Commodity Risk Management

Commodity Risk Management Definition

Commodity risk is the risk a business faces due to change in the price and other terms of a commodity with a change in time and management of such risk is termed as commodity risk management which involves various strategies like hedging on the commodity through forwarding contract, futures contract, an options contract.

Which sectors are exposed to Commodities Risk?

  • Generally, producers of the following sectors are most exposed to price falls, which means they receive less revenue for commodities they produce.
    • Mining and Minerals sector like Gold, steel, coal, etc
    • The 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 in which a commodity player can be broadly categorized into the following four categories.

Types of Commodity Risk

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  • Price Risk: Due to adverse movement in prices of commodities as determined by the macroeconomic 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 that 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 (SBU) like the 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, commodity products such as steel are obviously exposed to movements in steel prices. However, the changes in Iron ore, coal, oil prices, and natural gas prices also affect profitability and cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more.  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

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 lose 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/tonneScenario-1Scenario-2Scenario-3
Copper price per tonne (under different scenarios)INR 300002500036000
Annual tonnage of company “A”100000 tonnes100000 tonnes100000 tonnes
Movement in prices(5000)(10000)1000
Commodity “price” riskINR 500 mn lossINR 1000 mn  lossINR 100 mn profit

In case the commodities are priced in foreign currency, the risk is calculated by taking the combined result of currency and commodity price movements.

Portfolio Approach

In a portfolio approach, the company analyses commodity risk along with a more detailed analysis of the potential impact on financial and operating activities.

For example, an Organization that is exposed to changes in crude oil prices in addition to scenario testing of changes in crude oil prices also analyzes the potential impact of the availability of crude oil, changes in political policies, and impact on operational activitiesOperational ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more by any one of these variables.

In a portfolio approach, the risk is calculated utilizing stress testing for each variable and a combination of variables.

Value at Risk

Some organizations, particularly financial institutions, use a probability approach when undertaking sensitivity analysis known as “Value at Risk.” This, in addition to sensitivity analysis of changes in prices discussed above, the companies analyze the probability of the 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: In the case of Value at Risk, the Sensitivity analysis of a steel company can be analyzed based on steel and iron ore prices over the past two 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 

Commodity-Risk-Management

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The most appropriate method of managing risk depends on the organization to organization and depends on the following factors

  • Process of Production
  • Strategies adopted by the 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 from two angles

  1. Producers of commodities
  2. 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, producers should ensure that alternative products should not subject to the 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 high 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. A 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 use low-cost pulverized coal, which has the same effect at a lower cost. This flexibility has an 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 need to be considered.

#3 – Production contracts: In the case of production contracts, the producer and buyer enter a contract, usually covering price, quality, and quantity supplied. In this case, the buyer typically retains ownership over the production process(This is most prevalent in the case of live stocks). 

Commodity Risk Management Strategies for Buyers 

The following are the most common methods of managing commodity price risk for the business of purchasing commodities.

#1 – Supplier Negotiation: This buyer approaches suppliers for an alternative pricing plan. They may lower prices on increased volume purchases or offer alternatives or may suggest a change to the supply chain process

#2 – Alternative sourcing: In this buyer, appoint an alternative producer for getting the same product or approach a different producer for substitute productsSubstitute ProductsAny alternative, replacement, or backup of a primary product in the market is referred to as a substitute product. It refers to any commodity or combination of goods that might be used in place of a more popular item in normal circumstances without affecting the composition, appearance, or utility.read more in the production process. Companies generally have strategies in place to review the use of commodities within the business is risk compliant.

#3 – Production process review: In this company usually review the use of commodities in the 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 how to manage the commodity risks from the 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 October 2016 enters a contract whereby company “A” sells 1000 tonnes of wheat to company “B” at INR 4000/tonne  on 1st January 2017. In this case, whatever is the price on 1st January 2017, “A” has to sell “B” 1000 tonnes at INR 4000/tonne.

#2 – Futures contract:

In a simple sense, futures and forwards are essentially the same except that the Futures contract happens on Futures exchanges, which act as a marketplace 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 belong position holder, and the selling party is said to be a short position holderShort Position HolderA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more. As both parties risk their counterparty 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. ForwardsFutures Vs. ForwardsForward contracts and future contracts are very similar. Still, the key distinction is that futures contracts are standardized contracts traded on a regulated exchange, whereas forward contracts are OTC contracts, which stand for "over the counter."read more

#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 January 2017 at a premium of Rs 5 per tonne. In this case, the company “B” may exercise the 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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