Commodity Risk – The Physical & the Financial Chay Yiowmin Partner and Head of Financial Services Moore Stephens LLP Singapore.

Commodity Risk – The Physical & the Financial

Chay YiowminPartner and Head of Financial ServicesMoore Stephens LLP Singapore

Agenda

• Introduction

• Commodity Price Volatility

• Changing Patterns of Global Trade

• Responding to the Challenges

• Embedding Commodity Risk Management

• How Moore Stephens LLP Can Help You

Agenda

• Introduction

• Commodity Price Volatility

• Changing Patterns of Global Trade

• Responding to the Challenges

• Embedding Commodity Risk Management

• How We Can Help You

Introduction

• Physical and financial trading have progressively become more intertwined.

• With greater liquidity, there is increased participation of financial players.

• Increased commodity trading has impacted on the short and long-term contract prices, price volatility and choices faced by the end customers.

Introduction (cont’d)

• Increased trading to optimise and add more flexibility on asset position.

• New types of risk for companies that require a re-examination of risk strategies and how risk management is to be conducted.

Agenda

• Introduction

• Commodity Price Volatility

• Changing Patterns of Global Trade

• Responding to the Challenges

• Embedding Commodity Risk Management

• How We Can Help You

Commodity Price Volatility

• Commodity prices have risen dramatically in recent years, coupled with increased price volatility and diverging spot versus forward prices.

• Global economic growth in the rapidly expanding Asian economies has spurred demand and highlighted resource scarcity.

Commodity Price Volatility (cont’d)

• Entrants by fund managers and large and liquid investments have resulted in market prices to diverge from levels that would be predicted by economic fundamentals.

Commodity Price Volatility (cont’d)

Light Crude Oil Historic Price Year on Year

Agenda

• Introduction

• Commodity Price Volatility

• Changing Patterns of Global Trade

• Responding to the Challenges

• Embedding Commodity Risk Management

• How We Can Help You

Changing Patterns of Global Trade

• The demand side has shifted considerably with the driving force for growth coming from the east rather than the west.

• China’s economy expanded by over 12% in 2009, the seventh consecutive year of double digit growth.

• Industrial booms in South Korea and India have also contributed to the demand for commodities.

Agenda

• Introduction

• Commodity Price Volatility

• Changing Patterns of Global Trade

• Responding to the Challenges

• Embedding Commodity Risk Management

• How We Can Help You

Responding to the Challenges

Strategies for commodity trading activities vary:

• Proprietary Trading;

• Asset-Based Trading for Optimisastion; and

• Hedging.

Responding to the Challenges (cont’d)

A) Proprietary Trading

• Speculative trading based on market price changes.

• Additional value is pursued through taking a view on market prices.

• Governed by the amount of additional risk capital and limits set by the company’s management.

Responding to the Challenges (cont’d)

A) Proprietary Trading (cont’d)

• Typically very limited, given the considerable risk that stems from the huge volatility of commodity prices, and the scepticism of investors arising from cases such as Enron.

Responding to the Challenges (cont’d)

B) Asset-Based Trading for Optimisation

• Optimisation may be defined as maximising the company’s total margin over its value chain.

• Commodity trading that supports the optimising of production and corresponding revenue.

• General additional value from hedged positions based on market price views.

Responding to the Challenges (cont’d)

B) Asset-Based Trading for Optimisation (cont’d)

• Typically based on expected price developments and seeks to align hedged position with expectation.

• From a risk management perspective, certain activities may also qualify as proprietary trading, since hedged positions may be opened through optimisation.

Responding to the Challenges (cont’d)

B) Asset-Based Trading for Optimisation (cont’d)

• Such risk management is limited to the short-term horizon for which commodity markets are liquid.

• The long-term strategy are usually made outside of commodity trading.

Responding to the Challenges (cont’d)

C) Hedging

• The key activity by which management mitigates the impact of commodity and / or price volatility.

• The objective should be aligned with the overall financial expectations of the company’s stakeholders.

• However, this value proposition is often not very clear.

Responding to the Challenges (cont’d)

C) Hedging (cont’d)

• Typical objectives may include: Reduce earning volatility; Protect minimum cash flow; Ensure debt covenant not breached; Hedge fixed portion of production usage; Monetise value of unused commodity; Outperform budgeted targets; Protect existing underlying cash in relation to physical

positions; and To keep within pre-determined price ranges.

Responding to the Challenges (cont’d)

C) Hedging (cont’d)

• Failure to articulate clear risk management objectives may lead to management pursuing contradictory hedging strategies.

Responding to the Challenges (cont’d)

How is risk capacity established?

• The board of directors, based on the assessment of value to the shareholders, should set the overall level of acceptable risk.

• It needs to define and quantify the understanding of the “underlying exposure”.

• The defined level of confidence or “risk appetite” provides the foundation for establishing, monitoring and modifying the hedging strategies.

Responding to the Challenges (cont’d)

How is risk capacity established? (cont’d)

• A hedging programme requires investments in infrastructure and governance to support various functions, including risk analysis, deal execution, reporting, settlement and accounting.

• Consideration should include the following: Understand the range of financial instruments or derivatives

available in the marketplace to mitigate exposure to the identified risks;

Responding to the Challenges (cont’d)

How is risk capacity established? (cont’d) Evaluate the costs, benefits and risks associated with the

proposed strategy; Consider direct transactions costs for using hedge

instruments; Consider potential systematic costs of hedging, reflected in

the shape of the forward price / yield curve; Consider the increased management / operational costs for

the establishment and implementation of required systems; Consider increased compliance costs associated with

accounting, legislative and stakeholder requirements; and Consider how hedges will qualify under new and existing

accounting rules, e.g. IFRS 9 and IAS 39.

Responding to the Challenges (cont’d)

How is risk capacity established? (cont’d)

• Any hedging programme where the full economic effects are not properly understood, controlled and managed, whether or not derivatives are used, can have disastrous consequences.

Responding to the Challenges (cont’d)

How is risk capacity established? (cont’d)

• Key points to consider when formulating your company’s financial risk management and hedging approaches: Ensure hedging philosophy can be supported by a thorough

exposition of how it contributes to stakeholder value; Undertake impact analysis to understand how financial risk is

impacting on ones business; Ensure that clear communication of risk profile to investors;

and Conduct regular performance assessments on hedging policy

to ensure that objectives are met.

Agenda

• Introduction

• Commodity Price Volatility

• Changing Patterns of Global Trade

• Responding to the Challenges

• Embedding Commodity Risk Management

• How We Can Help You

Embedding Commodity Risk ManagementAccounting

• The accounting risk within commodity risk management mainly relates to financial instruments.

• Accounting for financial instruments under International Financial Reporting Standards (IFRS) as well as US GAAP can have a major impact on the company’s financial statements.

Embedding Commodity Risk Management (cont’d)Accounting (cont’d)

• The three major areas related to commodity trading activities are: Derivatives; Embedded derivatives; and Hedge accounting.

Embedding Commodity Risk Management (cont’d)A) Derivatives

• Derivatives without physical delivery of the underlying commodity are within the scope of International Accounting Standard (IAS) 39.

• Derivatives are recorded at fair value within changes in fair value recorded in income irrespectively.

Embedding Commodity Risk Management (cont’d)A) Derivatives (cont’d)

• Contracts that are for an entity’s “own use” are not within the scope of IAS 39.

• Contracts that qualify as a written option for an underlying commodity that can be net settled, will be accounted for in accordance with IAS 39.

• However portfolios of derivatives are usually created based on economics and not accounting requirements.

Embedding Commodity Risk Management (cont’d)A) Derivatives (cont’d)

• Portfolio of derivatives may consist as follows: “Own use” derivatives entered for the receipt or delivery of

commodities in the normal course of business; and Trading derivatives for pure speculation.

Embedding Commodity Risk Management (cont’d)B) Embedded Derivatives

• Long-term commodity purchase contracts frequently contain an index pricing clause.

• Such contracts contain embedded derivatives that may have to be separated and accounted for under IAS 39 as a derivative.

Embedding Commodity Risk Management (cont’d)B) Embedded Derivatives (cont’d)

• Such price clauses must be separated if: The economic characteristics and risks of the embedded

derivative are not closely related to the economic characteristics and risks of the host contract;

A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and

The hybrid instrument is not measured at fair value with changes in fair value recognised through the income statement.

Embedding Commodity Risk Management (cont’d)B) Embedded Derivatives (cont’d)

• Within commodity risk management, such contracts are often used as a natural hedge.

• From an accounting point of view, generally the embedded derivatives are accounted for at fair value but not for the underlying item, therefore income volatility may arise.

• A solution may be hedge accounting, but this cannot be achieved with ease.

Embedding Commodity Risk Management (cont’d)C) Hedge Accounting

• Hedging, as understood in risk management, is not hedge accounting.

• Hedge accounting reflects the technique to book relationships between a hedging instrument and a hedged item, thereby mitigate volatility of trading transactions.

• Practical experience of hedge accounting has shown that complying with the requirements may be onerous.

Embedding Commodity Risk Management (cont’d)C) Hedge Accounting (cont’d)

• Most hedge relationships in hedge accounting are micro hedges, rather than portfolio hedges.

• Macro hedges, which are also common in economic hedging, are disallowed under IAS 39.

• Two main hurdles for hedge accounting are documentation and measurement of effectiveness.

Embedding Commodity Risk Management (cont’d)C) Hedge Accounting (cont’d)

• Detailed formal documentation must be in place at the inception of the hedge relationship.

• To apply hedge accounting, the prospective and retrospective effectiveness of a hedge relationship must be between 80% and 120%, and must be assessed periodically.

Embedding Commodity Risk Management (cont’d)C) Hedge Accounting (cont’d)

• Ineffectiveness resulting from hedge accounting is always recorded through the income statement.

• Active commodity risk management, such as dynamic hedging strategy, requires hedges to be entered into and derocognised frequently.

• The effectiveness tests are complex for dynamic hedging, and may also lead to additional ineffectiveness.

Embedding Commodity Risk Management (cont’d)Valuation

• Valuation of standard commodity contracts are generally not a major issue as forward prices are available.

• If no market quotes are available, forward prices are derived from comparable commodities in a different market with price modifications.

Embedding Commodity Risk Management (cont’d)Valuation (cont’d)

• In those cases, guidelines of IFRS 7 or FAS 157 in particular the fair value hierarchy, should be followed to enable the contracts to be valued for accounting purposes.

• When valuing a contract with indices for which no forward prices are available, companies may have to derive own forecast for a forward price of the indices within those contracts.

Embedding Commodity Risk Management (cont’d)Valuation (cont’d)

• Approaches to derive a price-forecast vary in practice, and may include trend-analyses, regression-analyses, Monte-Carlo-simulations, etc.

• If forecasts are used as input into a valuation model for accounting purposes, the method should be suitable and verifiable.

Embedding Commodity Risk Management (cont’d)Credit Risk in Pricing

• Credit risk from an accounting viewpoint has to be considered when valuing a commodity contract and should be considered when pricing a contract.

• Credit risk, as with other valuation inputs, should be based on assumptions from the perspective of an independent market participant and not from the company’s perspective.

Embedding Commodity Risk Management (cont’d)Credit Risk in Pricing (cont’d)

• Common practice within the commodity industry is that such risk is not considered directly in the pricing but in other ways (i.e. counterparty limits).

• In theory, there should be a price premium, depending on the credit risk of the counterparty.

• Counterparty with better credit standing would be priced better.

Agenda

• Introduction

• Commodity Price Volatility

• Changing Patterns of Global Trade

• Responding to the Challenges

• Embedding Commodity Risk Management

• How We Can Help You

How We Can Help You

A) Strategy and Policy

• Develop clear objectives for commodity risk management and trading.

• Realign policies and strategies with market changes and new developments.

B) Trading Operations

• Improving effectiveness and efficiency of trading execution.

• Auditing of trading control framework.

How We Can Help You (cont’d)

C) Governance

• Support management in the design of governance and control framework.

• Internal audit of trading activities.

D) Accounting

• Evaluation of accounting impact on new products.

• Designing of accounting guidelines, including tools in accordance with IAS 39 and FAS 133.

How We Can Help You (cont’d)

D) Accounting (cont’d)

• Training regarding accounting issues.

E) Taxes

• Support transfer pricing issues.

• Support VAT issues.

F) Corporate Transactions

• Valuation of commodity trading positions.

• Due diligence of commodity trading activities.

Commodity Risk – The Physical & the Financial

Chay YiowminPartner and Head of Financial ServicesMoore Stephens LLP Singapore