Commodity Risk Management
Published on: 18th October 2022
By Renu Kothari: Research Analyst, QuantArt
Commodity Risk is the risk of P/L volatility due to change in commodity price movements. Producers are averse to commodity price fall leading to squeezed revenues resulting in losses. Consumers on the other hand are exposed to rising commodity prices which increases their cost of purchase. Companies should hedge and try to mitigate these risks to ensure maximum focus on its core activities.
Impact due to Commodity Fluctuations considering a commodity manufacturer:
- Fall in commodity price-
- Commodity Producers will be able to capture smaller profits due to decrease in revenue
- Commodity Consumers will gain more due to lower input costs
- Rise in commodity price-
- Commodity Producers will be able to capture larger profits due to increase in revenue
- Commodity Consumers will gain less due to higher input costs
Significant fluctuations in the commodity markets might hinder the business profitability affecting production costs, credit availability and revenue. Therefore, these price fluctuations make it crucial for a company to be able to effectively hedge its commodity price risk.
Popular commodity hedging instruments used:
Let us consider a CASE STUDY to get an in-depth understanding:
Say, a battery manufacturer agreed to buy one tonne of refined lead from a lead smelter for December delivery at December price. Since he doesn’t know the price after three months, he is taking a price risk (also a currency risk if he is importing it and paying a different currency). Simply, as the transaction is not at a fixed price, both the smelter and battery manufacturer may be exposed to a change in price between the date of agreeing on the transaction and its future delivery date. Here hedging comes into the picture.
We mainly hedge using a futures or options contract. In case of commodities forwards are not usually preferred as they involve physical delivery which might be less convenient (all forwards only physical?).
Hedging using Futures:
Sticking to the above scenario, the battery manufacturer is scared that prices might go up in the future. He wants to lock in the spot price that is $1829. He could enter into (buy) a ‘3-month futures contract’. This essentially means that he has to buy Leads from the seller after 3 months at the futures price. As shown in the chart below, 3 months’ futures are trading at $1776.
Hedging using options:
In LME, lead can be hedged using futures and options. The market participants like the miners, producers, traders, hedge funds, bulk consumers often find it difficult to choose the exact instruments, strikes, timing, etc. In the case of futures, the obligation is the biggest deterrent whereas in options the premiums are expensive. So, low-cost appropriate option structures with effective monitoring systems may provide sufficient flexibility with much lower cost. Here the pricing plays a vital role. Because of the non-availability of pricing easily, most of the participants do not use options or structures.
1. Range Forward
A range forward is a derivative contract that protects buyers against adverse market movements, allowing them to benefit from favorable spot rate movements within a certain range that lies between the strike and barrier rate.
|Ref Price: 1829.97
|Buy Call Strike
|Sell Put Strike
Here, (for the buyer) the adverse movement being priced going up. The range being $1925 to $1750- the buyer can take advantage of falling prices. The “barrier rate” being 1750 below which the buyer is at a loss.
To sum up, we are structuring a zero-cost option to protect our loss if the prices go up and at the same time take benefit of prices falling up to a certain limit ($175).
A seagull option is a three-legged option trading strategy- a long seagull consists of a bull spread using calls (long ATM/shallow OTM call, short high OTM call) + short OTM put. This strategy is used when you think an asset is going up but stops just at the short high OTM exercise price. The strategy provides inexpensive protection at the cost of losing upside potential.
Here, Long ATM: Call 1975
Short High OTM: Call 2175 (Let’s assume we consider $2175 to be highly unlikely)
Short OTM: Put 1800
The current Price is $1829. If actual prices after 3 months go above $1975, we are protected till $2175. Below that, till $1800, we can take benefit of price falling. If prices go below $1800 or above $1975, we cannot take benefit/ we are not protected.
|Ref Price: 1829.97
|Buy Call Strike
|Sell Call Strike
|Sell Put Strike
While the above example demonstrates the use of options and futures in hedging commodity risk, the company should formalize risk management options in a step-by-step process to ensure that hedge strategies and instruments align with the hedge objective and targets. Given that commodity exposures also involve indirect risks and correlations, an appropriate quantitative approach needs to be adopted to ensure success in the hedging program.
Further, a clear monitoring mechanism, to measure risk and to estimate the effectiveness of the hedge strategies, is critical for the success of any risk management program including commodity risk management.
Few of the tasks that should be considered for Commodity Risk management are listed below:
1. In-depth analysis of commodity risk: Need to evaluate detailed price movements which impact your company and the price movements in the market traded instrument. Also evaluate basis risk, correlation risk and appropriately advise how to hedge. Analyze historical data and carry out correlation studies. Basis risk evaluation is one of the most important criteria for the evaluation of commodity risk hedging.
2. Commodity hedge set up: End-to-end set up of commodity risk management and hedging desk. One should have the required contacts to help you set up and engage with creditworthy brokers. Once the set-up is done, you can hedge your risks in appropriate exchange or in the OTC market.
3. Commodity Risk management Policy: Commodity RMP is a comprehensive document that covers the exposure, objective, hedge rules, allowed instruments, limits, process, MIS formats, and documentation process. The policy is also an RBI requirement if you want to hedge. The policy to be customized for every company with specific requirements.
4. Commodity Hedge Strategy making: Make a hedging strategy for you that is geared to protect your risk and meet the objective. Strategy broadly covers the time of hedge, the quantum of the hedge, an instrument of hedge, and cost of the hedge.
5. Using option-based commodity hedging: Options help you to mitigate risk while allowing you to benefit from the favourable moves. Often in commodity risk management, options are extremely useful. Option structures are also used to reduce the cost of options.
6. Monitoring and Performance Management: Monitor your overall exposure, past deals, settlement details, etc to ensure that policy adheres, and strategy is aligned for achieving the objective. Also remain focused on objectives like achieving cost reduction, profitability enhancement, or volatility elimination. Simultaneously evaluate the gain/loss based on the suitable strategy decided.