices by use of swaps or futures
End result is price risks are matched

Examples:

• Highly leveraged companies
• Brewers
• Manufacturers
• Food producers

Combined Floating and Fixed Price Risk Profile

Company is willing to accept some risks of commodity price volatility

• Usually companies with medium debt or trading companies
• Company will try to cover a base level of cash flows and optimize the remainder of their transactions
• Purchases and sales are denominated in floating or fixed prices depending on status of base load hedging plan
• Normal approach is to hedge XX percentage of purchase and sales with fixed price contracts or use swaps to convert to fixed prices.
• The remaining sales and purchases can be floating or can be fixed depending on customer’s market view of commodity prices wherever possible (customer or vendor dependent)

Examples:

• Commodity traders
• Commodity producers

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