Hedging of commodity price risks

The current economic developments present many companies with enormous challenges when it comes to the procurement of production-relevant raw materials and energy. This year's April issue of the Corporate Treasury Newsletter already drew attention to the volatile market situation in the raw materials sector and highlighted it with a view to the agricultural economy. In addition to general uncertainty due to the Ukraine war, high inflation and a possible imminent recession, the associated volatility in commodity and energy prices, such as for gas, electricity, oil or soft commodities, leads to poorly predictable business developments and annual results as well as planning uncertainties with regard to corporate liquidity.

To counter this uncertainty, companies are currently facing the challenge of implementing appropriate risk management measures or expanding existing hedging strategies. Especially in manufacturing industries with high demand for energy or raw materials, companies use commodity derivatives to stabilise production costs and protect operating margins. At the same time, it is essential for companies in such extreme scenarios to communicate as realistic a picture as possible of their own risk management strategy and its influence on the asset, financial and earnings situation to the capital market in order to maintain access to the equity and/or debt capital they need.

The application of hedge accounting under IFRS lends itself to the most realistic representation of corresponding hedging strategies. In this context, however, the ban on hedging individual risk components of non-financial hedged items anchored in IAS 39 regularly leads to companies having to report economically unjustifiable ineffectiveness in their reporting. Under IAS 39, it is not possible to properly reflect commodity price risk hedges without disturbance variables that arise along the operational value chain (the so-called basis risk).¹ Under certain circumstances, it is even completely impossible to reflect economically meaningful hedging strategies within the scope of hedge accounting due to the restrictive requirements regarding hedge effectiveness. IAS 39 does not allow the designation of individual risk components of non-financial hedged items - except for foreign currency risks (IAS 39.82). However, contracts for the purchase or sale of commodities regularly contain other components such as transport and storage costs in addition to a pure price component, so that no value identity can be established between the underlying and hedging transactions in the balance sheet and the application of hedge accounting is made more difficult - especially against the background of measuring effectiveness.

Under IFRS 9, however, it is possible to designate risk components of non-financial hedged items separately as hedged items in hedge accounting and thus exclude the above-mentioned disturbance variables from the hedging relationship. However, the standard restricts the use of component designation to the extent that the risk component to be designated must be separately identifiable and reliably measurable (IFRS 9.6.3.7(a) in conjunction with IFRS 9.B6.3.8 f.). If the contractual basis explicitly regulates how the risk component is taken into account in pricing, it is considered to be separately identifiable. A risk component is considered to be reliably measurable if the valuation parameters or input factors for an isolated valuation or measurement of the risk can be determined via publicly accessible market data or if non-determinable parameters are not material for the valuation. In principle, an implicit derivation of a risk component underlying the underlying transaction is also possible under certain conditions (so-called non-contractually specified risk components). Whether the conditions for this are met must be decided in each individual case against the background of the relevant market structures. In general, the greater the degree of subsequent transformation and value creation in the production of the product in question, the more difficult it is to establish a discernible impact of a contractually non-explicitly specified physical component on the price of a product into which the component flows. However, based on the given market structures, entities may also designate contractually unspecified risk components as hedged items. In this case, the reporting entity must then demonstrate that there is a clear and stable economic relationship with the hedged item over the entire hedging horizon. As an example of this special form of designation, the IASB mentions the hedging of paraffin purchases by means of crude oil derivatives (IFRS 9.B6.3.10(c)).

In addition to the possibility of avoiding significant confounding factors for hedge effectiveness by means of component designation, this approach opens up the possibility of providing the prospective evidence of effectiveness required under IFRS 9 in qualitative terms if a 1:1 relationship is achieved between the hedged item and the hedging instrument. In practice, qualitative proof is regularly provided by applying the critical terms match, i.e. a comparison of the valuation-relevant parameters of the hedged item and hedging instrument (IFRS 9.BC6.268). This results in a significant simplification, not least at the procedural level, in order to fulfil the application requirements for hedge accounting.

Although the application of component designation for non-financial hedged items offers the above-mentioned simplifications, some aspects must be taken into account prior to operational implementation. First of all, IFRS 9 (unchanged from IAS 39) requires in the context of the designation of risk components, beyond the separate identifiability and reliable measurability of the component, that the hedged component of a financial or non-financial position may not be greater than the sum of all cash flows resulting from the position (so-called sub-benchmark prohibition, IFRS 9.6.3.7 in conjunction with IFRS 9.B6.3.21). However, if the cash flows from the risk component to be designated are greater than the total cash flows from the underlying purchase or sale contract, the application of the component approach is excluded.² In some industries, there is no direct market quotation for the risk to be hedged, so pricing is based on a spread deducted from a benchmark price (e.g. non-ferrous metals).³ In addition, contracts to buy or sell non-financial items may include components such as price caps or floors, so that the expected cash flows from the entire transaction are lower compared to an isolated consideration of the underlying. A detailed analysis of the contractual regulations for pricing is therefore one of the basic prerequisites for a successful implementation of the component design.

Furthermore, depending on the transaction(s) to be hedged, the current economic situation has a direct influence on the hedge accounting eligibility of the hedging relationship. This is particularly the case if the underlying transaction is an expected transaction and is not already contractually fixed in terms of timing and quantity. Due to the increased price level and the growing uncertainties on the market with regard to economic development, there is an acute risk that production quantities cannot be achieved in the originally planned scope. Derived from this, the high probability of occurrence of the hedged transaction required for a designation as an underlying transaction (IFRS 9.6.3.3) may have to be questioned. In order to avoid possible overhedges and the associated additional volatility in earnings, companies are therefore encouraged to thoroughly review their own planning processes and forecasts in this context.

Finally, it must be taken into account that the costs for corresponding hedging instruments are driven by the volatility of the underlying reference prices. Based on current market developments, significant hedging costs can arise here. Depending on the strategic orientation and the risk appetite of the accounting company, it is therefore advisable when selecting hedging instruments to consider not only classic, unconditional forward transactions (forwards or futures) but also, for example, the use of option combinations that are as premium-neutral as possible, such as (zero-cost) collars or bull/bear spreads.

IFRS 9 offers the possibility to create an increased alignment between risk management and accounting by applying the component approach. Entities that have not previously engaged in commodity risk management or have not accounted for such hedges under hedge accounting rules can take advantage of the simplified designation options available under IFRS 9 in the short term. Companies that have so far continued hedge accounting under the regulations of IAS 39 should consider a transition to IFRS 9 on the basis of corresponding cost/benefit analyses. At the same time, it is important for a successful implementation to reconsider the selection of hedging strategies and, if applicable, hedging instruments to be used. 

Your finance and treasury management team will be happy to discuss this with you.

Source: KPMG Corporate Treasury News, Issue 126, October 2022

Authors:

• Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG. 
• Philipp Wallis, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
• Yannic Diefenbach, Assistant Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG

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¹ Prokop/Wallis, KoR 4/21.

² However, the option already available under IAS 39 to designate the entire contract as the hedged item remains. 

³ Prokop/Wallis, KoR 4/21.