Commodity Risk Management Definition

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, etcThe agricultural sector like wheat, cotton, sugar, etcEnergy 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.

What are the types of Commodity Risk?

The risk in which a commodity player can be broadly categorized into the following four categories.

  • Mining and Minerals sector like Gold, steel, coal, etcThe agricultural sector like wheat, cotton, sugar, etcEnergy sectors like Oil, Gas, Electricity, etc.

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  • Price Risk: Due to adverse movement in prices of commodities as determined by the macroeconomic factorsThe Macroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more.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 impact prices or availability of commodities.

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

Methods of Measuring Commodity Risk

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 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)

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.

Commodity Risk Management Strategies 

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

  • Process of ProductionStrategies adopted by the company in marketingSales and purchases timingHedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more products available in the market

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

  • Producers of commoditiesBuyers of commodities

Commodity Risk Management Strategies for Producers 

Strategic Risk Management

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.

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 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.

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

Flexibility Example: 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.

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).

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, 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.

Example: Manufacturers of food products continuously look for improvements in a product using less 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 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.

Financial Market Instruments to Manage the Commodity Risk

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.

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

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.

  • Embedded Derivatives MeaningEmbedded Derivatives MeaningEmbedded derivatives are when a derivative contract is disguised in a nonderivative host contract (either debt or equity component) that does not pass through the profit and loss account and therefore a part of the cash flow is dependent on an underlying asset while another part of the cash flow is fixed.read moreWhat are Options?What Are Options?Options are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read moreOptions Trading StrategiesOptions Trading StrategiesOptions trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index.read moreSwaps in FinanceSwaps In FinanceSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more