Now I'll look at risk management strategies from two perspectives.
Producers of commodities
Buyers of commodities
Commodity Risk Management Strategies for Producers
Strategic Risk Management
#1 – Diversification:
To mitigate the price risk or cost risk connected with production, the manufacturer often rotates his production (either via multiple products or through different production facilities of the same product). Producers should ensure that alternative items are not exposed to the same price risk while diversifying.
Diversification example: In the case of a farm business, crop rotation to produce diverse goods can help to mitigate the substantial losses caused by market fluctuation.
While resources are redirected to a different business, producers may face substantial costs in the form of diminished efficiency and lost economies of scale as a result of diversification.
#2 – Flexibility:
It's part of a broader diversification plan. A flexible business is one that may alter in response to market conditions or events that may have a negative influence on the company.
Flexibility Example: In a case where steel prices are declining, a steel business might employ low-cost pulverised coal instead of coal to produce steel, which has the same effect at a lower cost. This adaptability has a positive impact on financial performance.
Price Risk Management
#1 – Price pooling arrangement: This commodity is sold in bulk to a cooperative or marketing board, which determines the price based on a number of parameters that result in an average price for everyone in the group.
#2 – Storing: When there is an increase in output, which results in a lower selling price, some producers may decide to keep the goods until a better price is found. However, storage expenses, interest costs, insurance costs, and spoiling costs must all be addressed.
#3 – Production contracts: In the case of production contracts, the producer and customer agree on a price, quality, and quantity of goods to be delivered. In this instance, the buyer usually retains control of the manufacturing process.
Commodity Risk Management Strategies for Buyers
The most prevalent approaches for managing commodity price risk in the commodity purchasing industry are as follows.
#1 – Supplier Negotiation: This buyer seeks suppliers in search of a different price strategy. They may provide alternatives or recommend a modification to the supply chain process, or they may cut pricing on larger volume purchases.
#2 – Alternative sourcing: Appoint an alternative producer for the same product or contact a different producer for substitute products in the manufacturing process for this buyer. Companies, on the whole, have strategies in place to ensure that the use of commodities in their businesses is risk-free.
#3 – Production process review: This corporation evaluates the use of commodities in the manufacturing process on a regular basis, with the goal of changing the product mix to offset commodity price rises.
Example: Food manufacturers are always looking for ways to improve a product by utilising less of higher-priced or more variable ingredients like sugar or wheat.
Now that we know how to manage commodity risks from both a producer and a buyer's perspective, let's look at the various financial market instruments that may be used to control commodity risks.
Financial Market Instruments to Manage the Commodity Risk
#1 – Forward contracts:
A forward contract is essentially an agreement between two parties to purchase or sell an item at a price agreed upon today at a future date.
The risk of price adjustments is eliminated in this scenario by locking the pricing.
Forward Contract Example: Company “A” and Company “B” on 1st September 2017 enters a contract whereby company “A” sells 1000 tonnes of wheat to company “B” at INR 4000/tonne on 1st January 2018. In this case, whatever is the price on 1st January 2018, “A” has to sell “B” 1000 tonnes at INR 4000/tonne.
#2 – Futures contract:
Futures and forwards are similar in many ways, except that futures contracts take place on Futures exchanges, which operate as a marketplace for buyers and sellers. Futures exchanges, which operate as a marketplace for buyers and sellers, negotiate contracts. A contract's buyer is referred to as a position holder, while the seller is referred to as a short position holder. Because both parties risk their counterparty walking away if the price changes, the contract may require both parties to deposit a margin of the contract's value with a mutually trusted third party.
#3 – Commodity options:
Commodity options are contracts in which a corporation buys or sells a commodity in exchange for the right, but not the duty, to carry out a transaction at a future date.
Commodity Options example: Broker “A “written a contract to sell 1 lakh tonnes of steel to company “B” at INR 40,000/tonne on 1st January 2018 at a premium of Rs6 per tonne. In this case, the company “B” may exercise the option if the price of steel is more than INR 40,000/tonne and may deny buying from “A” if the price is less than INR 40,000/tonne.
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