Risk Management Basics
- Derivatives Basics
- Put-Call Parity
- Forwards vs Futures
- Spot Rate
- Forward Rate Formula
- Cash Settlement vs Physical Settlement
- Backwardation vs Contango
- Residual Risk
- Best Futures Books
- Futures vs Options
- What are Options in Finance?
- Exercise Price (Strike Price)
- In the Money
- Options Trading Strategies
- Call Options vs Put Options
- Options vs Warrants
- Writing Call Options
- Writing Put Options
- Gamma of an Option
- Options Trading Books
- International Option Exchanges
- Interest Rate Derivatives
- Interest Rate Swap
- Swap Rate
- Random vs Systematic ErrorÂ
- Equity Strategies
- Swaps in Finance
- Embedded Derivatives
- Commodity Derivatives
- Commodity Risk Management
- Managed Futures Strategy
- Top 7 Best Books on Derivatives
- Structured Finance Jobs
- Commodities Trading Books
- Best Commodities Books
Commodity Risk Management – Commodities risk is the risk due to which business financial performance is adversely affected by fluctuations in the prices of commodities. In this article on Commodities Risk management, we look at the various commodity risks and the tools to manage those risks –
- Which sectors are exposed to Commodities Risk?
- What are the types of Commodity Risk?
- Methods of Measuring Commodity Risk
- Commodity Risk management Strategies
- Commodity Risk Management Strategies for Producers
- Commodity Risk Management Strategies for Buyers
- Financial Market Instruments to Manage the Commodity Risk
Which sectors are exposed to Commodities Risk?
- Generally, producers of following sectors are mostly exposed to price falls, which means they receive less revenue for commodities they produce.
- Mining and Minerals sector like Gold, steel, coal etc
- Agricultural sector like wheat, cotton, sugar etc
- Energy sectors like Oil, Gas, Electricity etc.
- Consumers of commodities like Airlines, Transport companies, Clothing and food manufacturers are primarily exposed to rising prices, which will increase the cost of commodities they produce.
- Exporters/importers face the risk from the time lag between order and receipt of goods and exchange fluctuations.
- In a company such risks should be appropriately managed so that they can focus on their core operations without exposing a business to unnecessary risks.
What are the types of Commodity Risk?
The risk which a commodity player can be broadly categorized into following 4 categories.
- Price risk: Due to adverse movement in prices of commodities as determined by the macro- economic factors.
- Quantity Risk: This risk arises due to changes in the availability of commodities.
- Cost risk: Arises due to adverse movement in the prices of commodities which impact business costs.
- Regulatory risk: Arises due to changes in laws and regulations which is having an impact on prices or availability of commodities.
Now let us move to understand how to measure commodity risk.
Methods of Measuring Commodity Risk
Measurement of risk requires a structured approach across all strategic business units like production dept, procurement dept, Marketing dept, Treasury dept, department of risk. Given the type of commodity risk many organizations will not only be exposed to a core commodity risk in which they are dealing but may have additional exposures within the business.
For example: A commodity producer such as steel is obviously exposed to movements in steel prices , however, the changes in Iron ore, coal, oil prices and natural gas prices also affect the profitability and cash flow. In addition, if any imports or exports happen, then the movements in the currencies also have an impact on the profitability/ cash flow.
Sensitivity Analysis is done by choosing arbitrary movements in commodity prices or basing commodity price movements in past history.
For example: A copper mining company will calculate the risk, on the basis of how much it loose or gain based on the downward or upward movement of copper prices and related input commodities to make copper.
Currency used – INR (Indian rupee)
|Current copper price INR 35000/tonne||Scenario-1||Scenario-2||Scenario-3|
|Copper price per tonne (under different scenarios)||INR 30000||25000||36000|
|Annual tonnage of company “A”||100000 tonnes||100000 tonnes||100000 tonnes|
|Movement in prices||(5000)||(10000)||1000|
|Commodity “price” risk||INR 500 mn loss||INR 1000 mn loss||INR 100 mn profit|
In case the commodities are priced in foreign currency, risk is calculated by taking the combined result of currency and commodity price movements.
In a portfolio approach, the company analyses commodity risk along with a more detailed analysis of potential impact on financial and operating activities.
For example: Organization that is exposed to changes in crude oil prices in addition to scenario testing of changes in crude oil prices also analyze the potential impact of the availability of crude oil, changes in political policies and impact on operational activities by any one of these variables.
In portfolio approach, the risk is calculated utilizing stress testing for each variable and combination of variables.
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Value at Risk
Some organizations particularly financial institutions use a probability approach when undertaking sensitivity analysis known as “Value at Risk”. In this in addition to sensitivity analysis of changes in prices discussed above, the companies analyze the probability of event occurring.
Accordingly, sensitivity analysis is applied using past price history and applying to current exposure to model the potential impact of commodity price movements on its exposures.
For example: Incase of Value at Risk, Sensitivity analysis of a steel company can be analyzed based on steel and iron ore prices over past 2 years, given the quantified movement in commodity prices, It can be 99% confident that it will not experience a loss of more than a particular amount.
I hope now you understand what risks are and how to calculate the commodity risks. Let’s move ahead to understand Risk management strategies for commodities.
Commodity Risk management Strategies
The most appropriate method of managing risk depends on organization to organization and depends on following factors
- Process of Production
- Strategies adopted by company in marketing
- Sales and purchases timing
- Hedging products available in the market
Large companies with greater commodity risks will often appoint financial institutions or risk management consultants to manage risk through financial market instruments.
Now I will discuss the risk management strategies in two angles
- Producers of commodities
- Buyers of commodities
Commodity Risk Management Strategies for Producers
Strategic Risk Management
#1 – Diversification:
In the case of diversification, the producer generally, rotates his production (Either rotation through different products or rotation of production facility of the same product) to manage the price risk or cost risk associated with production. While adopting diversification producer should ensure that alternative product should not subject to same price risk.
Diversification example: In the case of a farm business, rotation of crops to produce different products can greatly reduce the large loss from price volatility.
While adopting the diversification producers may incur significant costs in the form of reduced efficiencies and lost economies of scale while resources are diverted to a different operation.
#2 – Flexibility:
It is a part of a diversification strategy .Flexible business is one that has the ability to change in line with market conditions or events that may have an adverse impact on business.
Flexibility Example: A steel company in falling prices scenario may instead of producing steel using coal may use low cost pulverized coal which has the same affect with lower cost. This flexibility has effect of improving financial performance.
Price Risk Management
#1 – Price pooling arrangement: In this commodity is collectively sold to a cooperative or marketing board, which sets the price of the commodity based on a number of factors that result in an average price for all those within the group.
#2 – Storing: In times where there is an increased production which resulted in reduced selling price, some producers may store the production till a favorable price is obtained. However, when considering this, storage cost, interest cost, insurance and spoilage costs needs to be considered.
#3 – Production contracts: In the case of production contracts, the producer and buyer enter contract usually covering price, quality and quantity supplied. In this case, the buyer typically retains the ownership over production process(This is most prevalent in the case of live stocks).
Commodity Risk Management Strategies for Buyers
The following are most common methods of managing commodity price risk for the business of purchasing commodities.
#1 – Supplier Negotiation: In this buyer approaches supplier for an alternative pricing plan. They may lower prices on increased volume purchases or offer alternatives or may suggest a change to supply chain process
#2 – Alternative sourcing: In this buyer appoint an alternative producer for getting same product or approach a different producer for substitute product in the production process. Companies generally have strategies in place to review the use of commodities within the business are risk compliant.
#3 – Production process review: In this company usually review the use of commodities in production process regularly with a view to change the mix of products to offset commodity price increases.
Example: Manufacturers of food products continuously look for improvements in a product using less of higher priced or more volatile inputs such as sugar or wheat.
Now that we understand the how to manage the commodity risks from producer and Buyer perspective, let us go ahead to see what are the various financial market instruments to manage the commodity risks.
Financial Market Instruments to Manage the Commodity Risk
#1 – Forward contracts:
A forward contract is simply a contract between two parties to buy or to sell an asset at a specified future time at a price agreed today.
In this case, the risk of changes in the prices is avoided by locking the prices.
Forward Contract Example: Company “A” and Company “B” on 1st Occtober 2016 enters a contract where by company “A” sells 1000 tonnes of wheat to company “B” at INR 4000/tonne on 1st Jan 2017. In this case whatever is the price on 1st Jan 2017, “A” has to sell “B” 1000 tonnes at INR 4000/tonne.
#2 – Futures contact:
On a simple sense futures and forwards are essentially same except that Futures contract happens on Futures exchanges, which act as a market-place between buyers and sellers. Contracts are negotiated at futures exchanges, which act as a marketplace between buyers and sellers. The buyer of a contract is said to be long position holder, and the selling party is said to be short position holder. As both parties risk their counter-party walking away if the price goes against them, the contract may involve both parties lodging a margin of the value of the contract with a mutually trusted third party.
Also, have a look at Futures vs Forwards
#3 – Commodity options:
In the case of commodity options a company purchase or sell the commodity under an agreement that gives the right and not the obligation to undertake transaction at an agreed future date.
Commodity Options example: Broker “A “written a contract to sell 1 lakh tonnes of steel to company “B” at INR 30,000/tonne on 1st Jan 2017 at premium of Rs 5 per tonne. In this case company “B” may exercise option if the price of steel is more than INR 30,000/tonne and may deny buying from “A” if the price is less than INR 30,000/tonne.
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- Embedded Derivatives
- What are Options?
- Options Trading Strategies
- Swaps in Finance