Managing Commodity Price Risk

Sustained periods of market volatility such as the current situation in the Eurozone makes hedging an expensive option. However, the volatility in the Eurozone pales in comparison to the volatility that commodities’ consumers and producers have experienced in the last ten years, and it shows no sign of abating. This has forced companies to examine various ways of battling this volatility in both the financial and physical markets.

Many senior financial executives from several large companies addressed this question at Reval’s 2012 Annual Client Conference and User Group Meeting in May.  In normal markets, companies of their size can manage increasing commodity prices (assuming that commodity price risk management was done through the procurement department)  by using physical hedges to buy enough time to modify their pricing models, or to arrange pass through arrangements to customers. However, these executives said that the unusually high level of commodity price volatility over the last six years has made it difficult execute these plans solely through the use of physical hedges.

Commodity volatility coupled with the Global financial crisis has led companies to examine various other approaches to managing commodity risk. One macro trend appears to be the de-coupling of price risk from supply chain risk. Under this model, the procurement department is responsible for managing the physical sourcing of various commodities while the treasury department is responsible for managing the price risk of these commodities. This model has worked fairly well as treasury departments have a wider array of financial instruments to choose from as well as relationships with financial counterparties, and have the added benefit of managing interest rate, currency, commodity, and counterparty risk all from a centralized location.