June 06, 2023
Commodity Price Risk Management:
Commodity Price Risk Exposures
Commodity buyers have had to manage extreme volatility over the past few years following disruption from the global Covid-19 pandemic and war in Ukraine which compromised supply chains and led to drastic price fluctuations. While this commodity price volatility has settled down to some degree as the economy normalizes post-pandemic and the world adjusts to the impact of commodity flows from the ongoing war, buyers have become more sensitive to how price risk can change abruptly with little warning. They likely are also more sensitized to the increased risk these events represent to managing forward commodity input cost in their business operations as well as the impact on margins and profitability.
Many commodity buyers historically have had a relatively short-term focus on price management. As an example, a grain buyer purchasing corn for further processing may hold limited inventory to manage near-term production and buy “hand-to-mouth” as needed to replenish supply as it is depleted. This approach may work fine in an environment of stable supply and prices; however, it could prove challenging when supply sources are disrupted or through sudden price volatility episodes. Buyers have begun to move away from just-in-time inventory practices and hand-to-mouth purchasing though and are strategically thinking longer-term.
Risk Management Metrics
Budget control is a key consideration and spikes in volatility, even if short-lived, can prove detrimental to achieving budget goals and objectives. As a result, more and more purchasing departments are looking at controlling costs over a longer timeframe, managing prices a year or more into the future rather than the traditional 3-6 months to which they have historically been accustomed. This usually would be considered risky as being stuck with a potentially non-competitive price a year or more forward in time can prove very disadvantageous, particularly if competing suppliers are able to capitalize on lower commodity costs.
This assumes, however, that a commodity buyer is “locked in” to a forward price over an extended time horizon and not proactively managing price as commodity values fluctuate through time. Derivative contracts including futures and options have been available to commodity buyers for decades, although they are not always utilized effectively as part of a comprehensive risk management program. While many companies actively include these tools in their arsenal, they may take a “set and forget” approach to contracting. As an example, a corn buyer may scale into long futures contracts to set a purchase price for a forward time slot, then transfer these futures contracts to a supplier in exchange for physical ownership with a basis commitment.
As an alternative, the buyer may purchase call options that allow the right to purchase corn at a pre-determined price level. As corn prices hopefully decline over time, they may wish to sell the call options back to the market and replace with owning futures or physical through a supplier. In some cases, this may be the extent of the adjustments a risk manager might make to an initial position. To be sure, some companies with formal hedging policies stipulate the conditions under which a purchasing department may offset or replace derivative transactions as part of their risk management program. In addition, these policies may also define the types of contracts or strategies that may be used to manage commodity price risk. Historically, these policies have been established to promote discipline and prevent speculation from creeping into the hedging process. Good mechanics such as tying the size of a derivatives position to actual risk exposure in a certain inventory slot or timeframe demonstrates how a formal, written policy can help promote best practices for the organization.
As another example, some hedge policies may place restrictions on selling options as part of a risk management strategy. Because short options carry obligations that may be triggered under certain price conditions, these may be considered risky by limiting protection against adverse price moves or exposing the commodity buyer to a purchase commitment at lower price levels. While these points are valid, there may be cases where selling options allows a risk manager to capitalize on higher volatility to reduce cost against other options that were purchased previously. Furthermore, short options may be bought back at any time prior to expiration. There could be opportunities to remove these obligations in the future after capturing a majority of the premium initially received.
Commodity Risk Profile
In general, the longer a time horizon the risk manager has to actively manage a position as market conditions change, the more opportunities there may be to improve upon an initial hedging strategy implemented. Many companies have embraced this idea by taking a longer-term view with their risk exposure to implement strategies further out in time. Ideally, a commodity buyer who is exposed to higher prices on an ongoing basis can find themselves in a position where they are protected against this upside exposure, yet able to participate in any savings that may occur from lower prices with limited or no cost.
While difficult to achieve when first initiating a hedge strategy to mitigate upside risk, it is possible for commodity buyers to build towards that profile over time. To illustrate this point, consider a corn buyer who is looking at protecting forward price risk on future purchases. Earlier this spring following initial bearish reports for increased acreage and higher stocks in the upcoming crop year, December 2023 corn futures prices briefly dropped below $5.00/bushel – the lowest price the market had achieved since September 2021. Recognizing perceived value in that price and potentially representing levels that would work into the company’s forward budget, a risk manager may have chosen to implement a hedging strategy to protect against potential upside exposure over a longer time horizon.
In addition to the December 2023 futures contract, December 2024 corn futures likewise traded below $5.00/bushel in mid-May. With the risk manager not wanting to take on too much exposure if the market were to continue dropping, they may have implemented an option strategy such as buying calls against both the December 2023 and December 2024 corn futures. The $5.00 call options for the December 2023 contract were trading for about $0.40/bushel at this point in time, while the December 2024 options were trading for a premium of $0.45/bushel. For illustration purposes, we will focus on the position for the December 2023 contract. Figure 1 displays the profile of a long call option strategy at the $5.00 strike price with a cost of $0.40/bushel.
Figure 1. Initial Position: Buy December $5.00 Calls for $0.40 Premium
The market subsequently made a sharp move higher as hot weather and expanding drought across the Corn Belt raised concerns of adverse crop development and deteriorating yield potential. By mid-June, December 2023 corn futures exceeded $6.00/bushel as risk premium was added to the market. The $5.00 call options were now trading for around $1.30/bushel, presenting a potential opportunity for the risk manager to adjust their position. Focusing on the December 2023 calls, the buyer would be able to sell the $5.00 calls previously purchased and buy the $5.60 calls in their place for a cost of about $0.85/bushel. The net result of this transaction would result in a credit of $0.45/bushel ($1.30 proceeds from the sale of the $5.00 calls minus the new $0.85 cost for the $5.60 calls). Given the initial cost for the $5.00 calls of $0.40/bushel, the resulting credit would completely offset that cost and leave the risk manager with unlimited upside protection in December corn above $5.60/bushel. Figure 2 illustrates this adjusted position, taking into account the new strike price at $5.60 and the net credit of $0.05/bushel.
Figure 2. Adjusted Position: Long $5.60 Calls for Net $0.05 Credit
The green line in the graph shows the adjusted position relative to the initial position from Figure 1 in blue. Looking at the table, you will note that at no price level will the position experience a loss in either a higher or lower market. At higher price levels above $5.45 where the blue and green lines intersect, the adjusted position will be $0.15/bushel worse than the initial position. This is because while making the adjustment nets a credit of $0.45/bushel ($1.30 premium proceeds from selling the $5.00 call minus $0.85 premium cost for buying the $5.60 call), this does not cover the entire $0.60 difference between the 2 strike prices as the protection will now start at a higher level.
Despite this limitation, the $0.45 credit still represents 75% of the 60-cent range between $5.00 and $5.60 which is attractive as that is a relatively high percentage of that range and accomplishes the goal of offsetting the initial strategy cost from mid-May. While the previous illustration is one example of how that initial position could have been adjusted, another would be to keep the $5.00 call options and then sell calls at a higher strike price to recover the initial premium paid. In mid-June, the $6.60 call options in December corn could have been sold for around $0.40/bushel which would have effectively covered the initial cost; however, the protection to higher prices would then have been capped above $6.60.
The buyer may have considered that risky following the sharp increase in price that had just ensued and the uncertain crop prospects. Analogies at the time to the 2012 drought year when corn eventually exceeded $8.00/bushel would likewise have given pause to that potential adjustment. In either case though, ongoing volatility in the corn market since mid-June would have presented other adjustment opportunities as prices recently retreated below $5.00/bushel again. Taking advantage of these opportunities may allow potential benefits to improve upon the initial strategy, either by allowing protection against rising costs to start at a lower price level and/or further reducing the cost or increasing the credit to the strategy. Markets constantly change, but taking a longer-term approach to managing risk can help better manage the inevitable volatility.