Question

COULD YOU USE COMMODITY LINKED NOTES TO REDUCE CREDIT RISK AND TO ADDRESS POLITICAL RISK AND/OR EXCHANGE CONTROL?

Answer 1

What Is Commodity Price Risk?

Commodity price risk is the possibility that commodity price changes will cause financial losses for the buyers or producers of a commodity. Buyers face the risk that commodity prices will be higher than expected. For example, many furniture manufacturers must buy wood, so higher wood prices increase the cost of making furniture and negatively impact furniture maker profit margins.

Understanding Commodity Price Risk

The Risk to Buyers: Automobile Manufacturers

Commodity price risk to buyers stems from unexpected increases in commodity prices, which can reduce a buyer's profit margin and make budgeting difficult. For example, automobile manufacturers face commodity price risk because they use commodities like steel and rubber to produce cars.

In the first half of 2016, steel prices jumped 36%, while natural rubber prices rebounded by 25% after declining for more than three years. This led many Wall Street financial analysts to conclude that auto manufacturers and auto parts makers could see a negative impact on their profit margins.

The Risk to Producers: Oil Companies

Producers of commodities face the risk that commodity prices will fall unexpectedly, which can lead to lower profits or even losses for producers. Oil-producing companies are exceptionally aware of commodity price risk. As oil prices fluctuate, the potential profit these companies can make also fluctuates. Some companies publish sensitivity tables to help financial analysts quantify the exact level of commodity price risk facing the company.

For example, the French oil company Total SA once stated that their net operating income would fall by $2 billion if the price of a barrel oil decreased by ten dollars. Similarly, their operating cash flow goes down by $2.5 billion when the oil price drops by ten dollars. From June 2014 to January 2016, oil prices fell by over $70 per barrel. According to the formula, this price move should have reduced Total's operating cash flow by about $17.5 billion during that period.

Hedging Commodity Price Risk

Major companies often hedge commodity price risk. One way to implement these hedges is with commodity futures and options contracts traded on major exchanges like the Chicago Mercantile Exchange (CME). These contracts can benefit commodity buyers and producers by reducing price uncertainty.

Producers and buyers can protect themselves from fluctuations in commodity prices by purchasing a contract that guarantees a specific price for a commodity. They can also lock in a worst-case-scenario price to reduce potential losses. Futures and options are two financial instruments commonly used to hedge against commodity price risk.

Lower commodity prices are a risk for producers of a commodity. If crop prices are high this year, a farmer may plant more of that crop on less productive land. If prices fall next year, the farmer may lose money on the additional harvest planted on less fertile soil. This is also a type of commodity price risk.

Factors in Commodity Price Fluctuations

Factors that can influence commodity prices include politics, seasons, weather, technology, and market conditions. Some of the most economically important commodities include raw materials like the following:

• Cotton
• Corn
• Wheat
• Oil
• Sugar
• Soybeans
• Copper
• Aluminum
• Steel

Political Factors

Political factors can raise the price of some commodities while reducing the prices of others. In 2018, President Donald Trump imposed tariffs on steel and aluminum imported from foreign countries. The direct effect of these tariffs was to increase steel and aluminum prices in the United States relative to the rest of the world.

China retaliated against Trump's tariffs by imposing its own tariffs on U.S. agricultural products. With lower demand from China, excess crops must be sold in other markets. As a result, many crop prices were down in the U.S. in 2019.

The Weather

Seasonal and other weather fluctuations have a particularly large impact on commodity prices. The end of summer brings with it plentiful harvests, so commodity prices tend to fall in October. These seasonally depressed commodity prices may be one of the reasons why major stock market crashes often happen in October. Droughts and floods can also lead to temporary increases in the prices of certain commodities.

Technology

Technology can have a dramatic influence on commodity prices. Aluminum was considered a precious metal until procedures for isolating it improved during the 19th and 20th centuries. As technology advanced, aluminum prices collapsed.