What is Commodity Price Risk
Commodity price risk is the price uncertainty that adversely impacts the financial results of those who both use and produce commodities. For example, as the price of steel rises, this increases the cost of automobile production and can negatively impact that producer's profit margins.
Commodity price risk can equally impact producers of a commodity, not just users. If crop prices are low one year, a farmer may plant less of that crop. If prices subsequently rise next year, the farmer will miss out on a potentially profitable crop. This is commodity price risk.
BREAKING DOWN Commodity Price Risk
Commodity production inputs include raw materials like cotton, corn, wheat, oil, sugar, soybeans, copper, aluminum and steel. Factors that can affect commodity prices include political and regulatory changes, seasonal variations, weather, technology and market conditions. Commodity price risk is often hedged by major consumers. One way to implement these hedges is with commodity futures and options contracts traded on major exchanges like the Chicago Mercantile Exchange (CME). These contracts are equally beneficial to commodity users and producers by reducing price uncertainty.
Effects of Commodity Price Risk
Commodity price risk stems from unexpected changes in commodity prices that can reduce a producer's profit margin and make budgeting difficult. For example, in the first half of 2016, steel prices jumped 36% while natural rubber, which declined for more than three years, rebounded by 25%. This led many Wall Street financial analysts to conclude that major auto manufactures, as well as major parts makers, could see a materially negative impact on their profit margins for the full financial year.
Major crude oil producing companies are especially aware of commodity price risk. As oil prices fluctuate, the potential profit these companies can make also fluctuates. Some companies publish sensitivity tables to help financial analysts quantify the exact level of commodity price risk facing the company. For example, the French oil major Total SA says that, for every $10 per barrel change in the price of oil, their net operating income fluctuates by $2 billion and their operating cash flow by $2.5 billion. From June 2014 to January 2016, oil prices fell by over $70 per barrel. The magnitude of this price move reduced Total's operating cash flow by $17.5 billion in the period.
Fortunately, producers can protect themselves from fluctuations in commodity prices by implementing financial strategies that will guarantee a commodity's price (to minimize uncertainty) or lock in a worst-case-scenario price (to minimize potential losses). Futures and options are two financial instruments commonly used to hedge against commodity price risk.