Price Risk Management Tools – Potential Application With Manure. About 25 years ago I completed my Risk Management Masters Degree dissertation by reviewing how the Oil Company BP might introduce Price Risk Management tools to improve its marketing of chemical products. These products could be quite smelly but nothing compared to some other traded commodities (see below…).
A common problem faced by both chemical manufacturers and their customers was the unpredictable volatility of market prices for these products. It was not unknown for prices to more than double (or reduce by half) in the space of a few months. This made forward planning very difficult especially when the chemicals were used to manufacture products like textiles or household items whose prices were relatively stable.
The kind of tools I investigated included futures and options and ‘over-the-counter’ (OTC) bespoke hedging products. One of the problems with futures and options is that you need a very liquid market to reduce the risk of someone cornering the market and trying to make money by forcing prices in a certain direction. These tools are popular in the financial and oil industries because large volumes of products are bought and sold in numerous transactions every day. This high liquidity helps buyers and sellers to quickly find the most appropriate price for the product based on the current balance of supply and demand.
Where liquidity was not so high, and this was the case for most chemical products, bespoke hedging products were found to be more suitable. This was the direction many of us in the chemicals industry chose to follow. Based on an approach initially tested by suppliers of jet fuel to the airline industry we devised OTC price risk management products for our customers.
Put very simply these bespoke tools were designed to provide customers with a level of price risk that they considered appropriate for their business. For example if the customers’ end-product market required very stable pricing we found ways of offering our customers price stability by smoothing out the peaks and troughs in our own sales prices. Clearly we did not know in advance when peaks and troughs would occur but as our chemicals were manufactured from oil products we could evaluate over history how these oil products influenced our manufacturing costs. We could then buy futures contracts in the oil, energy and currency markets which would allow us to try and cancel out any potential raw material price volatility arising from these areas.
Clearly this kind of arrangement requires trust and a long term commitment between buyer and seller. When prices in the general market for our chemical were low our ‘hedged’ contract price would actually be higher than the market price. However when prices rose dramatically in the open market our product became relatively cheaper.
Not all customers want the volatility to be totally taken out of their raw material prices. For some customers we produced a formula price in which the chemical’s sales price was calculated based on a ‘basket’ of the raw materials and energy prices needed to manufacture the chemical. To avoid giving away our exact prices (which were often confidential) we could use published price lists (like ICIS or Platts). So if oil was used to make the chemical and the oil price went up the formula sales price for the chemical also increased. This meant that if the customer wanted to they could buy their own oil futures to manage that element of the formula price volatility for the chemical they were buying.
Although some level of volatility remained in a formula based purchasing contract the huge swings in price that could result from a sudden shortage (or oversupply) of the chemical were avoided. This was a common issue for customers of chemicals which were often only manufactured in a few locations around the world. If one of these major plants had a manufacturing problem the availability of the product in the spot (or free) market would dry up. This is when the spot prices would spike. Our formula contract customers were cushioned from this demand/supply driven volatility. Of course we also needed to make sure we had back-up supply sources in case the plant that had the manufacturing problem was one of ours! Therefore along with pricing certainty our customers also knew they had security of supply.
These kind of bespoke price risk management tools can be applied to many product areas. The first thing you need to have is a sufficiently large and liquid market in which the product is traded and priced based on the principles of supply and demand. This week I was interested to learn about the development of just such a traded market (or exchange) in Germany for a rather unusual but very important product.
This product was natural liquid manure – yes the stuff that cows, horses, pigs and birds excrete in quite large quantities on farms. One of the problems for farmers is that they are limited in how much of this manure they can dispose of on their own land (and in Germany the law states that the number of animals you can have is limited by the amount of land you have to dispose of their excretia – this is to minimise pollution of the water table with nasty things like nitrates). I have written a dedicated article about how the German Farming Community has developed an exchange dedicated to trading in this valuable commodity. If you are interested just click on the title below:
One of the interesting things about the liquid manure business is that, depending upon short term supply/demand, farmers will pay to either buy or sell the product. The exchange referred to in my article (which includes a link to an organisation managing the manure exchange) puts potential buyers and sellers in touch with each other and addresses issues such as product quality and transportation obligations. This exchange therefore has many of the characteristics of a traded market which can be used as the basis for developing bespoke price risk management tools.
Perhaps we will find some enterprising ‘start-up’ developing an app to enable farmers to buy or sell forward manure at a fixed price (e.g. ‘Pig Shit Futures and Options’). This illustrates how price risk management can still be applied to many ‘novel’ areas where suppliers and consumers strive to have better control over their future pricing.