Commodity risk is the risk a business faces due to change in the price and other terms of a commodity with a change in time and management of such risk is termed as commodity risk management which involves various strategies like hedging on the commodity through forwarding contract, futures contract, an options contract.
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, etc
- The agricultural sector like wheat, cotton, sugar, etc
- Energy sectors like Oil, Gas, Electricity, etc.
- Consumers of commodities like Airlines, Transport companies, Clothing, and food manufacturers are primarily exposed to rising prices, which will increase the cost of commodities they produce.
- Exporters/importers face the risk from the time lag between order and receipt of goods and exchange fluctuations.
In a company, such risks should be appropriately managed so that they can focus on their core operations without exposing a business to unnecessary risks.
What are the benefits of managing commodity risks?
Cash flow benefits
Working capital is the essence of any business and managing cash flow is a challenge for almost every company. Business owners as a result stay vigilant in order to keep the business financially viable. Fluctuating commodity prices especially on a significant part of the value chain can cause cash flow fluctuations in the business. Hence, forecasting and protecting future cash flows become vitally important. Difficulties in liquidity as a result force the company to undertake short-term financing arrangements to address the liquidity deficit – which increases the costs to the company.
One of the advantages of hedging commodity price risk is the ability to minimize cash flow fluctuations attributed by commodity price movements. Hedging insulates the company from such volatile price movements, and is poised to stabilize cash flow volatility by creating an offsetting impact in case of commodity price fluctuations – with the aim to almost achieve a zero-sum game for the commodity exposures covered under that hedge.
For those companies that are exposed to the same pricing benchmarks on its costs and revenue side, using a net exposure approach in its hedging program, if done correctly, helps mitigate the overall exposure to fluctuating commodity price with the net exposure being hedged – therefore additionally protecting that portion of the impact of the exposure from fluctuating commodity prices.
P/L offset and accounting benefits
The advent of IFRS 9 (as explained in the subsequent section) has allowed for most companies to realize the impact on their hedges and exposures on the P/L thereby offsetting the impact on the P/L – which as a result helps the company to reduce P/L volatility attributed to fluctuating commodity prices.
Furthermore, IFRS 9 allows for hedges undertaken against highly probable forecasted exposures – which are off balance sheet items, to not have their MTM impact realize on the P/L – till the time this exposure is recognized as a balance sheet item. Therefore, the lop-sided impact on hedges as done earlier is now moved away from the P/L thereby adding additional stability to the P/L volatility attributed to fluctuating commodity prices. However, it is essential that the hedge-exposure relationship is based on offset and not on the same side.
Hedging the commodity price risk using exchange traded derivative contracts tends to lower the cost of hedging as compared to undertaking an over-the-counter derivative contract for the purpose of hedging – especially where the traded derivative contract is highly liquid. This is largely attributed to the lower spreads on the quoted derivative prices as compared to the over-the-counter market which do not require any additional negotiation (again as done on the over-the-counter market) and the true cost is primarily attributed to margin maintenance. This is essential for those companies that do not have the necessary ability to pass on the costs of commodity price fluctuation and hedges on to the customer – due to competition and other market pressures.