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DecisionNext Blog

Whether You Call It Trading or Not, Your Company is Taking Market Positions

Published by Arden Arnold January 18, 2017

Introduction: Market Risk at Commodities-Driven Companies
When an investor buys a stock, she is taking a position, placing a bet on the stock’s value going up so that she can sell it later for a profit. In commodities industries like food processing and mining, many executives see their companies solely as producers of commodity products and believe that playing the ups and downs of the market is risky and best avoided. The reality is that every time one of these companies buys raw materials or sells their products, the company is taking a market position (this assumes that these companies have the ability to change the timing of input purchases or output sales). Many companies have responded by trying to offload risk, both purchasing raw materials and pricing their products on formula (setting price based on a published price index), but this carries its own risks. The more a company prices its products on formula, the more that company allows its competitors to set prices and becomes a passive price taker. Furthermore, it becomes impossible to beat the market, perpetuating mediocrity. The challenge for companies in commodity driven industries is to understand and monitor the net market position they’re actually taking with their purchases and sales. The latest advances in big data analytics allow companies to put tools in place to quantitatively monitor the market risk of their transactions. Avoiding just one or two market moves against you in a year will easily justify heading down this path.

Let’s take a quick look at another example of trading in finance before we explore its similarities to everyday activities at commodities companies. If an investor believes that the value of a commodity—let’s say coffee—is going to go up, he might decide to buy coffee futures. Futures are basically a bet between the buyer and seller over whether the actual price of a commodity will be higher or lower than its “futures price” at a certain date in the future. If the price of coffee rises between the date the futures contract is purchased and its settlement date, the investor makes money, but if it falls than the counterparty in the contract makes money, having sold coffee for a higher price than it is actually worth. Futures contracts are often used at commodities companies to manage risk, to lock in a price floor for sellers and a price ceiling for buyers. But futures are also used for speculatively, to place bets on the future price of a commodity.

Market Risk at Meat Processors
Imagine a meat packer that slaughters a set number of cattle each week, processing the animals to produce beef which it sells to customers. The packer could choose to buy all of its cattle in the spot market, taking delivery before immediately slaughtering the animal, processing the meat, and selling the beef. Packers know that if prices rise dramatically they may not be able to purchase enough meat at a price which will allow them to fulfill their orders profitably, so many choose to enter long-term purchase agreements with suppliers at a fixed price, or at a fixed offset from the spot market price. Every meat packer makes a choice between alternative buying and selling transactions and that choice is a form of speculation. This is true because market movements after the decision is taken will make one alternative more profitable than the other. Just like a futures trader, the company is making a bet on the price of cattle. If the price falls, the packer who chose to wait and purchase beef in the spot market will look brilliant; if the price happens to rise, the packer who purchased on a long term contract ends up getting a deal.

Market Risk at Mining Companies
A similar dynamic exists on the sales side of natural resources companies. Imagine a mining company deciding which offer to accept for a shipload of iron ore. Iron ore is normally priced on formula, meaning the customer agrees to pay the mining company the average price per ton for iron on a specified index over an agreed upon period of days, called the quotation period or QP. Different buyers prefer different QPs (in some cases, this is merely a product of a country’s business tradition.) A salesperson at a mining company may have the choice between a 1-month forward QP or a trailing 2-weeks QP. If the salesman believes the price will increase over the next month, he will want to take the 1-month forward QP so that the price he is paid is calculated as the index rises. If the miner believes the price will fall, he will want to use the trailing 2-weeks period where price is calculated before prices fall. Deciding between these two alternatives is by definition taking a market position. In other words, all commodity buyers and sellers are traders.

How to Get a Handle on Market Risk
Calculating and updating the financial risk of a portfolio of purchase and sales transactions is complicated and generally requires specialized software. Companies that have not adopted purpose-built analytics tools to monitor their market risk might be tempted to “ban trading.” Since we have already shown that all companies are in fact trading when they make a purchase or sale, let’s ask what the effects of these bans on trading are? 1) suboptimal performance as more deals are shifted to formula pricing, and 2) executives paying too little attention to their company’s actual market risk. It is difficult to calculate the impact of a market shift on a company with traditional tools (e.g. spreadsheet models), however recent software innovations can provide executives with a clear picture of how a market move would affect a specific deal or a company’s overall financial performance. By harnessing the power of simulation and cloud computing, a new breed of analytics tools enable companies to see how various probable and improbable market movements will affect a portfolio of transactions and the company’s bottom line.

For commodities companies to truly benefit from their proprietary market knowledge and their investments in forecasts and market intelligence, they need to recognize that they are active traders and begin rigorously analyzing their portfolio of purchases and sales to make smart “trades” which optimize profit subject to specific risk constraints. Trading bans are just words and they don’t actually eliminate risk—in fact, they increase it by lulling executives into a false sense of security and turning companies into price takers. All commodities companies are taking market positions, but companies that “ban trading” aren’t merely ignoring profit opportunities, they are choosing to ignore risks they don’t want to confront instead of understanding and managing them.

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