Commodity Price Risk
What Is Commodity Price Risk?
Commodity price risk is the possibility that commodity price changes will cause financial losses for either commodity buyers or producers. Buyers face the risk that commodity prices will be surprisingly high. Numerous furniture manufacturers must buy wood, for instance, so higher wood prices increase the cost of having furniture and negatively effect furniture producers' profit margins.
Lower commodity prices are a risk for commodity producers. Assuming crop prices are high this year, a rancher might plant a greater amount of that crop on less useful land. In the event that prices fall next year, the rancher might lose money on the extra harvest planted on less prolific soil. This, too, is a type of commodity price risk. The two producers and consumers of commodities can hedge this risk utilizing commodities markets.
Understanding Commodity Price Risk
Commodity price risk is a real risk to organizations and consumers, and not just to traders in commodities markets. This is on the grounds that everything from raw materials to completed products rely upon buying and processing different commodities, from metals and energy to agricultural and food products. Subsequently, changes in prices can impact things from the price of gas at the pump to that of food or plastic goods.
The Risk to Buyers: Automobile Manufacturers
Commodity price risk to buyers originates from unexpected increases in commodity prices, which can reduce a buyer's profit margin and make budgeting troublesome. For instance, automobile manufacturers face commodity price risk since they use commodities like steel and rubber to deliver cars.
A case in point: In the primary half of 2016, steel prices hopped 36%, while natural rubber prices bounced back by 25% subsequent to declining for over three years. This drove many Wall Street financial analysts to infer that car manufacturers and vehicle parts creators could see a negative impact on their profit margins.
The Risk to Producers: Oil Companies
Producers of commodities face the risk that commodity prices will fall unexpectedly, which can lead to bring down profits or even losses for producers. Oil-creating companies are outstandingly aware of commodity price risk. As oil prices change, the potential profit these companies can make additionally vacillates. A few companies distribute sensitivity tables to assist financial analysts with measuring the specific level of commodity price risk a company faces.
The French oil company Total SA, for instance, when stated that its net operating income would fall by $2 billion on the off chance that the price of a barrel of oil diminished by $10. Likewise, their operating cash flow would drop by $2 billion when the oil price dropped by $10. From June 2014 to January 2016, oil prices fell by more than $70 per barrel. This price move ought to have reduced Total's operating cash flow by about $17 billion during that period.
Hedging Commodity Price Risk
Major companies frequently hedge commodity price risk. One method for carrying out these hedges is with commodity futures and options contracts traded on major commodities exchanges like the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX). These contracts can benefit commodity buyers and producers by diminishing price uncertainty.
Producers and buyers can safeguard themselves from variances in commodity prices by purchasing a contract that guarantees a specific price for a commodity. They can likewise lock in a worst situation imaginable price to reduce possible losses.
Futures and options are two financial instruments ordinarily used to hedge against commodity price risk.
Factors in Commodity Price Fluctuations
Factors that can influence commodity prices incorporate politics, seasons, climate, technology, and market conditions. The absolute most economically essential commodities incorporate raw materials, like the accompanying:
- Cotton
- Corn
- Wheat
- Oil
- Sugar
- Soybeans
- Copper
- Aluminum
- Steel
Political Factors
Political factors can raise the price of certain commodities while decreasing the price of others. In 2018, former President Donald Trump forced tariffs on steel and aluminum imported from foreign countries. The direct effect of these tariffs was to increase steel and aluminum prices in the United States relative to the remainder of the world.
China fought back against Trump's tariffs by forcing its own tariffs on U.S. agricultural products. With lower demand from China, excess crops must be sold in different markets. Subsequently, many crop prices were down in the United States in 2019.
Climate
Occasional and other climate vacillations considerably affect commodity prices. The finish of summer carries with it abundant harvests, so commodity prices will generally fall in October. These seasonally depressed commodity prices might be one explanation major stock market declines frequently occur in October. Dry spells and floods can likewise lead to brief increases in the prices of certain commodities.
Technology
Technology can affect commodity prices. Aluminum was viewed as a precious metal until procedures for secluding it improved during the nineteenth and twentieth hundreds of years. As technology advanced, aluminum prices fell.
Highlights
- Commodity price risk is the chance that commodity prices will change such that causes economic losses.
- Factors that can influence commodity prices incorporate politics, seasons, climate, technology, and market conditions.
- Futures and options are two instruments usually used to hedge against commodity price risk.
- Commodity price risk for buyers is due to increases in commodity prices; for dealers/producers it is frequently due to diminishes in commodity prices.
