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Commodity Price Risk: A Guide to the Impacts and Solutions

Mar 20 2024

Over recent years we’ve seen some dramatic movements in the commodity market, the most recent example being cocoa. The price on for the front-month ICE cocoa contract on March 15th 2023 was $2,616 per tonne and now stands at $8,303 (15th March 2024), having long-eclipsed the record high set in 1977 of $5,379. 2022 saw palm oil, brent and natural gas prices all allied aggressively. These are just a couple of examples of the volatility in the cost base of manufacturers and such movement in price can drastically impact a company's bottom line.

How do we define Commodity Price Risk?

Commodity price risk refers to the potential financial loss that businesses or investors may face due to fluctuations in the prices of commodities. These commodities can include raw materials like industrial metals or precious metals, energy commodities like oil and natural gas, agricultural products, and packaging materials. 
The uncertainty in commodity prices can significantly impact the profitability and financial stability of companies that produce, trade, or consume these commodities. As such, managing commodity price risk is crucial for businesses involved in commodity-dependent sectors.

Even businesses that don’t buy direct raw materials can be exposed to commodity price fluctuations as increased prices can easily be passed through directly to buyers of finished goods. Businesses that buy any manufactured goods, or raw materials are exposed to commodity price volatility.

What causes Commodity prices to fluctuate?

At a purely economic level, commodity prices are a function of the demand and supply of the commodities. From that sense, prices fluctuate due to changes to the supply and demand dynamics of the commodity market. Therefore, anything that impacts the supply or demand of a commodity can impact the price and lead to volatility. Common factors that can lead to price volatility in commodity markets include:

  • Geopolitical Events: Political events, such as wars, trade disputes, sanctions, and changes in government policies regarding commodities, can lead to volatility in commodity prices. These events can affect not only the physical supply of commodities but also market sentiment and investor expectations.
  • Currency Fluctuations: Since commodities are often priced in a global currency, such as the US dollar, fluctuations in currency values can affect commodity prices. A stronger currency can make commodities more expensive in other currencies, potentially reducing demand and affecting prices.
  • Seasonal Patterns: Many agricultural commodities exhibit seasonal patterns in both production and consumption, leading to periodic price changes. Energies also tend to show strong seasonal patterns as consumption patterns differ significantly by season.
  • Regulatory Changes: Changes in regulations, such as environmental policies, taxes, and trade tariffs, can impact the cost of production, supply chain logistics, and market access for commodities, thereby influencing their prices.
  • Supply and Demand Dynamics: Supply disruptions, such as natural disasters, political instability in producing regions, or changes in production technology, can lead to sharp price increases. Conversely, demand fluctuations, driven by economic growth rates, technological advancements, or changes in consumer preferences, can also significantly impact prices.
  • Market Speculation: Speculative trading in commodity markets can lead to price volatility. Traders and investors buying and selling futures contracts or other financial instruments linked to commodities can cause prices to move independently of traditional supply and demand factors.

Which market participants are greatly impacted by commodity price risk?

The impact of commodity price risk varies across different market participants, based on the direction of the movement, and overall sense of volatility. Understanding how different participants in the market view price risk, and its impact on their business is crucial to developing effective risk management strategies.

  • Producers and Extractors: For those involved in the extraction and production of commodities, such as mining companies, oil producers, and farmers, price volatility can directly affect revenue and profitability. High volatility can lead to significant fluctuations in income, affecting their ability to invest in production, manage operational costs, and plan for the future. For example, a sudden drop in commodity prices can make some extraction or farming operations unprofitable, leading to closures, layoffs, and economic distress in communities dependent on these industries.
  • Manufacturers and Industrial Users: Manufacturers that rely on raw materials, such as metals, energy, or agricultural products, to produce goods, face cost uncertainty due to commodity price volatility. This uncertainty can complicate budgeting, pricing strategies, and profit margins. For instance, an unexpected rise in metal prices can increase production costs for automobile manufacturers, potentially reducing their competitiveness if they are unable to pass these costs onto consumers.
  • Consumers: While less direct, the impact on consumers can be significant. Volatile commodity prices can lead to fluctuations in the cost of goods and services. For example, variations in crude oil prices directly affect gasoline prices, which can influence consumer spending and broader economic conditions. Similarly, fluctuations in agricultural commodity prices can lead to changes in food prices, affecting household budgets such as Chocolate prices for Valentines' or Easter.
  • Investors and Financial Markets: Investors in commodity markets, including individual investors, hedge funds, and institutional investors, are directly affected by price volatility. While volatility can create opportunities for profit, it also increases the risk of loss. Investors need to carefully manage their exposure to commodity price risks through diversification, hedging strategies, and constant market analysis.
  • Governments and Policy Makers: Fluctuating commodity prices can have broader economic impacts, influencing inflation, trade balances, and fiscal revenues, particularly in countries heavily dependent on commodity exports. For governments, managing the economic implications of commodity price volatility is crucial. It can affect policy decisions regarding interest rates, taxation, and subsidies, especially in regions where commodities play a significant role in the economy.
  • Traders and Speculators: Traders and speculators, who buy and sell commodities and commodity-linked financial instruments with the aim of profiting from price movements, play a role in market liquidity and price discovery. However, they also face the risk of substantial losses if market movements go against their positions. Effective risk management through the use of derivatives and other financial instruments is essential for these participants.

How can we manage commodity price risk/protect ourselves against the impacts of volatility?

While the terminology ‘Commodity Price Risk’ might be fairly recent, this is a problem that has existed practically as long as trade has existed, and there are many operational solutions that are employed by businesses to manage this problem. There are also several financial solutions that exist to help manage this problem.

Operational Solutions: These solutions are not financial products, but rather supply chain mechanisms that can be used to ensure that price volatility doesn’t impact the business. Some operational solutions include:

  • Long term price fixing arrangement with suppliers 
    • Buyers and sellers agree to transact on a known volume of a raw material at a predetermined price at a future date.
    • In this situation, the buyer is often paying a premium to remove the uncertainty around price rises.
    • Sellers who expect the market prices to rise are less likely to agree to such agreements without a significant premium.
    • Such agreements are not always possible as aligning incentives can be tricky.
  • Cost pass through 
    • Buyers of raw materials can pass on increased costs straight through to their consumer.
    • Tends to not work as well in cases where demand is elastic.
  • Strategic buying (stockpiling) 
    • Another mechanism that can be used to manage commodity price risk is to stockpile materials when prices are low, and burn through the stockpile when prices are high.
    • Requires proactive management.
    • In cases like the current Cocoa market, where prices are at record highs and trending upwards, this strategy will eventually fail.

Financial Products: There are a variety of financial tools available to mitigate commodity price risk today, ranging from options trading to OTC Swaps through dedicated providers.

  • Futures contracts on an exchange
    • A futures contract is a legal agreement to buy or sell a particular commodity at a predetermined price at a specified time. The buyer of a futures contract is taking on the obligation to buy and receive the underlying commodity when the futures contract expires. On the flip side, the seller is obliged to deliver the underlying commodity at the contract's expiration date.
    • This typically allows the futures contract buyers to lock in the price up front.
    • Exchanges are able to provide this type of product as they typically have market participants who are participating both in downside protection and upside protection. This allows them to balance their overall risk.
  • Options
    • An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they decide against it.
    • Buyers of options have the ability to participate in the markets when prices move in their favour while being protected in the case where prices move against them.
  • OTC Swaps
    • An OTC Swap contract is an agreement between two parties to exchange assets that have cash flows for a set period of time. At the time the contract is initiated, the value of at least one of the assets being swapped is determined by a random or uncertain variable, such as an interest rate or a commodity price.
    • OTC Swaps are typically sold as bespoke arrangements between two parties because:
      • There isn’t a typical exchange or options market that a material can trade on, or there isn’t enough liquidity in the market.
      • The buyer of the product has a varied portfolio of risk, and wants to aggregate the risk into a single product as opposed to a variety of trades.
    • In general, OTC swaps require a high level of sophistication on the part of the buyers, and can be expensive as a bespoke product is created to fit the risk profile of the buyer.
  • Insurance
    • There are some specialty insurance companies that are currently able to offer a commodity price risk insurance product on demand.
    • ChAI is one and has a commodity price insurance product (ChAI Protect), you can see more details below if you are interested.

ChAI Protect

ChAI with a deep experience in the intersection of AI, Commodity trading, and now Insurance, have built a Commodity Price Risk Insurance product that can help manufacturing businesses mitigate their risks allowing clients to:

  • Tailor a price protection product around their exact raw material needs, be it packaging materials or any materials that are benchmarked against an index price.
  • Protection designed similar to a bull call spread (or bear put spread) option.
    • Charge a premium up front at inception of the policy to protect your raw material costs.
    • Choose coverage start and stop ranges of interest.
    • On the settlement date, ChAI simply evaluates if the prevailing raw material price as published by the exchange falls within the clients coverage range. If it does, the clients policy pays out the excess of their losses.
  • As an insurance, there are no minimum volumes, and no margin calls
    • You can also use simplified mark to market accounting.
    • Inclusion & exclusion can be seen here.

If you’d like to learn more about ChAI Protect, please get in touch.

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ChAI provides price forecasts and market intelligence for a range of commodities across Metals, Energies, Plastics and Agricultural.

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