cOMMODITY TRADINGWhITepApeR We have the

solution!

2

ContentsWhat Are Commodities? ................................................................................................................................ 3

Trading & Processing of Commodities ...................................................................................................... 4

Control .................................................................................................................................................................. 6

Flexibility ............................................................................................................................................................. 6

Satisfying the Contradiction ......................................................................................................................... 6

Visibility ................................................................................................................................................................ 6

Market Volatility ................................................................................................................................................ 7

Managing Risk ................................................................................................................................................... 7

Meeting the Challenges ................................................................................................................................. 8

ERP Resellers ...................................................................................................................................................... 8

Example of a Trade ........................................................................................................................................... 8

Buying the Commodity .................................................................................................................................. 9

Selling the Commodity .................................................................................................................................. 9

Shipping the Commodity .............................................................................................................................. 9

Example of a Manufacturing Commodity Purchase ..........................................................................10

Buying the Commodity ................................................................................................................................10

Taking Delivery of the Commodity ..........................................................................................................11

Using the Commodity ..................................................................................................................................11

Financial Transactions ...................................................................................................................................11

3

What Are Commodities?Commodities are generally raw materials or prime agricultural products that can be bought and sold. The definition of commodity may also be extended to materials that have been processed but where there is a recognized ‘commodity market’ such as steel, alu-minium and metal alloys.

By their very nature commodities are mainly natural materials and as such their availability and quality are dependent on many factors outside the control of the organizations trad-ing them. While the range of commodities is quite diverse the business issues associated with the trading of commodities are very similar in each sector.

While there are an infinite number of individual commodities they are generally grouped in to several main categories.

Commodities are found all round the world and many countries will be involved in the production, harvesting or mining of a wide range of commodities. However there are recognised geographical regions where some commodities are more dominant than others. For example, high volumes of mining commodities are produced in Australia.

The following diagrams give an indication of the different types of commodity and their key geographical sources.

Commodity Manufacturing Industry

Agricultural Coffee, Sugar, Coca, Grains & Cereals,

Metals Copper, Zinc, Nickel, Aluminium, Steel

Bulk Chemicals and Ores Iron, Potash

Energy Coal, LPG, Natural Gas, Petroleum & Oil

4

Trading & Processing of CommoditiesHistorically the trading of commodities has centred round large cities or ports, many of which were significant distances from the source of commodities.

For example, London was the first centre for trading coffee and cocoa. The merchants sourced the coffee and cocoa in faraway places then shipped them back to London and a market or exchange was established.

Minneapolis was one of the first agricultural trading centres because of its position at the head of two key rivers; the Missouri and the Mississippi, and it was the natural terminal port for the transportation of the large volumes of cereals grown on the plains.

See Example -1 at the end of this document for an Example of a Trade

As industrialisation grew the next logical step was to have major factories in the same regions that would process the commodities to finished goods. A good example of this is trading of cotton in Liverpool and the industrialisation and establishment of textile manufacturing factories in Manchester.

As commodities were sourced from a wider geographical area and transportation routes became more reliable companies were formed who took the control of the sourcing, transportation and selling of the commodities, acting as principals in the deal and tak-ing ownership of the risk associated with the business. These companies, or physical trading organizations, buy and sell from and to other trading organizations or to companies who will use the commodities to manufacturers.

While the trading of commodities is a specialised area the table above shows how diverse the impact of commodity trading is and also how integral to the manufacturing process it is.

Many manufacturing or processing companies have a need to procure com-modities and will have their own trading or purchasing department.

The increase in volume of commodities traded can be directly related to the demand for manufactured goods globally. The diagram below reflects the increase of exports of the main commodity groups over the last ten years.

The manufacturing companies who need raw commodities to meet their processing requirements form a significant number of all processing com-panies.

There are therefore potentially two inter-related market sectors that trade or procure commodities; Trading companies and Manufacturing companies.

Both types of organizations have common business problems and issues associated with commodities that need to be addressed.

See Example -2 at the end of this document for an example of Procurement for Manufacturing.

5

Trading Company StructureA Physical Commodity Trading company takes control of all aspects of the commodity trading lifecycle. This deals with sourcing the commodity, negotiating the contracts (buy and sell), arranging the transportation of the commodity from source to destination and all financial functions associated with the deal.

A manufacturing company that purchases commodities for their production process will generally deal with the buying of commod-ity from trading organizations or in some cases direct from the producer of the commodities; farmers, miners etc.

By their very nature commodities are variable products. You cannot guarantee that they will be available on a specific date or that the quality available will be exactly the same for every batch or load. For example, agricultural product availability and quality during a Harvest is dependent on weather and growing conditions up to, and during, harvest. Too much or too little rain affects the quality and quantity of the grain available. The weather can also affect when the grain is ready to be harvested.

These variables out with a trading company’s control mean that everyone has to be prepared to be flexible in terms of quality, quantity and availability of a commodity. This flexibility comes as second nature to many traders and logistics people but can cause problems, particularly in finance.

Finance usually want to know what they are paying for a commodity, when they are paying for it, what they are selling it for and what is the profit associated with the trade. This is just one of the Controls required throughout an organization.

6

ControlCommodities are traded under strict contractual terms with quantity, quality, price, payment and delivery terms defined for each contract. There may be financial penalties involved when contractual terms are not met.

As the trading of commodities is a global industry with some commodities being available only in specific geographic regions it is imperative that the control of as many aspects of trades is monitored and managed. In some cases the commodities are high value but with equally high costs associated with the movement of the commodity from origin to destination, the resulting margins can be very low. Cost control is essential to safeguard the profitability of a deal.

Companies will have Risk strategies in place which demand the close monitoring of position information, whether that be for physi-cal, derivative or foreign exchange positions, to minimise exposure and control risk in volatile markets.

FlexibilityFlexibility is required in many areas associated with trading commodities; delivery or shipping dates, quantity and quality. For exam-ple, a hurricane damages a coffee crop and the required grade cannot be supplied. The Trader either has to find a comparable grade or source the coffee from an alternative provider.

Traders have to be flexible in the commodities they can source and deliver in an ever changing and demanding market. The logistics department has to be flexible in the scheduling and delivery of the commodity. For example, a manufacturing plant has a breakdown in the production line, and the logistics department needs to divert the arranged deliveries to another plant.

Alternatively a load may be rejected by a customer for poor quality, so both trade logistics may quickly need to redirect the original load and source another load to meet the original contract requirement.

Satisfying the ContradictionIn order to provide the control and flexibility required it is essential that a trading organization or department has immediate access to accurate up to date contract and logistics information from one central source of data.

Access to such information enhances the ability for a trading company to be pro-active in a fast changing market while at the same time providing the contractual and financial controls necessary to minimise risk and maximise profit.

VisibilityThe availability of accurate up to date contract, logistics and risk information raises the profile of commodity trading related depart-ments. With CT fully integrated with a comprehensive ERP solution that offers powerful financial controls provides visibility of the whole process so that decisions are being made utilizing all known factors.

Visibility of all CT related data to everyone in the organization provides the following:

• One central source of data

• Integration with financial processes

• Improved communications – Internal and External

• Ability to be pro-active to changing market conditions

7

Market VolatilityCommodity contracts may be agreed months or years in advance of the actual supply of the commodity. These contracts, called For-ward contracts, are a contracted commitment for a trading organization which it must meet. The supply or demand for a command is heavily influenced by many factors including natural disasters and economic conditions. As such the current or market prices for commodities will vary according to such changes.

There are several issues that a trading department has to address around forward contracts and market volatility.

When buying and selling commodities under contract a trading organization must monitor its commodity position on a regular basis. A Physical position reflects, for each commodity, the quantity a company has available.

Position is generally calculated as:

Inventory + Buy Contracts - Sales ContractsIn an ideal world the position nets out to zero. There are other factors that play a part in position; delivery periods, Inco terms and source and destinations. A company may have a square (ideal) position but the commodity could be sourced in Australia and to be delivered in Europe; not ideal as shipping time is a factor and transportation costs need to be taken in to account to ensure a profit-able deal.

Trading organizations have to monitor not only quantity but time periods, locations and associated costs. Not an easy task if the information is not readily available to everyone and it is continuously changing.

As mentioned previously market prices for commodities change on a regular basis. Trading companies will therefore monitor what their overall exposure to a market is by calculating the value of their open contracts against the current market price and determining a Mark to Market Value and a theoretical Profit or Loss against that Market value. Again, time, locations and costs have to be taken in to account.

There are also regulatory Financial requirements around Mark to Market Valuation that a company has to comply with.

The easiest of tasks becomes a huge logistical problem if position and mark to market values are not readily available.

Managing RiskProducing Position reports and Mark to Market reports all help an organization to manage Risk.

For a commodity trading organization, the term Risk applies to a number of different factors associated with commodities; Price, Quantity, Costs, Currency.

There are recognised strategies for dealing with each of the above.

Price and Quantity risk can be managed or Hedged for commodities that have a recognized Futures Exchange. Futures Exchanges, such as NYMEX, LME, are regulated organizations that will allow commodities to be traded for future delivery periods at pre-agreed prices. This can then allow a trading organization to hedge their physical contracts with future contracts, allowing them to either en-sure a source or outlet for commodity at a known price. The exchanges also publish market prices or indexes that are used through-out trading for valuation or rice fixing purposes.

Contracts and costs associated with a contract may involve different currencies and as such an organization will have a foreign ex-change exposure. These exposures have to be managed. This is done by agreeing foreign currency contracts at an agreed conversion rate thus allowing an organization to ‘lock in’ the conversion rate and help manage currency risk.

All aspects of managing risk require tight controls to be in place in an organization to meet both financial and regulatory require-ments. However these controls cannot hinder or restrict the actual trading of the commodities.

8

Meeting the ChallengesCommodity related organizations in many ways have similar challenges to other types of business; manage costs, increase revenue drive efficiencies to aid the bottom line. However unlike the majority of businesses who can rely on standard ERP solutions to provide standard functions and processes to help overcome their business issues, commodity related organizations do not have that luxury.

Taking a superficial look at the needs of a commodity related organization may lead many people to believe that standard purchase order and sales order functionality would satisfy their requirements. It is only when you investigate the requirements in more detail and account for the complexities of the business that it becomes obvious that standard ERP functionality does not address the issues.

As a result many trading organizations have disparate standalone solutions for different parts of their business. It is not an exaggera-tion to say that commodity trading organizations are one of the biggest users of Excel. These are companies with hundreds of millions of dollar revenue streams operating without an integrated solution.

Commodity related organizations need a single solution that ties all the systems; trading, logistics and finance together so that man-agement has one version of the truth and can better manage the business as a whole.

Commodity organizations manage Risk in terms of market volatility and exposure on a daily basis when in fact it is the systems that many of them rely on, manual or computerized, that pose the biggest risk to the organization.

Manufacturing organizations that purchase Commodities need to manage the same market volatility and exposure as a trading or-ganization, but they have an additional layer of complexity because the goods procured drive production and production planning. Therefore it is even more important that commodity trading or procurement and all its associated requirements are an integral part of the Extended Supply Chain.

ERP ResellersERP VARs for Manufacturing organizations can offer a unique value proposition if they understand the nature of buying commodi-ties. More processes can be taken out of Excel or Custom applications and brought into the core ERP implementation. This gives the Reseller the opportunity to differentiate their services from other ERP Vendors and Resellers by providing a solution to common problem.

The risk associated with purchasing commodities for manufacturing can be great ---in many cases core ingredients that have the most impact on the final cost of goods are commodities. If a VAR can show a CEO/CFO/COO that they would have a complete view of their costs ---including long term contracts for materials/ingredients/parts/fuel then there is a greater opportunity to sell that ERP solution. Resellers have a better win ratio if direct value is demonstrated to the C-Level executives.

Example -1

Example of a TradeThe trading organization, based in London, buys 10000 metric tonnes of potash at US$600 per metric tonne, FOB Alexandria from a producer in Egypt. The commodity will be shipped in March.

The trading organization then sells the commodity to a fertiliser manufacturing company in the Netherlands at a price of Euro850 per metric tonne, CIF Rotterdam. Delivery period is April.

In the above example the trading organization is responsible for:

• Buying the commodity

• Arranging the shipping of the commodity from Alexandria to Rotterdam

• Discharging the commodity in Rotterdam.

9

Buying the CommodityThe trading organization is based in London and all financial transactions are taken back to its Home currency of GBP. This means that there is a foreign exchange currency exposure from USD to GBP. This has to be managed as part of the Risk associate with the contract.

The trading organization is responsible for the costs associated with the shipping of the commodity and any associated costs with shipping the commodity from Alexandria to Rotterdam. These costs will include Sea freight, Agents Fee, Inspection Fees, Custom Documents. All costs will be estimated by the trader at the time the contract is agreed. Costs may be incurred in any currency.

The contract will appear in the Commodity Position for March.

Selling the CommodityThe trading organization has sold the commodity CIF and is therefore responsible for all costs of shipping, inspection etc. up to the point the cargo is discharged in Rotterdam.

The commodity has been sold in Euros and this in turn gives rise to a foreign exchange currency exposure between Euro and GBP.

The contract will appear in Commodity Position for April.

Shipping the CommodityThe trading organization arranges for the commodity to be shipped in two lots of 5000 metric tonnes.

The freight rate for the first shipment is US$75 per metric tonne and US$80 per metric tonne for the second shipment.

Financial Transactions

The above example results in a number of different financial transactions;

• Invoice(s) from the supplier of the commodity

• Invoices to the customer for the sale of the commodity

• Invoices for the costs associated with the shipping of the commodity

» Freight

» Agents

» Inspection

• All financial transaction must be recorded using the appropriate foreign currency exchange rate.

• The AP invoices will be received at different times and must be tied back to both the appropriate shipment and contracts to ensure accurate profitability reporting.

• Initial estimates of the cost must be accrued for multiple purposes including checking the costs on the actual invoices when they are received.

The above is a very simple example of a commodity trade but even then the management and monitoring of all contract and ship-ping elements is complex; foreign exchange rates, estimated and actual costs comparison, position monitoring, ensuring delivery and shipping dates are met.

With so many elements to be monitored and managed it can be time consuming, ineffective and inefficient operation.

10

Example -2

Example of a Manufacturing Commodity PurchaseA fertiliser manufacturer with plants in Rotterdam and Brussels has forecast that it will need 10000 metric tonnes of potash in April. This forecast is based on sales budgets and has been produced at the beginning of the trading year. This forecast is revised on a monthly and weekly basis using revised forecasts and actual sales orders.

The company has to commit in advance to buy the potash from a trading company. The commodity procurement department and manufacturing/processing department do not use the same software systems.

The manufacturer buys the 10000 metric tonnes at Euro 850 per metric tonnes CIF Rotterdam for delivery April. (see example for the trading company above).

In the above example the manufacturing company is responsible for the commodity once it has been discharged from the ship at Rotterdam. The company will have to arrange transport to take it in to inventory at its own stores or to a third party store.

Buying the CommodityThe commodity procurement department negotiates and arrange the buy contract with the commodity trading organization. The contract will appear in the potash position for April. The trader will record estimates for transportation of the commodity in the port and to the manufacturing plants as well as any other costs that might be incurred.

11

Taking Delivery of the CommodityThe commodity procurement department will be notified of each shipment of the commodity (two shipments in the example above). On receipt the procurement department will review the anticipated demand for the commodity from the two processing plants. They will decide if the commodity is to be delivered directly to the plants or if it is to be stored in a store not directly tied to either of the plants. In this example the commodity will be transferred by road but it may be any form of transport.

Movement instructions will be prepared for transport companies telling them the quantity and destination where the commodity is to be taken. Each movement instruction will be for a specific date or range of dates. Company policy will dictate whether a move-ment instruction is for one load or multiple loads. As the loads are uplifted from the docks and delivered to the stores individual load details will be recorded. This information has to be recorded and used to update the buy contract, inventory and MI details.

Using the CommodityIn this example, the processing requirements are reviewed on a weekly basis by the manufacturing plants. The processing require-ments are based on up to date demand. It is unlikely that each plant has sufficient commodity on site to be able to satisfy all the demand.

The plant has to then ask the commodity procurement department which commodity contacts or inventories can be used to meet the processing requirements. The commodity procurement department has to then make the decision to use existing inventory, ex-isting buy contracts or go out to the spot market and buy more commodity. When these decision have been made the commodity procurement department either has to notify the individual plants which contracts or inventories can be used or they will notify the logistics department.

Regardless of who makes the arrangements movement instructions will be sent to transport companies detailing quantities to be delivered to the plants and when they are to be delivered. This is a key function to ensure that the deliveries are scheduled correctly as there may be storage constraints for the commodity at the plant and to keep the production lines running.

Every movement instruction will have freight costs associated with it. These costs have to be taken in to account for accurate inven-tory costs.

A movement instruction will have one or many loads associated with it.

Financial TransactionsThere are numerous financial transactions associated with the above example. These include:

• Purchase invoices for the Buy contract

• Freight invoices for the movement instructions

• Cost accruals for accurate inventory valuations

• Recording of actual invoices for costs

The above is a relatively simple example involving only one commodity and two production plants. In real life this has to be repeated for many commodities and plants.

Contracts, Movement instructions, inventory levels, outstanding invoices all have to be monitored and managed. This is complicated in many cases because multiple departments are involved and in many cases multiple disparate computer systems add to the com-plexity.

Your contact detail here