Commodity risk

What is Commodity Risk?

Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following kinds of risks:

  1. Price risk is arising out of adverse movements in the world prices, exchange rates, basis between local and world prices. The related price area risk usually has a rather minor impact. Factors that can affect commodity prices include political and regulatory changes, seasonal variations, weather, technology and market conditions.
  2. Quantity or volume risk.
  3. Cost risk (Input price risk).
  4. Political risk.

Commodity risk is the potential for changes in commodity prices to result in losses. Commodity prices tend to be volatile and can change rapidly over the short term. It’s also possible for prices to shift higher or lower for long periods of time, a phenomenon known as a commodities super cycle. Many industries take commodities as a basic input and are highly sensitive to changes in prices.

Groups at Risk

There are broadly four categories of agents who face the commodities risk:

  1. Producers (farmers, plantation companies, and mining companies) face price risk, cost risk (on the prices of their inputs) and quantity risk.
  2. Buyers (cooperatives, commercial traders and trait ants) face price risk between the time of up-country purchase buying and sale, typically at the port, to an exporter.
  3. Exporters face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion.
  4. Governments face price and quantity risk with regard to tax revenues, particularly where tax rates rise as commodity prices rise (generally the case with metals and energy exports) or if support or other payments depend on the level of commodity prices.

Commodity Risk Management

When a company has exposure to commodities, it must decide how to manage the financial risk associated with price movement. Commodity risk is complicated and responsibility for mitigating risk can fall across disparate departments like procurement, treasury, and supply chain.

Nonetheless, with an effective risk management program, companies can gain a consolidated view of their risk and significant benefits in the form of reduced volatility and improved forecasting. Understanding market swings, quantifying net exposures, valuing hedges, and determining applications for hedge accounting all work toward establishing a firm handle on the risks and how to effectively manage them.

Unexpected changes in commodity prices can reduce a producer’s profit margin, and make budgeting difficult. Fortunately, producers can protect themselves from fluctuations in commodity prices by implementing financial strategies that will guarantee a commodity’s price (to minimize uncertainty) or lock in a worst-case-scenario price (to minimize potential losses). Futures and options are two financial instruments commonly used to hedge against commodity price risk.

The main Commodity Risk Management processes are:

  • Identify risk factors;
  • Prioritize the risk factors, defining the most relevant for the business;
  • Measure the relevant risks;
  • Define quantitative limits to risk exposure;
  • Monitor the evolution of the exposure against the limits;
  • Managing the limit trespassing events.