What are the inherent risks in commodity markets, and how can you manage them?
The entire chain in all commodity markets is exposed to risk. But some can be managed by using specific strategies such as hedging.
Agricultural and livestock activities are of key importance in the country’s economy. In 2021, this sector had a 27.5% share of the national GDP, while in 2022, it should close a little lower, but still maintain more than a quarter of the total.
As a result, we can only imagine the number of financial transactions that take place on a daily basis in this market. They involve not only commodity buyers and sellers, but also manufacturing industries and financial institutions, along with the entire supply chain.
The peculiarities of commodity markets
Some characteristics are common to all commodities. These definitions give rise to the products that fit into a single category, since there’s a great variety of them.
Commodities can be categorized by origin:
- Agricultural (such as soy, corn, sugar, cotton, biofuel)
- Minerals (oil, natural gas, ore)
- Industrial (petrochemicals)
Or by use:
- Food (such as soy, corn, sugar)
- Metals (ore, steel, aluminum)
- Energy (oil, natural gas, gasoline, biofuel)
- Fibers (cotton feather, synthetic fiber)
Commodities are raw materials typically produced on a large scale, without being industrialized. But perhaps the most striking trait they share is their volatility of in terms of price formation.
Commodity values are defined by supply and demand. The trick is that many factors directly influence what the market offers or not, causing prices to drop or rise quickly.
So many aspects come into play at the same time—weather, currency fluctuations, the vagaries of transport and world supply, and more. There are also different kinds of risks—some manageable, and some not.
Systemic vs. Non-Systemic Risks
Among the different risks agribusiness is exposed to, we can consider some as systemic (when they encompass the entire supply chain) and others as non-systemic (those that affect each one’s reality, and that won’t necessarily affect the entire chain).
Non-Systemic: The non-systemic ones are thought of as uncontrollable, and normally aren’t linked directly to financial transactions. The main types here include climate and operational risks.
Climatic risk concerns natural phenomena. Even if you have a weather forecast, you can’t change it. Yet surprises do occur. Anyone can try to anticipate the problems that come from too much rainfall or drought, but agricultural commodities need certain conditions for a good harvest.
On top of that, there are tornadoes, storms, frosts, and phenomena like La Niña, which can cause great damage. There’s simply no way to stop them. Even the current weather forecast isn’t enough, since agricultural markets work with forecasts that predict four or five months ahead. It’s possible to make an estimate, now, but an awful lot can change over such a long period.
Another type of non-systemic risk we must consider is operational. As the name implies, these risks occur in operations, and are usually linked to human failure, accidents, machinery defects, among other similar things.
Systemic risks can be seen as those that lead to a snowball effect. When this type affects one part of the chain, it’ll likely end up affecting the whole chain.
A clear example of this was when Russia went to war against Ukraine, making fertilizer prices rise. These increases were then passed on to the producer who passed them on to the buyers, and so on down the line.
Among systemic risks, we can identify two main types: Market/price risk and Credit/counterparty risk.
Credit risks include those when one of the parties doesn’t honor its contractual obligations. These include issues such as non-compliance with deadlines, non-delivery of the product, late payments, and other snags.
What can you do about problems of this nature? The best way is to take precautions: use recommendations, look for good references from those buying or selling, check into the history of the contracted / contractor, and harness other information that makes the transaction more secure.
Market risk is related to price changes. They’re internationally defined, and there are lots of aspects that influence them, depending on global economic situation at any given moment.
What are the market risks for commodity chains?
Commodity prices are determined by international supply and demand – even when their distribution is on national soil. Demand generates competition between both the countries that produce and those that consume.
The Chicago Stock Exchange in the USA is the main reference for price formation. That’s where most negotiations for the purchase and sale of agricultural products are carried out.
FOB (Free on Board) indicates the soybean price quoted at the port of origin. It’s derived from a combination of the Chicago Stock Exchange quote added to the Soybean Premium (a balance between the exchange value and that of the origin/destination of the soybeans) at the port of origin.
For this reason, market risk is mainly related to the exchange rate. It can influence not just once, but several times, the price definition of the very same commodity – the value at the time of investment in the next harvest, the purchase of inputs, the import of supplies, and of course, the quote at the time of sale.
Such variations can even end up generating profit, specifically when the dollar exchange rate is higher at the time of sale than at the point of investment. But for that to happen, you need to have a bit of luck.
In order for you not to be at the mercy of chance, risk management is necessary. Today, there are market resources to protect against this volatility and prevent surprises, while guaranteeing good deals.
How can you protect yourself from fluctuations in commodity markets?
Creating a good hedging strategy can be the key to avoiding unpleasant surprises in your financial planning. But it’s not enough to just decide to use this form of protection without extensive study and prior knowledge.
The best way to enter this universe is to work with a partner who has vast understanding of financial and agricultural markets at the same time. Only by taking a broad view of this complex context along with global markets is it possible to make the best decisions.
hEDGEpoint unites the knowledge of specialists in agricultural markets with risk management solutions through technology, together with customized consulting, to always offer the best experience in futures operations.
We are globally present, and always ready to serve you—at any time, in any place. Get in touch with one of our experts to find out more about how to use this instrument to favor your business.
Talk to a hEDGEpoint specialist.
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