Commodity risk refers to the uncertainty of future market conditions based on the fluctuations and availability of a commodity. The industries most affected by commodity risk are energy, agriculture and production.
Due to the sheer volatility of commodity prices, which some industries experience as 70% swing in average price in a single year, organizations in the affected industries dedicate entire departments to commodity risk management. This practice involves the strategies used to adapt to changes in the market to ensure profitability for the organization.
Types of Commodity Risk
Although risks vary depending on industry, each industry can experience four different types of risk:
- Price risk occurs with adverse movement in the world prices and exchange rates.
- Quantity or volume risk occurs with a shortage in consumption or sourcing of the commodity.
- Cost risk occurs when a business adjusts their costs of services due to price increase of the commodity
- Political risk, also considered regulatory risks, occurs when law or regulations affect pricing of a commodity.
In the production industry, commodity risk not only affects the manufacturers but the exporters and importers as well. With supply shortage, they can face time lag between production order and delivery.
To help commodity managers face the many risks involved in commodity fluctuations, this article identifies key challenges in commodity risk management and the strategies to mediate them.
Key Challenges in Managing Commodity Risk
Specific challenges depend on the type of commodity and industry. However, there are common risk management challenges each commodity industry shares.
Setting the Right Objectives
First and foremost, members of a commodity risk management team strategize to stabilize commodity costs. The primary aim is to achieve the lowest possible price while ensuring the quality of the commodity remains high and the supply is available from one or more sources.
Working With the Proper Capabilities
Developing a team with the right level of specialization that understands the incentives and rewards of the risk involved in creating an operable trading program should be consistent with the broader organization. In other words, understanding the overall business strategy of the organization helps align risk management goals.
Some of these challenges are experienced because the situations can occur regardless of the commodity manager’s efforts. For example, if the price of aluminum increases, how does an original equipment manufacturer (OEM) supplier ensure the costs of a product remains stable?
Top Strategies To Manage Risk as a Commodity Manager
Hedging is the most common risk management strategy across each industry. Hedging uses futures, or financial contracts that agree upon a predetermined future date to transact an asset. The expectation is that the price on a commodity will rise in the future, so standardizing a price on the current commodity fixes for future costs.
A hedging strategy takes into account several sub-strategies. In the manufacturing industry, commodity managers need to focus on diversification of products and resources in addition to price targeting.
1. Monitor Price Forecasts
Frequent price jumps with base metals are not uncommon. These jumps occur for a variety of reasons, but a few indicators are as follows:
- Strong industrial activity coming from global manufacturing hubs
- Health of the global economy
- Momentum in global industrial sectors
- Supply chain disruptions due to political or environmental occurrences
Monitoring these indicators allows your commodity management team to anticipate potential changes to prices and availability of commodities.
2. Implement Product Storing
Product storing can be viewed as an investment in the product. When there is an increase in production of a commodity, the selling price reduces. Some commodity risk management teams will store the production until a more favorable price is obtained.
With this strategy comes additional costs, including insurance, potential degradation, interest and storage.
3. Embrace Diversification
Diversification applies to raw material, product, facility and more, depending on the industry. Some types of diversification include the following:
- Diversification of source and material: Manufacturers use a variety of alloys made from either aluminum, magnesium, zinc or steel, and each base metal can fluctuate depending on availability and supply, which makes diversifying source and material a useful strategy.
- Diversification of parts and components: Manufacturers cannot rely on a single component to remain competitive in the market, which means they need to produce a larger inventory of parts and components for a variety of industries.
- Diversification of facilities and machinery: Manufacturers need a number of facilities to account for downtime, as well as the inventory of machinery needed for robust production capabilities.
4. Remain Flexible
The value of the global small manufacturing market is expected to expand at a compound annual growth rate of 12.4% between 2021-2028. The old driving principle of “low-cost, high-quality” also needs to incorporate flexibility for a manufacturer to remain competitive.
Flexibility should be enacted through the ability to respond to customer orders quickly, provide a range of products, and add machinery to their inventory to produce as many projects presented to them.
Consistent Costs for Flexible Services
At VPIC Group, we understand our clients’ need for reliable, consistent costs of components and products. That’s why we take commodity risk management seriously. By implementing hedging strategies, we are able to plan for the inevitable price jump in raw materials to keep costs consistent for our diversified capabilities.
When you’re ready to work with a customer-centric OEM supplier, contact one of our representatives. We look forward to hearing from you soon!