Commodity price, Commodity risk, Hedging, Risk management, trend following

Risk, Uncertainty and Profit

Frank Knight, the grand old man of Chicago wrote “Risk, Uncertainty and Profit,” one of the five most important economics books of the 20th century. Among other invaluable insights, Knight proposes that, “The responsible decisions in organized economic life are price decisions; others can be reduced to routine.” Knight recognized that price at which a firm sells its products or purchases materials tends to have greater impact on profitability than any other element. Based on the income statement of an average S&P 1500 company (and assuming constant sales volumes), a 1% improvement in the selling price would generate an 8% increase in operating profits. Conversely, a 1% drop in the cost of goods sold would lead to a 5.36% increase in operating profits. This impact was more than double that of a 1% increase in sales volume[1]. For commodity businesses where operating margins are typically very low, hedging can have a much greater impact on profitability.

It can also provide the most powerful means for a firm to differentiate itself from competitors and gain a difficult to match advantage over them. Consider for example the U.S. petroleum wholesale industry where the operating margins averaged at about 0.8%[2]. At a cost of around $800 per metric ton of heating oil, a typical wholesaler could hope to earn a margin of about $6.40 per ton of heating oil sold. But suppose a wholesaler were able to reduce their cost by an average of 1%[3]. That improvement would add $8 per metric ton to the firm’s profit margin, raising it from $6.40 to $14.40 – a 125% improvement in operating profits.

Price impact is far more dramatic when major price readjustments take place in commodity markets. These can bring firms major windfall profits or destroy them, depending on their risk exposure. Consider just the following two examples:

In 2010, AngloGold Ashanti, the world’s third largest gold miner took $2.47 billion in losses by hedging its exposure to the price of gold. AngloGold Ashanti’s hedge, put in place by the firm’s then CEO Bobby Godsell, locked the firm into forward gold sales at an average price of less than $450 per troy ounce during the time when gold price rose more than three-fold, reaching $1,400 in 2010. Rather than enjoying record profits from the high price of gold, AngloGold Ashanti had to issue $1.4 billion in new stock shares and convertible bonds to survive, diluting its shareholders in the process.

This was not a unique stroke of bad luck at one company. In 2013, Barrick Gold, the world’s largest gold miner posted a quarterly loss of $8.6 billion when gold prices crashed from nearly $1,700 per ounce to just over $1,200. Barrick Gold’s error was the opposite of AngloGold Ashanti’s – they did not hedge their exposure to gold price.

Similar stories recur frequently, underscoring the disproportionate impact of price on profitability for any business with significant commodity price exposure, whether it be gold, oil, copper, coffee, or any other commodity. The same is true for exposure to foreign currencies and interest rates. This is not a terribly controversial assertion, but the extent to which this source of risk can affect a firm’s profitability, shareholder value and competitive advantage is not sufficiently well appreciated and managers at any firm with significant commodity price, currency, or interest rate exposure would do well to give this issue the attention it deserves.

Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.

 

Notes:

[1] Marn, Michael, Eric Roegner and Craig Zawada. “The Power of Pricing” McKinsey Quarterly, 2003, Number 1.

[2] This is based on a 2003 FirstResearch survey of 13,828 companies engaged in the petroleum wholesale business. Since then, margins may have shrunk still further.

[3] An oil wholesaler could use hedging to its advantage by buying forward quantities of heating oil when the prices are advancing and keeping their position unhedged when they are declining.

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