Integrated Risk Management – Commodity Trading Firm (“CTF”)

CTF is in the business of importing crude edible oil and selling it across the Middle East after refining in ME. It serves four distinct market segments i.e.; (i) Government (ii) Wholesale (ii) Retail (iv) Business. Within the retail segment CTF markets both its own brands and also private label. CTF has achieved impressive growth both in revenues and sales, posting 40% growth in 2022 and forecast of 50% in 2023. The trend is expected to continue in 2024. The edible oil sector is cyclical. In addition, the commodity prices have seen elevated volatility in recent years.

The Challenges

Financial & Operations Exposures

1. As the business grew rapidly, the exposure to commodity price volatility increased significantly
2. In addition to linear exposure, the volatility in commodity prices also created non-linear exposure as this had a significant impact on client behavior
3. Focus on inventory management left significant gaps in price fixing for procurement and sales in terms of timing and flexibility exacerbated commodity price exposures. Supply chain management needed to be more robust

Risk Management

1. Prudent risk management took a back seat in favour of intense focus on sales and volume growth. This is typical for high growth companies
2. Lack of integrated risk management approach. Individual departments working in silos and risk management considered the sole responsibility of Treasury/ Finance department
3. Misaligned objectives and incentives created further issues in terms of risk management
4. Data is essentially used for accounting purposes and reporting and not leveraged to improve risk management

Risk Management Approach based on following Principles

1. Risk management is a firm-wide responsibility – Focus on Firm Value
2. The Firm should not take a view on the market as this is not its business
3. Robust data collection and analytics is critical for effective risk management
4. Understanding client behavior and management can provide significant risk mitigation
5. Risk limit structure to be established and complied with diligently
6. Risk management framework and policy not only manages risks but also guides client and sales behavior
7. Cross product subsidies can mask important risks and must be avoided
8. Sales margin to be decoupled from market risk
9. Only residual risks, after achieving mitigation internally, will be hedged externally

The Approach

• Thorough understanding of the edible oil sector and the Firm’s business model
• The review included the entire value chain from procurement to sales and payment terms
• Analysed client behavior in all four market segments
• Reviewed the technology platform and the data capture and analysis process
• Discussed decision making process at every step of the value chain
• Identified the sources of risk and quantified exposure
• Developed detailed risk management framework and executed hedging transactions

The Impact

• Created risk management culture across the firm – the first step towards managing risk
• Clearly identified sources of risk, including black swan events
• Altered the mind-set away from “sales” to creating and enhancing “Firm Value”
• Significantly mitigated risk by making changes in business philosophy and processes
• Risk management framework developed with a view to guide client behaviour
• Created hedging policy and established relationships with hedging counterparties