Brady: Measuring and Managing Risk in the Metal Processing Industries
Posted: 2 June 2009 | Source: Brady
For metals refiners and fabricators, operating margins have contracted sharply - often due to competition from developing countries. At the same time, price volatility has increased, adding further pressure on already slimming margins. Those metals processors who succeed in risk management have prospered at the expense of those who failed. Increased risk for processors is attracting attention from a variety of industry players. Lenders, shareholders, regulators, and auditors all want more rigorous risk management procedures, and are paying attention to risk management results. Customers are demanding more help in minimising their risk and competitors are providing that service - and making money doing so.
Because processors are not toll converters they are forced to take risk. There is a mismatch between their commercial activity and their pricings. Increasing price volatility makes this an intolerable risk. The solution for processors is managing the two aspects of the business separately. Separating physical flow from pricings means the business manager can use futures contracts and swaps to hedge unwanted exposure and actively manage residual price risk. This is a different management process and in order to execute it successfully, companies must incorporate hedge controls, reports, and accounting into a robust system.
The risk management process begins with measurement of risk, which can be challenging because of the lumpy physical flows, forecasting errors, production uncertainty and customer fickleness in the metals business. Processors must develop a risk profile that measures historic, current, and forecast risk positions. Our case studies show this process is full of complications - the variety of products and customers, differing pricing formulas, fluctuation of inventory and high volatility of prices. To measure the risk profile properly requires a sophisticated analytical system and cannot be achieved using traditional enterprise resource planning (ERP) systems.
The collected information for the risk profile measures intake and output formula pricings, mismatch quantities, cash flow, and sensitivity to prices and market structure. The risk manager then uses this data in a systematic form to build a robust risk model. Processors are often shocked by the financial impact of price risk when it is measured correctly. Often, monthly losses from a single month are larger than operating margins for an entire year. The natural reaction to this risk is to try to eliminate it, which is unrealistic and crippling to businesses. The risk manager must frame their company’s discussion on risk appetite, how much risk should it tolerate, and how to understand it. With a clear risk profile and appetite, a policy can be defined, and compliance by the risk manager measured, all using the same robust system.
Basic hedging techniques include fixing of production revenues or consumption cost, mismatch offset, stock-at-risk offset, price optimisation, and dynamic hedging. These strategies have specific uses and goals, which neutralise the financial impact of price volatility. Controlling these hedges entails management of cash flow, positions, risks, and attribution of hedge gains and losses. This requires a sophisticated system that can also integrate reporting, accounting, and other risks such as foreign exchange and default.
The need for a systems contribution to risk management is clear. Brady software provides an excellent solution for measuring the risk, creating a risk profile, stress-testing the user’s risk appetite, and controlling and accounting for both commercial and hedge transactions. It has been tried and tested since 1980 and is constantly being updated by a seasoned team of system designers and software engineers to meet the special needs of industrial risk managers.