Commodity risk management

What is commodity risk management?

A commodity is a raw material that can be bought or sold either as a raw material, or in a semi-processed state. Commodities can be split into two categories: hard and soft. A hard commodity is a material or metal that is mined. Soft commodities refer to agricultural goods that are grown, such as cattle or coffee. In a procurement context, commodity management refers to the strategies and processes developed to purchase and move commodities through the supply chain (CIPS,2024). Commodity risk management is the strategies and processes used by procurement professionals to identify, mitigate and manage risks that can affect supply conditions for commodities.

What are commodity risks?

There are many risks within the commodity environment. Some examples are listed below.

• Price fluctuations. Commodity pricing can be influenced by many factors, such as supply and demand, geopolitical stability and currency fluctuations. Commodities are bought and sold in a global context. For example, some grown commodities may only be grown in certain regions depending on climate. Some mined commodities can only be extracted from certain locations because this is where they have been formed. If you are located in a country outside of where the commodity is grown or produced, you will often have to purchase in a currency that is not the same as your home country. The value of one currency against another will fluctuate depending on the exchange rate, meaning that the price you pay for a commodity at one time, will not be the same you pay at another. Exchange rates are driven by many factors, such as politics. For example, the value of the Great British Pound (GBP) against other currencies, such as the United States Dollar (USD), following the announcement of Brexit. Commodity prices are also driven by changes in supply and demand. If demand for a particular commodity is high, then the price will rise. If demand for a particular commodity is low, then the price may drop. If a commodity is in high supply, again, then the price may drop as there is a high volume of products available. If there is low availability of a certain commodity – for example low volume of a grown commodity such as wheat, due to extreme weather producing low yield quantities, then the price may rise. Monitoring trends in commodity pricing is vital for establishing the optimal time to buy, particularly for seasonal commodities. The price for one commodity may also impact the prices associated with another. For example, if fuel prices rise, this may, in turn, affect the price of metal ores due to price increases associated with powering the machinery required to extract them.
• Availability of commodities. As mentioned above, commodity availability may be affected by factors such as extreme weather conditions, especially for grown commodities such as crops. Extreme weather conditions may also affect hard commodities by restricting the ability to extract them, for example, if a site floods, limiting access for the required machinery.
• Environmental, social and governance (ESG). There are many ESG risks surrounding commodities, such as human rights and scarcity. Many commodities, for example coal, are natural resources and are finite in nature. Once they have been fully consumed, there will be no more materials available to extract. Organisations are under increasing pressure to be more sustainable and revert to renewable materials where possible. Organisations that are over-reliant on non-renewable commodities may face future challenges as availability reduces longer term. In addition, there are many social risks in the commodity market with regard to the labour used to farm, mine or extract materials. Organisations using commodities in their supply chains will need to be aware of these risks and operate stringent supplier evaluation and selection criteria, along with supplier audits, to ensure the eradication of unethical behaviours.
• Regulatory risks. There are many regulatory risks associated with the commodity market, such as environmental regulations (e.g., carbon emissions, water emissions and land protection), trade and tariff policies (e.g., import and export tariffs, quotas, or trade restrictions and embargos), health and safety standards (e.g. occupational safety or product safety requirements), and market access (e.g. permits may be required to extract or produce certain commodities). It is important to understand the regulatory risks associated with the commodities you purchase and to audit and assess suppliers for compliance. Commodity markets can be heavily regulated, to promote competitive, transparent and fair marketplaces, free from fraud and unethical practices. Examples of commodity regulators include the Markets in Financial Instruments (MiFID) in the EU.
• Transportation risks. As outlined earlier, commodity trading operates in a global context, meaning commodities are bought and sold across borders. This, in turn, means that they need to be transported from one country to another. This can present risks associated with transportation, such as theft, loss or damage to goods in transit, import/export restrictions and documentation and the environmental implications of moving goods internationally (for example, carbon emissions produced by transportation methods). The use of experienced freight forwarders or third-party logistics providers (3PLs), appropriate insurance and Incoterms ® can help to mitigate these risks. Effective demand planning and consolidation of materials, alongside evaluation of the most environmentally appropriate transportation methods can help to mitigate these risks.

Why is commodity risk management important?

There are many risks within the commodity environment. Some examples were discussed above.

Effective commodity risk management can help to reduce and mitigate procurement organisations’ exposure to these risk factors and ensure that the business is able to achieve the best value for money and security of supply. In addition, exposure to some of these risks, especially legal, social or environmental risks can harm an organisations reputation, leading to an inability to trade, legal implications, fines or penalties, and reputational damage.

How can I mitigate and manage commodity risk?

Procurement and supply professionals can mitigate commodity risk in various ways.

Monitoring trends

Procurement and supply professionals can monitor commodity trends through the spot market or the use of relevant commodity indices. The sport market is where a physical product is sold for immediate delivery and immediate payment. Transactions are referred to as spot transactions. In this market, the commodity is bought at the price advertised at the time. By actively watching and monitoring price trends on the spot market, procurement professionals can attempt to forecast the best time to buy, and make purchases when prices are more favourable. Procurement professionals can also use commodity indices to monitor availability and trends in supply and demand. Keeping abreast of industry news through media and industry publications can also help identify any upcoming or emerging risks, such as political or economic instability, regulatory changes, or environmental factors like extreme weather, that may affect commodities.

Hedging

Hedging is commonly used to mitigate the risk of price fluctuations in the commodity market. Hedging methods can also be used to manage the risk of currency fluctuations when purchasing goods or services internationally. Hedging typically works by taking an opposite position in a financial instrument (such as futures, options or swaps) to offset the risk of price fluctuations.

Futures and forward contracts are a form of hedging. If a commodity is not required for immediate consumption, a forward contract may be used. A forward contract is used to purchase a commodity at the current spot price but for delivery at a specified future date. This means that the procurement organisation is able to purchase at a present-day favourable price but not receive or pay for the commodity until a later date. A futures contract is where a commodity is purchased for an agreed, locked-in futures price. These methods help mitigate the risk of price fluctuations if the spot price increases between the point of sale, and the point of delivery.

The risk with futures or forward contracts is that the spot price for a commodity may also decrease at the point of delivery, meaning that the business has lost money. An options contract can be used to mitigate this risk. Options require the purchaser to pay a premium, which gives them the right to buy or sell a set quantity of a commodity at a pre-agreed price, known as the strike price. This means that if the price movement does go against them, they are under no obligation to buy. If the spot price decreases at the point of delivery, they do not proceed with the purchase.

Supplier monitoring, selection and evaluation processes and auditing

Stringent supplier selection and contract award criteria, such as supplier questionnaires or pre-qualification assessments, can help to identify appropriate commodity suppliers and mitigate risks. Requesting evidence of relevant certifications or standards can help to mitigate social and environmental risks in commodity supply chains. Supply chain visibility exercises can help to identify high risk areas, which may require audits or further due diligence activities to ensure compliance.