Like every investment, there are risks involved when trading commodities. While the exchanges try to limit these risks they cannot be completely cancelled out. When entering a commodity market, it is important to take these market risks into account and have a structured risk management system in your company. This way, precautionary measures can be taken to limit the risks or determine that the possible profit is worth the risk. There are a number of parties exposed to market risks, such as producers and manufacturers, exporters and importers and traders of commodities. The exposure level to these risks differs per party as do the measures to minimize these risks. There are different specific risks per commodity market, but there are also common risks, which can be found on any type of commodity market. To successfully manage these risks and minimize their effect, a keen understanding of these risks is essential.
Price risk
Prices variations are the most well known risk in commodities. Producers, manufacturers and consumers are all affected by changes in prices. Prices are based on the supply and demand of a market. It is impossible to predict exactly which way a price will move in the future, but by using historical data and trend watching, the risk of unexpected price movements can be reduced. Therefore the different parties agree on futures contracts to make sure they buy or sell their products at an acceptable price thereby relinquishing any possibility to make an even greater profit should the market move in their favor.
Basis risk
This is a risk that occurs when hedging a commodity to minimize the effects of price fluctuations. This risk occurs when the basis or the difference between the spot and futures price, changes between the time a hedge is placed and lifted. Depending on the direction of the basis changes, it will be beneficial to one position and detrimental to the other position. Due to the basis being fairly stable, the potential loss or gain can be predicted with some degree of certainty. This type of risk cannot be eliminated via hedging, but due to its predictability can be calculated into the risk assessment.
Quantity risk
Mainly producers and manufacturers are in a position where quantity risks become a factor to take into consideration. This form of risk is based on the quantity of products realized by a producer. When he expects a high demand for a certain product and he produces a quantity of his products, he needs to be sure he is able to sell these products. Should the demand decline, he would end up with an amount of product for which there is no demand or he must sell his products for a much lower price and thus gain only a small profit or even a loss. To prevent this risk he can sell futures contracts, thereby insuring his products are sold at an acceptable price.
Another form of quantity risk arises when hedging commodities. To minimize risks, participants on the market may chose to hedge risks by using futures contracts. The use of futures however can create an extra risk on itself. Due to the standard size of futures contract, an out-of-balance may occur between the futures size and the number of products that need to be hedged. This can result in a portion of your products not being hedged or the hedge covering more production than required. Another risk involving hedging is the amount of products you want to hedge. In many cases only a portion of the production risk will be hedged. This brings the risk of uncertainty about the amount to hedge and can result in over or under hedging of a commodity.
Geopolitical risk
Some natural resources can only be found in certain parts of the world. In these situations, companies planning to extract these natural resources must consider the risks involved in working with the government of a country. To gain access to these resources, a lot of aspects must be considered and worked out with a government. Such aspects are tax structures, environmental concerns, license agreements and indigenous employers. All these factors can increase the costs considerably and thus must be considered whether it is still profitable. These aspects can change along the way due to political decisions and therefore the political climate must be monitored constantly. In extreme cases, the instability of a country can cause great risks, when this result in riots or coups. Such risks are very difficult to prevent.
Another considerable risk is the potential nationalization of the commodity. When a country decides to nationalize the natural resource, companies who have invested greatly in extracting the resource will now be without the access to the resource. It is therefore important to maintain good relations with the government, to minimize this type of risk.
Speculative risk
When investing in the commodity market one is always exposed to speculative risks, because there is no guarantee an investment will make a profit or loss. The level of speculative risk can however differ per commodity. Commodities with a high volatility also have a higher speculative risk, because the price will move significantly, which can result in large profits or losses. Therefore before making investments, it is important to have a good understanding of the factors that influence the price of a commodity. This way an assessment can be made as to whether an investment is likely to make a profit or that it has a high chance to result in a loss. This will help decide how to operate on the market and minimize the speculative risk.
