One of the benefits of FAS 133 is that it has pushed commodity risk management into the forefront of treasury/risk management and has standardized the disclosures companies must provide with regard to their commodity risk management activities.

Examining disclosures from the FAS133.com Portfolio of 33, there are 15 companies in seven major sectors which report in their 2001 10-Ks that they are exposed to commodities price risk and provide information of varying degrees on commodity risk management.

Of these 15, 12 are exposed to rising commodity prices and only two, Exxon Mobil and ChevronTexaco are also exposed to falling energy prices (for a company by company matrix, see here). Interestingly neither one makes extensive use of derivatives to manage its exposures. Indeed, Chevron's portfolio is so insignificant that it elected not to account for its derivatives under FAS 133 (although they may do so in the future).

2001 10-K analysis

Hedging relationship. Most companies account for their commodity derivatives as cash flow hedges. Not everyone, however. Alcoa, for instance, is an exception. The aluminum producer mainly uses fair value hedge accounting when managing the commodity risk in its core business. "Alcoa's aluminum commodity risk management policy is to manage, through the use of futures and options contracts, the aluminum price risk associated with a portion of its fixed price firm commitments," the company's most recent 10-K notes.

Basically, Alcoa enters into long-term, fixed price supply contracts with its customers, some as long as three-years, whereby it agrees to deliver product as a set price. As a result, the company is unable to participate in any market price increases, creating an economic exposure. Alcoa manages that risk by hedging some of its firm commitments as fair value hedges, basically allowing it to participate in the upside if prices surge.

"We use hedges to adjust our position to what we view as an appropriate exposure to market prices when customer orders or other factors drive us away from that level of exposure," says Alcoa's treasurer, William Plummer.

"At December 31, 2001, these contracts totaled approximately 802,000 mt with a fair value loss of approximately $65 ($42 after tax). A hypothetical 10% increase (or decrease) in aluminum ingot prices from the year-end 2001 level of $1,355 per mt would result in a pretax gain (or loss) of $108 related to these positions."

Time horizons. Hedge time horizons vary, but most of the companies represented in the automotive, basic materials and capital goods sectors tend to hedge as far out as three to four years. By contrast, the food and beverages and utilities sectors tend to hedge commodity risk out no further than 12-18 months.

Hedge tools. The use of exchange trade futures and options appears to be much more prevalent among commodity hedgers than with interest rate or currency hedgers.

Hedge ineffectiveness. Compared with most interest rate and foreign exchange risk disclosures, which usually report hedge ineffectiveness as not material or insignificant, when it comes to commodity hedging, ineffectiveness is more in evidence, although not with all companies. The reasons for potential ineffectiveness in commodity hedges are various (see prior article). In particular, basis risk comes into play when hedging commodities.

Here are some examples and exceptions:

Williams Companies. One example is Williams Companies, which reported gains due to hedge ineffectiveness of $1 million for cash flow hedges and $5 million for fair value hedges in its 2001 10-K, all related to energy commodity hedges.

These gains from ineffective hedges ended up contributing a penny per share to earnings in 2001, which came in at a loss of ($.95). The annual report also notes that the company uses an array of derivatives consisting of forwards, futures, swaps and options to hedge operations associated with crude oil refining and refined products marketing, which are not designated as hedges.

These derivatives are carried at fair value and the gains and losses associated with them are recognized in earnings as revenues or costs and operating expenses in the Consolidated Statement of Operations, which eliminates the need for the company to document their effectiveness under FAS133.

Con Edison. Another is Con Edison, which has exposure to natural gas and electricity price fluctuations. The company's 10-K for 2001 reports mark-to-market unrealized net pre-tax losses of $6.2 million due to ineffective derivative hedge transactions, negatively impacting annual earnings by $.03.

General Motors. GM provides mostly boilerplate information on commodity risk consisting of reference to exposures to various non-ferrous metals consumed in manufacturing automotive components which are managed with commodity forward and option contracts. While GM has significant ineffectiveness reported in its 10-K, it was all related to FX and interest rate hedges, not commodities.

Ford Motor Company. The good news at Ford is that in Q4/01, its engineers developed a breakthrough in catalytic converter designs, which will reduce the company's requirements for palladium by some 50 percent going forward. The bad news is that the company "painted the ceiling" with forward purchase contracts in 2000 and early 2001 when palladium prices reached $1,100 per ounce compared with $200 per ounce as recently as 1997. Ford had originally viewed these metals purchases as supply contracts, which did not fully meet the definition of a derivative under FAS133. However, it may be that Implementation Issue No. A19 (which defines net settlement) was instrumental in prompting Ford's reevaluation of its policy during the fourth quarter of 2001. Subsequently, Ford's automotive sector posted a mark-to-market adjustment of $449 million for contracts outstanding as of December 31, 2001 and began reducing existing stocks of inventoried precious metals and liquidating forward purchase contracts via cash settlement, resulting in a pre-tax write down of $953 million dollars.

Ford's 10-K did not indicate the time remaining to maturity of the supply contracts, but only stated that the contracts were purchased in 2000 and 2001 suggesting that the expiration of the contracts were within a reasonable time horizon that could be accommodated by existing forward and/or futures markets for that commodity. It is not clear however, why the transition to mark to market accounting for the outstanding contracts was not accompanied by any mention of hedge ineffectiveness in the annual report.

Boeing. By contrast, Boeing's 10Q from Q3/01 reported that the company would define its use of fixed-price purchase commitments for electricity as deated as cash flow hedges under the same C15 Implementation Issue. The company noted in its 10-K for 2001 that such contracts were entered into covering the next three years and that some that did not qualify for cash flow hedge treatment (as all in one hedges, presumably) resulted in a loss of $1 million in other income for the year ended December 31, 2001.

International Paper. International Paper apparently has very effective hedges relying primarily oap contracts of one year or less in maturity. The absence of hedge ineffectiveness makes sense in this context if the swap contracts entered into by IP were based on the specific natural gas products including origination and destination points. In other words, the counterparts to IP's natural gas swaps are the ones who are taking on the basis risk of hedging the swaps with natural gas futures.

Best in Class

Perhaps the two most noteworthy disclosures in the area of FAS 133 and commodity risk management came from Sara Lee and Dow Chemical.

Dow Chemical - plenty to chew on, but not too much to bite. The company provided a prodigious amount of information about commodity hedging policy, without getting bogged down into too much detail and their reporting practice worth noting here as an exemplary model.

"Open futures contracts at December 31, 2001, had notional amounts of 150,000 million Btu of natural gas with a weighted-average settlement price of $3.44 per million Btu. These contracts had various expiration dates in 2002. Combination options for natural gas at December 31, 2001, had a notional amount of 82,000,000 million Btu and weighted-average strike prices per million Btu as follows: long call ($3.54), short call ($4.70) and short puts ($2.60). These options had various expiration dates in 2002 through 2004."

The company states that it anticipates volatility in OCI and net income from its cash flow hedges. In addition to designating derivatives as cash flow hedges, Dow also makes use of options as economic hedges that do not meet FAS133 criteria for hedge accounting.

However, there is some ambiguity with regard to the hedge effectiveness issue. Clearly, one might anticipate some ineffectiveness coming across routine measures of basis risk associated with as concentrated a use of standardized exchange traded futures and options contracts as Dow does. There is mention of a $9 million gain recorded in income for hedge ineffectiveness, but it appears to be part of a $112 million gain from hedges of the company's net investment in foreign operations, which presumably is a currency hedge, but the filing does not explicitly state that.

Nevertheless, this $9 million gain due to ineffectiveness contributed $.04 to bottom line EPS which weighed in at $6.02 for all of 2001.

Sara Lee: Clearly defining materiality. As a foods processor, Sara Lee Corp must routinely purchase a range of food products and the company notes in its 10-K released in September of 2001, that it "uses futures contracts to hedge commodity price risk. The principal commodities hedged by the corporation include hogs, beef, wheat, butter and corn." But, the same filing also states that "commodity financial instruments" for hedging purposes is not that significant "due to a high correlation between the commodity cost and the ultimate selling price of the corporation's products." Evidently Sara Lee does not experience much difficulty in passing on higher costs of rising commodity inputs to end products consumed by their customers. One might wonder though if the timely use of commodity hedges when prices are rising might garner increased market share for the company by being able to put a cap on retail price increases for their products at the super market.

However, the most valuable find for this analyst in reviewing Sara Lee's annual report was the following statement made by the company under the heading of "Sensitivity Analysis":

"At year-end, the potential change in fair value of commodity derivative instruments, assuming a 10% change in the underlying commodity price, was $4.5 million. This amount is not significant compared with the earnings and equity of the corporation."

One of the most frustrating issues to tackle in assessing corporate risk management policies and practices has been in trying to figure out how what a company means by "not significant" or "immaterial".

More companies than not report that whatever hedge ineffectiveness they encounter is either not significant or not material, but they never quantify what they mean by that. But Sara Lee clearly stated that they consider the $4.5 million impact of a 10% change in commodity prices to be "not significant". True, they were not addressing hedge ineffectiveness per se, but one can assume that the same dollar amount would apply. Given, annual earnings of $2.266 billion in 2001, and an EPS of $2.75, $4.5 million is only half a penny of earnings. Not significant? We'll buy that.

In connection with this, the company disclosed that, "During the year ended June 30, 2001, $2 million of net losses related to cash flow hedge ineffectiveness and $2 million related to derivative losses excluded from the assessment of effectiveness was recorded in the consolidated statements of income. Other disclosures related to fair value hedge ineffectiveness, fair value gains and losses excluded from the assessment of hedge ineffectiveness, and gains or losses resulting from the disqualification of hedge accounting have been omitted due to the insignificance of these amounts."

Unfortunately, the disclosure does not indicate whether the $2 million of hedge ineffectiveness was related to commodity, currency or interest rate hedging. But, based on the standard Sara Lee set for what it means by "not significant" we'll take it at face value the amounts involved were truly insignificant.