Inventory Management and Financial Hedging of Storable Commodities

This paper studies the integrated physical and financial risk management of storable commodities used as inputs in end-products facing uncertain demand. In our stylized model, we study a problem of dual sourcing with financial hedging for a risk averse buyer (the seller of the end product) who procures a single storable commodity from a supplier via a flexible long-term contract and “tops up” via short-term purchases from a spot market. The spot market has adequate supply (i.e., market liquidity is assumed) but a random price. To hedge the uncertainty of the spot price and the end-product customer demand, the buyer can trade financial contracts written on the spot market prices such as forward contracts, call and put options. We obtain multi-period optimal inventory and financial hedging policies for a risk averse buyer with an inter-period mean-variance objective. For most cases, the optimal policies are myopic and easy to compute and implement. We examine different cases of financial hedging, single hedges and portfolio hedges, and characterize their optimal hedging amounts and portfolio structure. For optimal portfolios (use of forwards and call/put options) the allocation of funds to the various hedges can be obtained via the solution of a system of linear equations. We also offer insights on the role and impact of the operational and financial hedging on the profitability, risk control, and service level to the customer.For many cases better operational or financial hedging improves the end-customer service level via allowing more aggressive inventory policies.