Inventory price volatility makes efficient and profitable operations more difficult for businesses across the metals industry. When the cost of key materials quickly and substantially fluctuates, it is all too easy for companies to face price inefficiencies that ultimately harm their bottom line.
There are effective strategies for mitigating the impact of volatile commodity prices, however. Commodity risk management is a broad concept that incorporates several avenues for addressing price changes, such as hedging strategies that involve financial markets, contracts and thoughtful use of credit.
With a deep understanding of these concepts as well as effective use of them, your business may mitigate the financial risk inherent in an industry where commodity prices can change in a rapid and drastic fashion.
First, we will look at the answers to common questions related to managing price fluctuations, then review some workflows for managing volatile commodity prices.
What is commodity price risk?
Commodity price risk can be summarized as the lack of control that companies, including but not limited to those in the metals manufacturing industry, have related to price when purchasing commodities. The need to purchase raw materials on a continuing basis means businesses have to contend with market conditions, which can increase costs and therefore harm overall profitability.
That lack of control and associated uncertainty around cost is not a clear sign of poor management or inefficient processes. It is, instead, a risk inherent in the market. Commodities like metals are subject to a wide range of external forces, generally outside the control of any one business, that can drive costs up and down. Just a few potential reasons why prices on commodities markets may rise or fall include:
- Increased or reduced demand, whether by customers for finished products or competitors for raw materials or components.
- The influence of traders, investors and other actors on commodities markets, when a popular course of action may drive or lower demand.
- Recessions, recoveries and upswings in national economies, as well as the global economy.
- Geopolitical considerations, which may make it easier or more difficult to extract and ship certain materials through the supply chain.
How does commodity risk affect a company?
Commodity risk adds an element of uncertainty to core business processes. Budgeting becomes more difficult, especially for long-term projections. Companies may feel a need to keep more money on hand as part of a cash flow strategy to address the potential increases in cost, tying up funds that could be used for many other purposes.
Of course, companies can also benefit from conditions that cause a drop in the price of a relevant commodity. However, this is not a benefit that enterprises can count on.
Without a commodity risk management strategy, businesses are at the mercy of price volatility in the market. A spot purchase is completely dependent on the current rate for a given commodity. A contract that uses the commodity price at the time of actual purchase provides a guarantee in terms of access, but not price.
What is commodity risk management?
Commodity risk management refers to strategies businesses can put in place to limit the financial pressures faced when dealing with volatile commodities.
Hedging, the practice of reducing the financial and general business risk of fluctuating prices, is central to an effective commodity risk management strategy. This can come in two forms:
- Futures contracts: A futures contract is an agreement between a buyer and a seller, wherein both parties commit to a transaction for a specific amount of a commodity, at a specific time and for a specific price. This approach allows for a much higher degree of certainty in terms of commodity pricing than is possible with spot purchases. Buyers benefit from having clarity in terms of quantity, financial obligation and purchase date, while sellers protect themselves from price changes and guarantee a sale.
- Options: After purchasing an option, the buyer has the right to make a purchase of a specific amount of a commodity at a mutually agreed upon price and time, but is not obligated to do so. The seller, meanwhile, is obligated to make the sale — they cannot decline to take this action. This can be especially attractive to businesses, as an option puts the power of choice into the company’s hands. However, it involves a financial commitment that is not returned, should the buyer decide to not act on the option.
Hedging is a complex process that can differ greatly between industries, market sectors and individual businesses. It is vital to formulate a strategy based on factors unique to your company, such as financial position, obligations to customers and business goals, and involve financial advisors, executives and relevant department leaders.
Businesses can consider many other effective options to support and augment these core practices, such as business lending. A carefully planned influx of funds can make commodity risk management plans that much more effective, empowering business leaders to make the best decisions possible for their enterprise.
Comerica Bank has more than a century of experience offering effective lending products to companies across the metals industry. As a proud member and supporter of the Metals Service Center Institute (MSCI), we are committed to understanding and addressing the needs of organizations just like yours.
To learn more about how Comerica Bank can support your commodity risk management strategy through lending, get in touch with our team today.
