20.2 Commodity Price Risk

Commodity price risk can wreak havoc on businesses, affecting profitability and cash flows. Companies face uncertainty due to fluctuations in raw material prices, impacting everyone from farmers to manufacturers. The level of exposure varies by industry and position in the supply chain.

To combat this risk, businesses employ various hedging strategies. Long-term contracts, vertical integration, futures contracts, and commodity derivatives each offer unique advantages and drawbacks. The effectiveness of these strategies depends on factors like risk tolerance, market conditions, and the nature of commodity exposure.

Commodity Price Risk and Hedging Strategies

Commodity price risk definition

• Financial uncertainty businesses face due to fluctuations in raw material or commodity prices
  • Agricultural products (wheat, corn, soybeans), energy resources (oil, natural gas), and metals (gold, copper, aluminum)
• Price volatility significantly impacts company profitability and cash flows
  • Rising prices increase production costs, reducing profit margins (manufacturing companies)
  • Falling prices lead to inventory write-downs or reduced revenue for commodity producers (mining companies)
• Exposure varies depending on industry and role in the supply chain
  • Producers (farmers), consumers (food processors), and traders (commodity trading firms) directly affected
  • Businesses relying on commodities as inputs indirectly exposed (construction companies using steel)
• Risk exposure can be influenced by market volatility and global economic conditions

Hedging strategies comparison

• Long-term contracts:
  • Agree on fixed price for commodity over extended period (6 months to several years)
  • Provide price stability and predictability for buyers and sellers
  • Limit ability to benefit from favorable price movements
• Vertical integration:
  • Company controls multiple supply chain stages, such as production and distribution (oil companies owning refineries)
  • Reduces exposure to price fluctuations by internalizing commodity supply
  • Requires significant capital investment and may lead to operational complexity
• Futures contracts:
  • Standardized agreements to buy or sell specific quantity of commodity at predetermined price on future date
  • Allow companies to lock in prices and mitigate impact of price volatility (airline companies hedging jet fuel prices)
  • Require active management and may involve basis risk (difference between futures price and local spot price)
• Commodity derivatives:
  • Financial instruments whose value is derived from underlying commodity prices
  • Include options, forwards, and swaps, offering flexibility in risk management strategies

Advantages vs disadvantages of hedging

• Long-term contracts:
  • Advantages: Price stability, predictability, reduced exposure to short-term fluctuations
  • Disadvantages: Lack of flexibility, potential opportunity costs if market prices become more favorable
• Vertical integration:
  • Advantages: Greater supply chain control, reduced price volatility exposure, potential cost savings through economies of scale
  • Disadvantages: High capital requirements, increased operational complexity, reduced flexibility to adapt to changing market conditions
• Futures contracts:
  • Advantages: Flexibility, liquidity, ability to lock in prices without physical delivery
  • Disadvantages: Basis risk, margin requirements, need for active management and monitoring
  • Hedging ratio can be adjusted to balance risk mitigation and potential market opportunities

Effectiveness of risk management strategies

• Effective commodity price risk management:
  1. Stabilizes cash flows
  2. Improves budgeting and forecasting
  3. Enhances overall financial performance
• Choice of hedging strategy depends on:
  • Company's risk tolerance
  • Market conditions
  • Nature of commodity exposure
• Regular monitoring and adjustments necessary to ensure effectiveness
• Align hedging strategies with company's overall financial objectives and integrate into risk management framework
• Evaluate effectiveness using metrics:
  • Reduced volatility in costs or revenues
  • Improved margins
  • Better cash flow predictability
• Use sensitivity analysis and stress testing to assess hedging strategy robustness under different market scenarios
• Effective communication and collaboration between finance, procurement, and other relevant departments crucial for successful commodity price risk management

Additional Risk Management Tools

• Commodity indices: Provide benchmarks for tracking overall commodity market performance
• Price discovery: Process of determining fair market value of commodities through trading activities
• Commodity swaps: Agreements to exchange cash flows based on the price of an underlying commodity, useful for long-term hedging