THE FOUR PILLARS OF SUCCESSFUL COPPER RISK MANAGEMENT

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1 THE FOUR PILLARS OF SUCCESSFUL COPPER RISK MANAGEMENT By Federico Stiegwardt Cargill Risk Management Uncertainty, volatility, emotion, and a growing list of responsibilities the pressures on today s risk managers continue to grow. And with no clear anecdote, it can be difficult to know what to do next. To help, we have put together a summary of tools and learnings that have been successful for many of our customers who manage metals price risk. 1 I CARGILL RISK MANAGEMENT

2 Companies with commodity exposure that grow and thrive over time are not the ones that attempt to time market decisions and guess shortterm directional biases. Volatility and the Risk Approach Scale We live in a world of uncertainty and volatility. Macroeconomic factors, technology, liquidity restraints and tail-risk events are constantly moving. The truth is, the new normal for most companies is a world of significant commodity price volatility. Managing this is all about your approach. Here is what we know: Companies with commodity exposure that grow and thrive over time are not the ones that attempt to time market decisions and guess short-term directional biases. It is the companies that have a disciplined and proactive approach that ultimately succeed in these market environments. RISK MANAGEMENT APPROACHES PASSIVE RATABLE TACTICAL DYNAMIC Managing commodity price volatility is all about your approach. To break this down, think about the following scale of commodity risk management approaches: - Passive approach is a reactive strategy that uses spot purchases and does not include a risk policy to guide the way - Ratable approach is a methodical approach where pre-determined quantities are hedged at pre-determined hedge intervals - Tactical approach attempts to time the market to optimize price entry - Dynamic approach is a mix of ratable and tactical strategies So, where is the ideal spot to be on this scale? We tend to lean toward number four, the dynamic approach. Why? Because price points are impacted by a variety of factors, and simply hedging risk through futures trades will not meet all needs anymore. We feel success comes from being tactical in your thinking and ratable in your implementation. That is achieved through a dynamic approach to managing commodity risk. 2 I CARGILL RISK MANAGEMENT

3 Building a diversified portfolio Cargill Risk Management Tailored Solutions % Building a diversified portfolio as a business is like building an investment portfolio as an individual. When managing an individual investment portfolio, you will often hear about the importance of having a mix of different, non-correlated asset classes. This approach is used to minimize risk and maximize long-term results against market volatility. The same goes for a hedging portfolio. A mix of complementary, yet non-correlated tools is how to minimize volatility risk and maximize business results. An example of this in action is when I met with a risk manager at a mining company that looked to sell relative to a market that was trading below its desired budget. Now, just a few years ago, this company would have had limited pricing options with no flexibility in timing, volume or market bias. After meeting, we put in place tailored solutions that gave them the ability to sell at more favorable levels or receive compensation through a structured product, all while waiting for markets to move. Cargill Risk Management Vanilla Options % Other Pricing Mechanisms % HEDGING STRATEGIES SHOULD INVOLVE A DIVERSE SET OF COMPONENTS AND SCALING INTO POSITIONS 3 I CARGILL RISK MANAGEMENT

4 Value at Risk, or VaR, is a statistical technique used to measure and quantify the level of financial risk over a specific time frame to determine the extent and occurrence ratio of potential losses. JP Morgan Operation: Take some of the emotion out of trading It is no secret that market volatility and commodity trading comes with emotion. The fear of a bad trade or anticipation of what will come next can be a lot to handle. And historically, many businesses make risk management decisions after bad things happen. As a result, decisions are clouded by an emotional bias and decisions are made off of that bias, instead of analysis. Today, large and mid-sized companies are using a tool to take some of the emotion out of managing risk. Enter, Value at Risk, or VaR. EXAMPLE March 13, Assumed 2,000 lots - 50,000 tons December 2018 Copper Position - Market in December 2018 at $7,020/ton - Implied 7,020 strike Options Volatility at 19.90% %/( 252) = % (daily volatility) % x (95% confidence level) = % Daily VaR 7,020 $-ton x % = $-ton (expected 1-day market move) 2,000 lots x x 25 = US$7,238,120 Daily VaR Weekly VaR = $-ton = US$16,184,930 This is defined by JPMorgan as: a statistical technique used to measure and quantify the level of financial risk over a specific time frame to determine the extent and occurrence ratio of potential losses. The VaR methodology uses existing implied market volatility published by information sources of an underlying asset class. It projects the next logical move in a defined time frame. Using this method, risk managers are aware of potential positive or negative impacts to their existing or projected portfolio positions. The example to the left highlights what is a very real opportunity for many companies: To use VaR to help make proactive decisions about financial risk based on hard-and-fast numbers and statistical analysis. Using VaR is more rational and proactive looking at the potential or expected moves over a specific period of time, based on forecasts, underlying markets and potential outcomes. 4 I CARGILL RISK MANAGEMENT

5 Pulling it all Together: The 8-step Checklist We have reviewed volatility, diversifying, and ways to take emotion out of trading, but what about the growing list of pressures and to-do s for today s risk managers? With so much going on, it can be difficult to feel confident mitigating price risk. This pressure can be eased by building a comprehensive hedging and risk management discipline within an organization to lead efforts towards proactive risk identification and action recommendation. To build such a capability, the following considerations are essential for success: 1. Design a hedging policy Establish boundaries, rules and limits to guide hedging work and objectives. 2. Establish a Risk Committee Representatives from commercial, trading, credit, control and treasury should meet regularly and deliberate about positions, results, stress testing, portfolio concentration, sudden changes in market conditions and limits. 3. Identify and hire the right talent A combination of experienced talent from within the organization and individuals from outside the confines of the company can create a complementary and fresh approach. 4. Set up a recurring review schedule Establish regularly-scheduled meetings to review exposures, trends, market data, policy, proposals and exceptions. 5. Define the max concentration of each tool within your hedging portfolio Every tool within your portfolio needs to have a defined goal of why is it used and how it helps achieve specific objectives - as well as its downside. Define a max concentration limit for each tool to avoid excesses. 6. Practice recurring stress testing Put the team and company through the paces of different financial scenarios (i.e. stress testing ) and share the results at the weekly committee meetings. 7. Set up annual external audits and benchmarks Bring in an independent financial consultant/firm to review results from the prior year, assess risks, and help create benchmarks to measure against in the year ahead. 8. Set strict limits for exception approvals Create a short list of folks within the organization who can approve exceptions. 5 I CARGILL RISK MANAGEMENT

6 Cargill Risk Management Commodity price risk management is a balancing act, and we are here to help. Cargill Risk Management is devoted to helping you become smarter about managing your company s commodity risk, managing margins or minimizing volatility. For more information about managing your commodity price risk, us at cargill_risk_management@cargill.com or contact us at 6 I CARGILL RISK MANAGEMENT

7 2018 Cargill, Incorporated. All Rights Reserved. Disclaimer: These materials have been prepared by personnel in the Sales and Trading Departments of Cargill Risk Management, a business unit of Cargill, Incorporated based on publicly available sources, and is not the product of any Research Department. These materials are not research reports and are not intended as such. These materials are for the general information of our customers and are a solicitation only as that term is used within CFTC Rules 1.71 and , as promulgated under the U.S. Commodity Exchange Act. These materials are provided for informational purposes only and are not otherwise intended as an offer to sell, or the solicitation of an offer to purchase, any swap, security or other financial instrument. Information provided is general in nature and is provided without guarantee as to results. The information is not intended to be, and should not be construed as trading, financial, legal, or taxadvice. No warranty is made with regard to the information or results obtained by its use. Cargill, Incorporated, its subsidiaries, and affiliates disclaim any liability arising out of your use of, or reliance on, the information. 7 I CARGILL RISK MANAGEMENT