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Ernst & Young launches survey on how companies manage volatility in commodity Prices

12-17-2008 05:37 PM CET | Business, Economy, Finances, Banking & Insurance

Press release from: Ernst & Young India

/ PR Agency: Ernst & Young Pvt. Ltd.
Ernst & Young India

Ernst & Young India

Mumbai, December 16, 2008: Professional services firm Ernst & Young today released its survey entitled, “Commodity price risk management survey 2008”.The survey indicates that commodity risk management operations are not fully geared to protect margins. The survey also indicates a lack of focused and structured hedging program within companies.

The survey captures views of senior executives from more that 45 companies across sectors having exposure to a wide range of commodities including non-
ferrous metals, oil and petroleum products, precious metals, agro and soft
commodities. Responses were compiled from companies across the value chain
including producers, processors and end-users.

Accordingly to the survey, more than 50% of the respondents viewed hedging as
a tool to lock-in input costs at a target level, some of them still used market
views and expectations of future prices as a trigger of decision making.
Interestingly, more than 68% of the respondents had a hedging horizon of less
than 3 months indicating that the full potential of hedging to protect long-term
business cash flows was not being explored.

The survey findings indicate use of standardized exchange traded products by
more than 81% of the respondents. Relatively simpler instruments like forward
and futures were used by more than 92% of the respondents indicating that
customized hedging instruments are yet to gain ground.

Governance of commodity price risk management function is critical to ensure
that risk management activities are always consistent with the risk philosophy
and risk appetite of the company. As per the survey less than 58% of the
respondents reported the existence of an independent oversight function while
less than 20% have conducted and external review of the function.

Says Farrokh Tarapore, Partner and Industry Leader, Financial Services, Ernst &
Young, “While the concept of commodity price risk management in India has
steadily gained ground since the early part of this decade, with the increasing
volatility and growth in paper markets, the time is ripe for companies to look at
commodity price risk management as an integral part of the strategy to manage
the bottom-line.”

He further adds, “Stakeholders are expected to demand clear value add from the
function and measurable success in terms of protecting margins. Performance
and risk measurement through use of statistical measures like value at risk was
noted in less than 15% of the respondents. Use of such risk and performance
measures is likely to drive performance assessment.”

The survey points out that hedging program undertaken by companies in India
are still generally short-sighted, driven to a large extent by market views and not
always aligned with the risk philosophy of companies. Though companies
understand the need for hedging and the instruments available, the finer aspects
of hedging such as basis risk and timing risk, which can significantly affect hedge
cash flows are often ignored.

According to Hemal Shah, Associate Director, Financial Risk Services, Ernst &
Young, “Unprecedented volatility in commodity markets has threatened
structured margins in fundamental businesses like never before. For the first
time price risk management is being seen as an all pervasive function touching
every aspect of the business cycle. Commodity price risk management is no
longer limited to hedging. It is about managing price risk across the value chain.”

Commodity price risk management in India is at various levels of maturity,
depending on the commodity and where the player is positioned in the value
chain. The general attitude towards extracting value from this function has
however been lackluster. While the pressure to put in place sound risk
management practices is omnipresent, views relating to the appropriate strategy
and components of an ideal framework have been debatable. The Reserve Bank
of India (RBI) recently relaxing its regulations on hedging in overseas markets
has provided companies with a wider range of options relating to price risk
management. The RBI has also permitted hedging on international exchanges in
the case of certain commodities procured or sold locally.

Given internal and external development and the omnipresent shadow of
increased volatility, using commodity price risk management as an effective tool
is imperative.

Key findings –

1. Maturity of commodity price risk management operations appears to be
greater among producers and processors. Consumers are becoming
increasingly aware of the importance of commodity price risk
management as its impact on the bottom line is being increasingly felt.
2. Hedging programs are still generally short-sighted, driven to a large
extent by market views and not always aligned with the risk philosophy of
companies.
3. While companies understand the need for hedging and the instruments
available, the finer aspects of hedging, such as basis risk and timing risk,
which can significantly affect hedge cash flows, are often ignored.
4. The instruments used for hedging tend to be plain vanilla and are
generally limited to futures and forwards. Companies do not generally
explore the use of customized instruments, depending on their exposure
profile.
5. Companies show an appreciation of the need for oversight. However, little
is done to enforce sustainable oversight and governance.
6. Cash flows from hedges and underlying exposures are generally viewed in
isolation. The definition of position, for the purpose of assessing the
underlying exposure, is generally vague. This may prevent holistic
performance reporting.
7. Mark to market remains the single most important measure used for
performance measurement and reporting.
8. Investment in human resources to manage the function is still fairly low
and most commodity price risk management functions are staffed by less
than five persons.
9. Operational risk is not perceived as a major issue. This has resulted in less
than an optimal level of investment in streamlining operations and putting
in place a robust control mechanism.
10. There are continuing concerns relating to the accuracy of reporting and
accounting for hedging operations.

About Ernst & Young
Ernst & Young is a global leader in assurance, tax, transaction and advisory
services. Worldwide, our 135,000 people are united by our shared values and an
unwavering commitment to quality. We make a difference by helping our people,
our clients and our wider communities achieve their potential.

For more information, please visit www.ey.com/india

Ernst & Young refers to the global organization of member firms of Ernst &
Young Global Limited, each of which is a separate legal entity. Ernst & Young
Global Limited, a UK company limited by guarantee, does not provide services to
clients.
This news release has been issued by Ernst & Young Private Limited which is one
of the Indian client serving member firms of Ernst & Young Global Limited.

Ernst & Young Pvt. Ltd. is a company registered under the Companies Act, 1956
having its registered office at Block C, 3rd Floor, 22 Camac Street, Kolkata -
700016

- Many companies lack a focused and structured hedging program.
- Most hedging programs are still short sighted, market views driven and not
always aligned to a company’s risk philosophy.

Ernst & Young Pvt. Ltd.
Mumbai, India
Girish Bhosle,
girish.bhosle@in.ey.com
+91-22-40356796

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