Unlock Value with a Differentiated Approach
February 23, 2012 Our industry must depart from the conventional risk approach and include participants throughout the cotton supply chain who impact counterparty performance. The focus should be to develop risk management solutions that apply across the textile value chain to achieve better control.
For discussion purposes, participants in that chain are referred to as “Industry Risk Takers” (IRT) and include all parties who enter into a contract to take ownership of cotton, or cotton textile products, over a period of time, thus exposing them to price.
Over the past several years, with all of the price shocks rippling through the cotton market, merchants frequently looked to the commodity futures markets for price risk management tools – only to find that unexpected counterparty risk can far outweigh other tactical measures.
Historically, risk management in the cotton industry has focused on actions between growers and merchants, with limited risk management by spinners. It is now time for us as leaders to lead the IRT from the middle of the pack, directing our attention to contractual agreements down the supply chain.
For the cotton industry to expand during this volatile period, it must develop risk solutions that it can control to stabilize the entire supply chain.
Beyond currency risk tools, the price risk is largely managed by merchants who implement risk management across a large portion of their total volume procured from growers. The price movement may affect retailers at a less proportionate rate of return on investments versus spinners and traders; however, it is still the same gross dollar amount across the chain.
Previously, the supply chain could absorb these relatively small price movements, but over the last several seasons with higher volatility, the industry had to learn to cope with some new risks including cash flow, liquidity risk, and large swings in basis and outright price.
Olam’s risk management philosophy adopts a holistic approach to enterprise-wide risk allocation, measurement and monitoring. A key element is the allocation of risk capital, which involves detailed risk/return analysis considering factors such as size of profit pool, management team skills and capabilities, volatility of past earnings, and quality of counterparties. Olam actively engages in scenario analysis and stress testing at the portfolio level, considering outlier events to determine the boundaries on risk limits, and adjusts risk strategies dynamically.
It is evident that the merchant is ultimately exposed to inadequate risk management practices by value chain participants. Olam has developed collaborative approaches with its supply-chain partners to provide customized, affordable and flexible risk management solutions. This creates a win-win situation in case of adverse market circumstances and strengthens relationships. Conventional futures and options tools have severe limitations with liquidity and cost. Olam has developed innovative over-the-counter solutions with non-traditional participants to address these limitations.
In conclusion, the cotton merchant has to be conscious of the risks faced by its value chain participants. A more collaborative long-term approach is required, up to the retailer level, to reduce risks and improve margin profile across the value chain. The key is for the value chain participants to recognize the risks involved and make suitable investments to mitigate them.
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