Mitigate Risk through Long-Term Relationships
November 27, 2012 
Prior to the historic levels of price volatility we’ve seen over the last four years, risk management was a manageable part of daily operations for cotton merchants. There were various tried-and-true practices that had allowed traders to minimize their exposure and provide a relatively solid sense of security. But the price spikes of 2008 and 2011 dramatically changed the way merchants view their risk.
While options and other traditional tools are still a critical part of any comprehensive risk management strategy, it is in many ways becoming more of an art than a science. It is increasingly important for merchants to better understand and communicate with their customers. Given the vagaries and occasionally inexplicable moves of the cotton market, developing solid relationships with a select group of trustworthy business partners can be a critical step toward ensuring a company’s long-term security. Cotton International interviewed three top merchants to get a better sense of the challenges they face: Edmondo Levante, a trader with ICT Cotton; Urs Riederer, president of Sunrise Resources; and Nick Earlam, chairman of Plexus Cotton.
1 How has your approach to risk management changed over the last 3-4 years?
Levante: In view of the increasing problems we are witnessing in most producing and consuming markets, it has become more and more difficult to pinpoint a risk management strategy that is close to 100% safe.
Everyone knows that there are many industrialists who have entered the cotton and textile business without any background, experience or knowledge. Unfortunately, not being well informed about rules (or not really caring much about them) reflected directly on the supplier. It doesn’t matter if it’s a reputable, reliable international merchant or an unknown and obscure local exporter. In the past two years, we have witnessed so many defaults that many companies no longer care about the basic principles of our trade. Therefore, performing the usual risk management through information and hedging tools no longer secures the trade. The change that has been seen the most is in asking certain cash guarantees to sellers (producers) and buyers (traders/mills). However, while many accept such a condition, many others do not. As a result, traders have been forced to decrease their annual turnover and do much stricter research on both sides of the trade.
Riederer: As cotton agents for some of the most reputable cotton companies in the world, we have learned that good risk management begins at your own doorsteps. You have to ask yourself the same questions that banks ask when they undergo stress tests. The most fundamental question would be: “Is your capital sufficient to absorb punches like the ones that have occurred in 1998 (Asian financial crises), 2001/02 (9/11), the 2008 crises, or the more recent price collapse and its dire consequences.” The answer will provide clues as to what volume a company should trade and whether to limit the amount of business to select counterparties with AAA rating at the expense of volume.
There are other tools available, such as options strategies, that go beyond the traditional hedging purposes of one’s own positions, but are rather bought as additional protection (insurance) against the unexpected. Merchants have been trying to impress on mills the need to build that kind of protection into their purchasing decisions, but it is not happening frequently, as it is considered too costly. This is, of course, a mistake. From our perspective, we suspect that some merchants, too, do very little of that additional “what if” risk management that could defuse the consequences from unexpected events, such as unilateral government decisions or the fallout from defaults.
Earlam: Risk management has been ramped up and has been the focal point of our business ever since the crisis of 2008. We have a very conservative approach, with a risk management committee overseeing the risk management policy designated by the Board. This is a separate group of people from those concluding the daily business and is monitored daily. We are acutely aware of margin risk, counterparty risk, and market risk and we will not do anything at all that compromises any of these issues. We use options and counterbalancing physicals to monitor our exposure within our risk management policy and we are not interested in taking any chances on agents, suppliers or customers for the short term. Our aim is to build long-term business with long-term partners who can totally rely on each other and bring about win/win situations, and also to concentrate on traceability and sustainability, which will help mitigate the risk further.
2 Spending more time and effort to ensure customers are financially sound and trustworthy can reduce the number of potential customers and lengthen the business cycle. How is this affecting merchants’ business operations?
Levante: Basically, there remains a very selective number of sellers/buyers with whom one can trade comfortably. But we have also seen that this is not valid for all of the countries in the trade. We have experienced, both directly and indirectly, some previously classified A1 companies that have had problems with contracts … the main effect also being that companies spend a lot more time in negotiations because security must be a priority in all cases.
Earlam: We are not only a merchant – we also produce and gin our own cotton within several locations in Africa, which has helped us with security of supply and building up a long-term foundation with our customers and suppliers. We would argue that your business plan needs to fully take into account only dealing with financially sound and trustworthy partners, and if that results in less business or a lengthening of the business cycle, then so be it – and one should plan around this. The alternative, which would be to deal with less sound people, is not an alternative that we are prepared to consider.
Riederer: There are relatively few mill enterprises that are publicly traded and are therefore transparent. To get financial information from privately owned companies (the vast majority) is almost impossible. It therefore comes down to “knowing your customer” from past experience. As the question implies, it is not only a matter of financials but also of trustworthiness. It is here where an agent is of great importance in the decision making of merchants. It is a bit like the golfer and his caddy: Experience over many years is a great asset.
For the time being at least, merchants have to live with less business (sharp reduction in cotton consumption worldwide) and business with shorter lead times. This has far reaching implications on growers’ decisions as to which crops they will plant next season and perhaps even beyond. If the price for a certain amount of prospective acreage cannot be locked in far enough in advance to secure bank loans, the consequences are clear to everyone. Therein lies the base for the next evolution of a cycle and new risks connected with it. Merchants have to live with this. Knowing your partners is vital. To be prepared for the unexpected is now the constant companion of the merchant community.
3 How can merchants cope with government intervention in the cotton trade? What options do they have when dealing with potential business partners in those countries?
Levante: That is the million dollar question! We fear there’s not much to do unless they totally amend the concept of a sudden measure taken to protect and fulfill all domestic needs, parties, etc. There have been efforts by international merchants to approach embassies, commercial offices, foreign trade departments, and textile and arbitration associations in the effort to request stability in the policies on export of cotton or any materials produced with it. An effort to approach these governments through legal paths would most probably result in tough actions against the trading companies, which ultimately could lose their operations in that country. We believe that regular meetings among members of the ICA, ACME, ACSA, Bremen Cotton Exchange and AFCOT in order to reach common thoughts and communicate with the various governments is the best way of approaching this issue.
Riederer: Whenever governments come into the equation, it becomes dangerous because governments take political decisions, rarely commercial ones (although often they think their decisions are commercial). Take as an example the two decisions that were taken by the Chinese government – supporting local farmers with a minimum price that lies far above the world’s average and simultaneously importing cotton at discounts to its own cotton. This has never been witnessed before. It was referred to as the “Chinese P.” Hardly a commercial decision! As time went on, it became apparent that this policy had nothing to do with a “put” or creating a floor.
In the end, the policy that was supposed to bring stability failed in spite of its good intention. The fact remains that Chinese mills are forced to consume the majority of their cotton (other than what can be imported against quotas) at far above world parity, with the known consequence of destroying consumption. Having said that, well-informed merchants can analyze such policies as they evolve and can build in risk management strategies. The same cannot be said about India’s freak decisions to ban exports, which befell the world without warning. For merchants, it remains of paramount importance to be informed about (and where necessary, reduce trading in) certain origins and put more emphasis on origins with a reliable track record. That also applies to mills, and we see it happening.
Earlam: We feel that government intervention in the cotton trade is much more likely in some countries than in others. The contractual issues surrounding macro intervention in these countries should be covered within the purchase or sale contract since it is only the local population that can realistically achieve change – and if this change affects their pocketbook, they will push for it. We see this beginning to happen more and more. At the same time, we passionately believe that the current risk management and price discovery tool for cotton – namely the ICE No 2 contract – needs to be significantly changed to allow for global delivery or another contract put in place by another exchange. In our opinion, the current contract reflects neither proper risk transference nor proper price discovery on a consistent basis and until we can achieve such a vehicle, one’s ability to manage items such as government intervention will be compromised.
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