Dynamic Risk Management of Commodity Operations: Model and Analysis

Abstract

Adverse commodity prices can cause significant negative cash flows and expose firms that deal in commodities to financial distress. In this paper we consider the dynamic risk management problem for a commodity processor operating in a partially complete market, facing both price uncertainty and significant financial distress costs. The firm procures an input commodity, processes it to produce an output commodity, and trades the output commodity in each period over a multi-period horizon. The firm's objective is to dynamically and jointly plan operational and financial hedging decisions to maximize the market-based value of cash flows under a time-consistent risk measure. We show that the optimal operational policy has the same price and horizon dependent threshold structure that obtains when markets are complete. We also characterize conditions under which a myopic policy is optimal. We present numerical studies to illustrate that: (i) compared to using a myopic policy or a policy that neglects to model financial distress costs, the advantage of using the optimal policy is significant for firms that face moderate financial distress costs and have excess procurement capacity, (ii) more acute financial distress costs reduce the firm's market-based value and throughput, and (iii) financial hedging provides considerable benefit by reducing the incidence of large negative cash flows.

Keywords: Risk management, storable commodities, time-consistent risk measures, partially complete markets