Commodity Risk Management

Updated on April 19, 2024
Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Commodity Risk Management?

Commodity risk is the risk a business faces due to a 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.

What Is Commodity Risk Management

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Commodities like primary goods or raw materials are traded in huge quantities. Therefore, there is always a requirement to control the effect of risk due to factors like price fluctuation, political and supply chain disruption, which may affect the supply and cost. Good risk management will help companies raise their profit margin and run the business efficiently.

Key Takeaways

  • Commodity risk is a company’s risk due to changes in a commodity’s price and other terms over time. Commodity risk management involves several strategies, such as hedging on the item through forwarding, futures, and options contracts.
  • Price risk, quantity risk, cost risk, and regulatory risk are the types of commodity risk.
  • Large enterprises with higher commodity risks frequently use financial institutions or risk management experts to control risk using financial market instruments—the risk management strategies from the perspectives of commodity producers and consumers.

Commodity Risk Management Explained

The process of commodity risk management involves designing strategies to control and mitigate the various risk related factors in the commodity market. The commodities are goods that are traded in the financial market in large volumes, namely agricultural products, metals and energy related products.

They are commonly faced with risks like price fluctuations, political disturbances among countries, natural disasters, supply chain related issues, etc, which lead to frequent price fluctuations and also scarcity of supply in the market. This again leads to rise in prices or cost, giving risk to risk at the global level.

Thus, it is important for companies and manufacturers to identify such risks on time so that they can be controlled and mitigated. Implementation of commodity risk management policy through proper price, supply and demand analysis, interpretation of political information and weather tracking system can help to a large extent.

There are also various hedging strategies available in the financial market which help to offset the potential losses due to frequent price movements. Through hedging, parties do commodity price risk management by entering into contract to lock prices for future transactions.

It is equally important to maintain a good relation among buyers and sellers, be it at the domestic market level or a t the international level, because they are the stakeholders who facilitate sharing of risk, maintain strong and efficient supply chain and design strategies that are mutually beneficial.

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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, increasing the cost of commodities they produce.
  •  Exporters/importers face the risk of the time lag between order and receipt of goods and exchange fluctuations.
  • A company should manage such risks appropriately to focus on its core operations without exposing the business to unnecessary risks.

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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Now let us move to understand how to measure commodity risk.

Methods Of Measurement

Risk measurement requires a structured approach across all strategic business units ((SBUSBUThe full form of SBU is Strategic Business Unit. A SBU is an independent department or a sub-unit of a large organization that is fully functional and focuses on a target market. It has its own mission, vision, direction, and objectives, as well as support functions like training and human resources. This unit reports directly to the headquarters of the concerned organization.read more) like the production dept, procurement dept, Marketing dept, Treasury dept, and department of risk. Given the type of commodity risk, many organizations will not only be exposed to a core commodity risk they are dealing with but may have additional exposures within the business. For example, commodity products such as steel are exposed to price movements. However, the changes in Iron ore, coal, oil, 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 currencies’ movements also impact the profitability/ cash flow.

Sensitivity analysis

Sensitivity Analysis a type of commodity risk management policy that is done by choosing arbitrary movements in commodity prices or basing commodity price movements on history.

For example, A copper mining company will calculate the risk based on how much it loses or gains 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

The risk is calculated using the combined result of currency and commodity price movements if the commodities are priced in foreign currency.

Portfolio Approach

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

For example, an organization 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.” In addition to sensitivity analysisSensitivity AnalysisSensitivity analysis is a type of analysis that is based on what-if analysis, which examines how independent factors influence the dependent aspect and predicts the outcome when an analysis is performed under certain conditions.read more 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 it 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 you understand what risks are and how to calculate the commodity risks. Let’s move ahead to understand Risk management strategies for commodities.

How To Manage? 

The commodity risk management strategies in the commodity market involves a combination of factors like market knowledge, financial skil and expertise, and proper assessment of risk. They again depend on the commodity type, industry type, company’s risk appetite and business objective. Risk management professionals are skilled in handling such situations. However, let us go through some techniques to manage the risk in commodity market.  

commodity risk management strategies

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

Large companies with greater commodity risks 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

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 the 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 be subject to the same price risk.

#2 – Flexibility:

It is a part of a diversification strategy. A flexible business can change in line with market conditions or events that may hurt business.

Price Risk Management

#1 – Price pooling arrangement: This commodity is collectively sold to a cooperative or marketing board, which sets the commodity’s price based on several factors that result in an average price for all those within the group.

#2 – Storing: In times where there is an increased production, which results in reduced selling price, some producers may store the production till a favorable price is obtained. However, when considering this, storage cost, the interest cost, insurance, and spoilageSpoilageSpoilage is defined as waste material released during the normal manufacturing process, where the spoiled material is known as scrap material if it is no longer useful.read more 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).

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, offer alternatives, or 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 to review the use of commodities within the business as risk compliant.

#3 – Production process review: This company usually regularly reviews the use of commodities in the production process to change the mix of products to offset commodity price increases.

Now that we understand how to manage the commodity risks from the producer and Buyer perspective let us go ahead to see the various financial market instrumentsFinancial Market InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more to manage the commodity risks.

Examples

Let us look at some suitable examples related to commodity risk management strategies to understand the process in which the risks are managed.

Example #1

In the case of a farm business, the rotation of crops to produce different products can significantly reduce the significant loss from price volatility.

While adopting 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.

Example #2

A steel company in a 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 the effect of improving financial performance.

Example #3

Manufacturers of food products continuously look for improvements in a product using less higher-priced or more volatile inputs such as sugar or wheat.

Financial Market Instruments to Manage the Commodity Risk

#1 – Forward contracts:

A forward contract is between two parties to buy or sell an asset at a specified future time at a price agreed upon today.

In this case, the risk of price changes is avoided by locking the prices.Forward Contract Example: Company “A” and Company “B” on 1st October 2016, entered a contract whereby company “A” sold 1000 tonnes of wheat to company “B” at INR 4000/tonne on 1st January 2017. Whatever 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 to a 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 purchases or sells the commodity under an agreement that gives the right and not the obligation to undertake a transaction at an agreed future date.Commodity Options example: Broker “A, “wrote 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, company “B” may exercise the option if the steel price is more than INR 30,000/tonne and may deny buying from “A” if the price is less than INR 30,000/tonne.

Frequently Asked Questions (FAQs)

What are the lessons learned about commodity risk management maturity?

The lessons learned about commodity risk management maturity are:
1.Start small with specific datasets when improving commodity risk management to avoid overwhelming managers with too much data.
2. Commodity risk management maturity depends on data quality, insight delivery, and procedures
3. To manage commodity risk effectively, teams must align insights with strategic goals. Accurate insights aren’t enough – they must support the business to be valuable.
4. AI and data science can benefit commodity risk management. Teams with the right skills can proactively stay ahead of trends.

Why is commodity risk management critical?

You can control financial transactions using commodity risk management. It includes listed options, OTC options, commodity swaps, commodity forwards, commodity futures, and commodity futures and analyzes the relevant master and market data. Your commodity price risks may be diagnosed with the help of commodity risk analytics.

What are the common challenges in commodity risk management?

The common challenges in commodity risk management are choosing the correct goals, locating the required skills, senior leadership engagement, performance measurement, and making success-driven incentives.

This article has been a guide to what is Commodity Risk Management. We explain how to manage, sectors exposed to the risk, types & methods of measurement.

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