Commodity Risk

Commodity risk management is an important function for corporate treasurers, particularly in industries reliant on raw materials like agriculture, energy, and manufacturing. Below is an expanded analysis of commodity risks, their implications, and actionable strategies for treasurers, supported by real-world examples and frameworks.

1. Price Risk: Managing Market Volatility

Price risk arises from fluctuations in commodity prices, exchange rates, and basis risk (the mismatch between local and global prices). For example, aluminium prices surged by over 50% between 2009 and 2011, which created cash flow unpredictability for manufacturers dependent on this metal. Treasurers mitigate this through:

Derivatives: Hedging with futures, options, or swaps. For instance, Coca-Cola HBC centralized commodity hedging in its treasury to reduce profit/loss volatility by using derivatives for aluminium, oil, and sugar.
Long-Term Contracts: Locking in prices with suppliers. Fast-moving consumer goods (FMCG) companies often hedge staples like wheat and corn through fixed-rate agreements to stabilize input costs.
Proxy Hedging: Using correlated instruments (e.g., crude oil futures to hedge jet fuel costs) when direct hedges are unavailable.

Relevance for Treasurers: Centralized treasury teams can leverage economies of scale to negotiate better terms and align hedging with corporate risk appetite. For example, a buy/sell model—where a centralized purchasing entity acts as an intermediary—smooths price volatility across subsidiaries.

2. Quantity/Volume Risk: Managing Supply-Demand Mismatches

Volume risk occurs when production or demand forecasts deviate from reality. A food manufacturer might face excess grain stocks due to overestimating demand, leading to storage costs or forced sales at lower prices.

Flexible Contracts: Building volume adjustment clauses into supplier agreements. One treasurer highlighted negotiating flexible purchase volumes in contracts to avoid overstocking while retaining netting benefits.
Data-Driven Forecasting: Using analytics to align procurement with market trends. Coca-Cola HBC implemented a SaaS treasury system to track exposure and optimize hedging timing.

Relevance for Treasurers: Collaboration with procurement teams ensures physical supply risks (e.g., delivery delays) are integrated into financial hedging strategies, preventing over-hedging.

3. Cost Risk: Balancing Input Price Uncertainty

Input price risk affects producers (e.g., farmers facing rising fertilizer costs) and buyers (e.g., manufacturers reliant on energy). For example, a beverage company may hedge sugar prices but leave minor packaging costs unhedged to focus on material exposures.

Supplier Collaboration: Passing risk to suppliers via fixed-price contracts (though this often incurs premium costs).
Holistic Exposure Mapping: Cataloguing direct (e.g., raw materials) and indirect exposures (e.g., transport fuel). Treasurers at Coca-Cola HBC isolated market risk from operational procurement, improving cost predictability.

Relevance for Treasurers: Centralizing procurement and treasury functions allows for cross-departmental risk assessments, ensuring cost risks are prioritized based on financial impact.

4. Political Risk: Geopolitical and Regulatory Challenges

Exporters and governments face risks like export bans or currency controls. For example, a mining company operating in politically unstable regions may hedge against license cancellations using insurance or diversified suppliers.

Diversification: Sourcing commodities from multiple regions to reduce dependency.
Scenario Analysis: Modeling geopolitical shocks (e.g., trade embargoes) to quantify potential losses.

Relevance for Treasurers: Integrating political risk into enterprise risk management (ERM) frameworks ensures alignment with broader financial strategies, such as liquidity buffers or contingency funding.

Strategic Frameworks for Treasurers

Centralized Risk Management:
- Centralizing hedging in treasury improves transparency and reduces duplication.
- Example: A “trade hub” model centralizes purchasing and hedging, enabling fixed transfer pricing and netting opportunities 1
Technology Integration:
- Advanced treasury management systems (TMS) like to automate exposure tracking, hedge accounting, and reporting.
Cross-Functional Collaboration:
- Treasury and procurement teams must align on risk thresholds. For instance, procurement’s flexibility in vendor selection can reduce the need for financial derivatives.
Regulatory Compliance:
- Updated accounting standards (e.g., IFRS) now allow hedge accounting for commodities, reducing P/L volatility from fair-value adjustments.

Case Study: Proactive vs. Reactive Approaches

A food manufacturer facing barley price swings (which doubled in five years) adopted a portfolio approach:

40% fixed via long-term contracts.
30% hedged with futures.
30% retained for upside potential during inflation.
This balanced strategy reduced cash flow volatility while preserving margin flexibility.

Challenges and Solutions

Basis Risk: Standardized derivatives may not perfectly match exposures. Treasurers must monitor correlations (e.g., jet fuel vs. crude oil).
Data Gaps: Poor visibility into indirect exposures (e.g., transport fuel) can lead to under-hedging. Solutions include ERM frameworks and real-time analytics.

Conclusion

For treasurers, commodity risk management is no longer optional but a strategic imperative. By leveraging centralized structures, technology, and cross-departmental collaboration, treasurers can transform volatility into competitive advantage. Integrating commodity risk into a holistic treasury framework enhances predictability, reduces costs, and aligns with investor expectations.

References

https://www.theglobaltreasurer.com/2011/06/01/commodity-hedging-in-volatile-times/
https://www.theglobaltreasurer.com/2024/02/02/becoming-a-navigator-of-commodity-risk/
https://zandersgroup.com/en/insights/blog/challenges-to-treasurys-role-in-commodity-risk-management
https://www.pwc.com/sg/en/services/risk/commodity-trading-and-risk-management.html
https://wiki.treasurers.org/wiki/Guide_to_risk_management
https://www.theglobaltreasurer.com/resources/case-study-coca-cola-hbc-treasury-takes-control-of-commodity-risk-management/