To Hedge or Not to Hedge

If you’re a financial officer at a firm that uses a lot of oil or other commodities, this strategy might turn out to be a stroke of genius: Lock in current prices now, and watch competitors in the coming months pay double for those same commodities. Of course, the strategy could backfire if prices drop and the company has to overpay.

Welcome to the world of hedging, which has quickly turned into a high-stakes, albeit little-noticed maneuver for more and more firms globally since the start of the Middle East conflict.  In that time, the price of oil has shot up to $100 a barrel, and prices for a host of commodities have also soared—from natural gas to aluminum to wheat—in some cases, by as much as 50%. With analysts predicting that a prolonged conflict could send prices still higher, many organizations are essentially agreeing to pay today’s prices for goods they’ll be taking delivery of several months or a year from now. They’re spending more money now in order to potentially avoid spending even more money later. “Even if it means locking in a higher price, these companies might see this as a way to reduce overall volatility,” says Sara Panarese, a Korn Ferry senior associate in the firm’s Global Financial Officers practice.

Hedging involves the use of a futures contract, which is a financial instrument obligating a party to buy (or sell) a commodity at a stipulated price in the future. A prolonged war could send oil to more than $150 a barrel. Of course, depending on circumstances, oil could also fall far below $100 a barrel.

In some ways, the hedging quandary is akin to last year’s debate about tariffs. Back then, firms had to decide whether to front-load product orders they knew would be more expensive in a matter of months. But with the war in the Middle East, there’s even more uncertainty, because commodity prices could fall—possibly by a lot—a few weeks from now. The fact that the underlying commodity prices change daily makes the situation even more confusing.

Approximately 20% of global petroleum liquids—about 20 million barrels per day—normally flows through the Strait of Hormuz, the narrow waterway whose shipping traffic has been significantly curtailed because of the war. Roughly one-fifth of the global liquefied-natural-gas trade goes through the Strait as well. Few firms need to buy oil or gas directly, of course, but the war has sent other commodity prices surging, too, including those of petroleum-derived products such as resins and polymers, which are staples of nearly all manufacturing. Prices of palm oil, wheat, fertilizer, soybeans, and corn have risen since the fighting began, in part due to higher transport costs.

But if hedging was that easy, experts say, nearly every firm would already be doing it. Indeed, the practice has long been divisive. Companies will hedge all the time when their most expensive costs are one or two commodities. Jet fuel, for instance, is a massive expensive for airlines; even a 10% difference in price can hugely benefit an air carrier’s bottom line. So an airline will use hedging contracts, locking in the price they’ll pay for future fuel in order to gain a degree of certainty. The same goes for many food companies, which will hedge the prices of chocolate, beef, and other food stocks. These companies, which often have years of practice, use historic pricing patterns to determine how much they hedge, increasing their use of the strategy when they feel prices are low.

Others view hedging as too pricey, regardless of how volatile the market is. Hedging contracts require a large amount of cash up-front. But if a commodity’s price falls after a period of months, a company might need to unwind its hedge, requiring another outlay of cash. “It can be expensive,” Panarese says. Some companies prefer to manage the issue operationally—giving supply-chain leaders the autonomy to buy raw materials when they believe the price is right—rather than allowing the finance team to lock in a price that might later look excessive.

Other executives worry that the practice can confuse some stakeholders. Companies have to disclose the value of derivatives contracts on their financial statements. Those values—which can be quite high—don’t actually reflect an expense the company has paid, or even committed itself to paying. This doesn’t stop investors from asking how the hedging will impact the company’s future financials, however. “I think any company not in the business of primarily managing capital-markets risk wants their derivative disclosures to be as simple and understandable as possible,” says Jeff Constable, co-leader of Korn Ferry’s Global Financial Officers practice.

Learn more about Korn Ferry’s Organization Strategy practice.

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