Commodity risk is the risk that a firm confronts as a result of changes in the price and other terms of a commodity over time, and it is managed through various tactics such as hedging on the commodity through forwarding contracts, futures contracts, and options contracts.
Which industries are vulnerable to commodity risk?
In general, producers in the following industries are the most vulnerable to price drops, which means they earn less money for the commodities they create.
Gold, steel, coal, and other mining and mineral industries
Wheat, cotton, sugar, and other agricultural products
Oil, gas, and electricity are examples of energy sectors.
Commodity consumers, such as airlines, transportation businesses, clothing manufacturers, and food producers, are particularly vulnerable to rising prices, which will raise the cost of the commodities they produce.
The time lag between placing an order and receiving goods, as well as exchange rate variations, pose a risk to exporters and importers.
Such risks should be effectively controlled in a firm so that it can focus on its core operations without being exposed to unnecessary hazards.
What are the types of Commodity Risk?
The risk that a commodity player faces can be divided into the four categories below.
Price Risk: Due to a downward trend in commodity prices as a result of macroeconomic factors.
Quantity Risk: This risk comes as a result of changes in commodity availability.
Cost Risk: Arises as a result of a drop in commodity prices, which has an influence on corporate costs.
Regulatory Risk: Arises as a result of changes in laws and regulations, which have an impact on commodity prices and availability.
Let's have a look at how to calculate commodity risk.
Methods of Measuring Commodity Risk
Risk measurement necessitates a structured methodology across all strategic business units (SBUs), such as the manufacturing department, procurement department, marketing department, Treasury department, and risk department. Given the type of commodity risk, many businesses will be exposed not just to the core commodity risk with which they are dealing, but also to other risks inside the firm.
Commodity products, such as steel, are plainly affected by steel price fluctuations. However, variations in the prices of iron ore, coal, oil, and natural gas have an impact on profitability and cash flow. Furthermore, if any imports or exports take place, currency swings have an impact on profitability and cash flow.
Portfolio Approach
The company analyses commodities risk coupled with a more extensive examination of the potential impact on financial and operational activities using a portfolio approach.
For example, an organisation that is exposed to changes in crude oil prices studies the possible impact of crude oil availability, changes in governmental policies, and impact on operational activities by any of these variables in addition to scenario testing of changes in crude oil prices.
The risk is calculated using stress testing for each variable and a combination of variables in a portfolio approach.
Value at Risk
When doing a sensitivity study known as "Value at Risk," some businesses, particularly financial institutions, adopt a probability method. In addition to the sensitivity analysis of pricing changes outlined previously, the corporations assess the likelihood of the event occurring.
As a result, sensitivity analysis is used to simulate the potential impact of commodity price movements on its exposures by analysing historical price history and applying it to current exposures. For example, in the instance of Value at Risk, a steel company's sensitivity analysis can be based on steel and iron ore prices during the last two years; given the quantified movement in commodity prices, it can be 99 percent positive that it will not lose more than a certain amount.
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