Commodity Market Volatility: Causes and Strategies for Mitigation from Price Vision's blog

A commodity in the context of procurement is a raw or mid resource used to make a good. Chemicals, agricultural products, oils, minerals, and fuels are examples of commodities. The variety of commodities is expanding to include synthetic materials, special metals, and alternative energy sources. Labor support services are examples of intangibles that are not regarded as commodities. A difficult art to master is ensuring a continuous supply of commodities there at proper price, coupled with precise demand forecasts.

 

Commodities are high-value, business-critical products that are prone to large price volatility. Companies are moving away from just-in-time (JIT) supply strategies and toward buffer stock that takes supply interruption risk into account. The epidemic served as a sharp reminder of the interdependence between suppliers and procurement. Buyers must use their supplier network to adjust to this unstable climate because the commodity market is uncertain.

 

How Do Commodities Work?

Regardless of their origins, commodities are things that are generally of a similar quality and utility. For instance, most customers don't pay close attention to where a bag of wheat or an ear of corn was farmed or milled when they purchase them from a store. Given the interchangeability of commodities, a wide range of products where consumers don't give much thought to the brand may fall under this category. Investors frequently refer to a small number of essential items that are in high demand worldwide in their more focused discussions. Investors frequently concentrate on commodities that are used as raw materials to produce finished items.

 

Commodities are divided into two groups by investors: hard and soft. Metal like gold, iron, and aluminum as well as petroleum products such as crude oil, oil and gas, and undiluted gasoline are examples of hard commodities that need to be mined or drilled for. Soft commodities are produced agricultural products like corn, wheat, beans, and livestock.

 

Various Volatility Levels Commodities

The main factor influencing commodity price changes is supply and demand dynamics. A crop's price often decreases after a large harvest, but during droughts, prices may increase due to concerns that future supplies would be less than anticipated. Similar to this, the need for natural gas to heat homes increases when it's chilly outside, while a mild winter during the winter can cause prices to drop.

 

Commodities typically exhibit higher volatility than stocks, bonds, as well as other types of investments due to the cyclical nature of supply and demand. Some commodities exhibit greater stability than the others, such as gold, that central banks use as a reserve asset to protect them from volatility.

 

However, other commodities frequently fluctuate between steady and volatile circumstances based on market dynamics, including gold, which can occasionally become volatile.

 

How to Make Commodity Investments

Four strategies exist for investing in commodities:

1. Direct investment in the commodity.

2. Investing using commodity futures contracts.

3. Purchasing shares of commodity-focused exchange-traded funds (ETFs).

4. Purchasing stock in businesses that create goods.

 

5 Factors That Make Commodities More Volatile

1. Availability

Each day, a tremendous amount of volume is attracted to the share, bond, and currency markets. Over the years, trading in various asset classes has increased to astounding levels. However, compared to other common assets, many products that trade on futures exchanges have far less availability or trading volume. Even though gold and oil are the most actively traded commodities, both markets can experience extreme volatility due to the possibility of endogenous or exogenous shocks.

2. Mother Nature

Weather patterns and occasionally occurring natural calamities are determined by Mother Nature. A copper price increase could result from an earthquake in Chile, the greatest copper producer in the world. Corn and soybean prices could soar in the event of a recession in the U. S. as crop yields fall.

3. Demand and Supply

Supply and demand are the main determinants of the raw material price path of least resistance. Commodity production takes place in regions of the world in which the soil and climate is favorable for growing crops, where the earth's crust contains reserves, and where extraction can be done at a cost that is less than the market price. In contrast, demand is present everywhere. The fundamentals of daily existence, commodities, are consumed by almost every human on the planet. As a result, raw resources are frequently among the most price-volatile commodities in the world due to the demand and supply relationship.

4. Global politics

Political unrest in one place frequently affects prices since certain regions on our globe have significant commodity reserves.

 

Additionally, conflicts or acts of violence in one region of the world might block logistical channels, making it difficult or impossible to carry goods from producing areas to demand zones all over the world. The price dynamics of a commodity are frequently altered by tariffs, federal subsidies, and other political pawns, which increases volatility.

5. Leverage

The futures markets are the conventional route for dealing or investing in commodities. Futures have a lot of leverage available. In order to control a considerably bigger monetary stake in a commodity, a buyer or a seller of a long position simply has to make a modest deposit for a house or fair and reasonable deposit, known as margin. Initial margin rates for commodities typically range from five to ten percent of the overall contract value. As a result, compared to other assets, traders and investors have significantly more access to leverage in commodity futures.

 

Three strategies to lessen price volatility

 

Reducing cost uncertainty reduces pricing risk. The majority of businesses base their commodity purchases on current market prices. Spot buying or long-term supply contracts are used to accomplish this. Companies typically utilize one of two methods to reduce risk:

1. Hedging of finances - It is a strategy used to reduce uncertainty by safeguarding against negative price fluctuation.

2. Supply-side tactics - Companies might employ a cooperative partnership approach or use many suppliers to assure competitive pricing and lessen the impact of prospective price hikes. They can establish purchasing agreements with fixed prices or ones that include a cap on price rises.

3. Demand control - An alternate strategy for mitigating negative pricing effects is to rebuild the product BOM and cut back on the amount of time the commodity.

 

Hedging of finances

Financial hedging tries to reduce the risk of changes in external market prices. Companies employ derivative instruments to reduce risk, including forward, futures, swaps, and options. Some procurement teams lack a basic understanding of how derivatives or forward contracts operate and the variety of safeguarding possibilities that are available. Different instruments have different liquidities, which affects how effective they are in various circumstances.

 

Hedging entails communication with outside parties, including brokers and their preferred exchanges, such as Shanghai Futures Exchange, Euronext, and Intercontinental Exchange. Better flexibility and a sense of calm may be obtained by employing an outside trading firm or broker, even if the cost may be higher than just hedging the risk.

 

A strong governance framework is necessary for managing commodities prices risks and deploying mechanisms to hedge these risks. When marketplace prices are low, many businesses are attracted to insure their commodity prices, which is the equivalent of placing a market bet. Focus must be placed on minimizing exposure to a risk if it is costly or difficult to hedge that risk.

 

Supply-side tactics

Volumes are guaranteed for the term of the contract under set price agreements with a single supply partner, often at the going rate. This enables both partners to more effectively arrange their finances for the upcoming years. Price caps, fixed percentage increments, and increases correlated to an index of commodity prices are examples of variations on this sort of contract. By doing this, the supplier and the customer share the risk of price rises, and both are now responsible for successfully managing company’s financial performance to prevent and prepare for the negative effects of commodities price increases.

 

Equally knowledgeable and well-informed supply decisions should be made by procurement. The disadvantage of engaging with numerous suppliers is that you lose price pressure on volume commitments. Fixed-price contracts have not received the same attention from mid-size businesses as risk management and pragmatic hedging have. A trend is a slow transition from a cost-managed method to a combination approach. Risk is countered in part via hedging instruments including futures, swaps, and options.

 

Demand control

Reducing the dependency on a particular material by making adjustments to the design, manufacturing, or supply chain procedures is another method of controlling commodity prices.

 

Re-specification, continual supplier improvement, and the encouragement of innovation activities can all help with this. Together with diverse stakeholders, procurement can find affordable alternatives or go after the need.

 

There may be a chance to alter the product mix, which would lessen the demand for goods that are especially vulnerable to price fluctuations. In the food business, for instance, the cost of grains oils might fluctuate, and less expensive alternatives may be available.

 

What part does procurement play in controlling the price of goods?

Managing commodities risk successfully requires a category manager to:

 

1. Comprehend the key input costs for each supplier and the cost drivers for the finished product,

2. Be well-versed in their respective commodities markets and skilled in benchmarking methodologies,

3. Have access to forecasts, trends, and real-time market pricing data in a single database, and

4. Learn how to negotiate supply contracts and manage financial risk.

 

The nature of sourcing management is determined by the characteristics of the commodities, internal purchasing criteria, and risk tolerance. Buyers of commodities should conduct extensive due diligence to comprehend internal requirements and external market dynamics in order to choose the best risk reduction strategy.