Let us examine the potential impacts on the earnings of a medium sized manufacturing company. I will assume that the company earns a gross profit margin of 20% on sales. Let us also assume that 15% of total production costs are related to energy – energy to run machinery, energy to power lights, energy to heat buildings, etc. Let us also assume that the company maintains 60 days cash flow as working capital (some business articles in the mid-90s talked about corporate attempts to get to zero net working capital). What does margin do to this company’s business?
First we must assume that prior to collateralization the company had no margin out to either its utility or its counterparties. Let us assume that the company hedges 80% of usage out for one year. Typical margin or collateral amounts can run 20% of the notional amount of the trade. This means that the margin equals 16% of the annual total bill. Assuming the company runs at capacity and has no inventory build or draw (for simplicity) this means that the increase in working capital equals:
16% (margin) times 15% (percent of total cost) divided by 1.2 (ratio of costs to total sales revenue) = 2% of annual sales or 7.3 days more working capital - an increase of 12.1%
Now in a market where EPS growth targets are high single digit/low double-digit growth, an increase in non-productive working capital is significant. In a market where capital investment is already under pressure from EPS targets, increases of this magnitude get magnified.
But it gets worse if prices go up. If, as now, gas prices go from the mid $3 to the low $5 range, hedging frequently occurs to reduce risk of greater increase. How much has the margin requirement increased? The calculation is the same as the one shown above but the change in energy cost has just raised costs from 15% to 25% of total annual sales. The calculation results in a margin equal to 4.8% of sales or 17.5 days of revenue or a 29% increase in working capital. Therefore as prices go up the implications of hedging on operating costs and cash flow and working capital become worse.
The worst scenario is when prices go down. If, as now, gas prices go from the mid $3 to the low $5 range, hedging frequently occurs to reduce risk of greater increase. But what happens if prices go back down? Many contracts treat margin requirements like variation margin – requiring 100% of the change in collateral
If the collateral becomes 100% of an adverse movement in price, then a 40% decline in price on an 80% hedge of annual energy translates into a margin call equal to 12% of total sales or 43 days of revenue or a 73% increase in working capital. What this points out is that hedging strategy should cover not only costs but also future cash flow implications to the hedger.
Now if we turn this around the issue becomes even more critical for the energy producer. In this case energy may be 85% of annual sales, but let us assume gross margins equal 40%. The equation for hedging 80% of one year’s production now becomes:
16% (margin) times 85% (percent of total cost) divided by 1.4 (ratio of costs to total sales) = 9.8% of annual sales or 35.5 days working capital – an annual increase of 59%.
This makes the consumer margin exercise look wonderful by comparison. But the impact on the producer gets even worse when prices rise. Let us take the recent run up of gas from mid $3 to low $5. This means that the collateral has increased to 15% of total sales (at a 20% of notional margin) in the best case. However, what is more likely is that, just as for the consumer, the margin is dollar for dollar for the price rise. What does this mean?
This means that the collateral call could be equal to almost 60% of the total hedged revenue from the original trade. The cash flow could mean that 60% of the forward annual revenue is required now. Few if any companies hold over 50% of their annual revenue in cash on hand. The working capital increase is almost 180 days of revenue or a 300% increase. Yet if the margin cannot be provided then the trade is likely to be liquidated and the margin call now becomes a loss on the trade due immediately.
All this analysis shows is that hedging strategy needs to look at the competitive issues I have previously spoken about, and the working capital issues and cash flow issues that collateralization or margining raises. One implication is that the consumer and producer distaste for paying option premiums as potentially “wasted” money may be overcome with an analysis of the beneficial cash flow implications for margin. Failure to create a comprehensive solution and business plan can expose a hedger to significant unintended risks in the future.
This is something that the purchasing or sales group frequently ignores. I have had comments from hedging groups that they will not accept collateral clauses in physical contracts because of the cash flow impacts. That is becoming more difficult to stand by, and in those instances where open credit is offered it comes at an embedded transaction cost. Whichever route is chosen will have a negative impact on EPS. Therefore, risk management has become an exercise not only in managing commodity market price and volume exposure, but also in managing working capital commitments.