An introduction to commodity-specific risks

 

In this article, the first in a planned series of risk management topics by Inside Out Advisors, we begin with a discussion about risks particular to commodities.

Although many of the risks we will deliberate over below do occur in non-commodity asset classes, they are not defined by them. For commodity markets, however, these characteristics are their very identity and it would be impossible to understand the functioning of any of them without having considered each individually.

The primary risk for commodity producers and consumers is the price that they receive or pay for the material. Commodity prices are highly mean-reverting. Deviation from the invisible mean is based upon assumptions concerning the future availability of the commodity. Convergence of inventory levels to the market consensus of quantities required for a balanced market are the driver of mean reversion. Shortages of inventories will mean consumers are willing to pay premiums for earlier deliveries than at later dates whilst surpluses of inventories mean consumers command a discount for material today compared to delivery at a later date. The fluctuation of this spot price from top to bottom is the mean-reversion cycle. This is also the cause of significantly higher volatility observed in a commodity market.

Commodities are also subject to a degree of substitution as prices diverge from the mean in either direction and hence over the longer term the mean-reversion cycle is limited to theoretical bounds. The practical challenges to appropriate supply and demand responses inevitably take time to materialise and so these boundaries can often become quite stretched. As a result, supply or demand deficits can persist for long time intervals, generating a commodity price cycle measured in years, not months.  Long-term hedging plans should be cognizant of where one is in that cycle.

Commodity prices often exhibit high degrees of seasonality.  This can be driven by the cyclical changes of production, storage and consumption (for example natural gas for heating during winter or agricultural production which is dependent on expected weather patterns).  Strong seasonal patterns are exhibited in the forward price curve (the ‘Term Structure’) for those commodities where inventories are built and depleted rapidly at certain times of the year. For example, see the current Natural Gas term structure in the chart below.

Both producers and consumers of commodities typically buy and sell material at the average price over a loading-period against a benchmark index, plus or minus a spread (more on this below). To mirror this, price risk management in commodities often takes place using average-price instruments, called ‘Asian’-style options or swaps.  Because large producers may be loading their material continuously, hedging using calendar-month averaging instruments provides a very close proxy to the overall price-risk being run. In more traditional financial asset classes, such as FX, the entire notional volume of an obligation can be transferred instantaneously and this limits exposure to a single point in time which can be managed by more traditional ‘European’ style options and swaps.

Beyond the discussion of high-level price risk management, commodities display many peculiar second-order risks once physical settlement is introduced into the equation.  These can be broadly classified as basis risk: the risk that the value of a hedging contract will not move in line with its underlying exposure.

Basis risk in commodities can be broken into two parts.  The first part is generally acknowledged by most risk management literature to be the difference between the spot price and the futures price, and is a concept that we will discuss in more detail in a future post on commodity forward curve structure.  The second part, often overlooked, relates to the potential price difference between the physical commodity being hedged and the reference spot price being used to determine the actual buying and selling price. This can be down to differences in quality, brand or location.

Quality risk occurs when the product type or quality specified in the hedging contract differs from the product or quality of the underlying commodity being hedged. For example, a steel mill using cleared Iron Ore swaps contracts to hedge this core input cost would receive a price hedge referenced to 62% iron ore fines, a medium grade of fine ore. However, to produce high-quality steel its furnace may require 65% grade material, and the price differential between these two grades can vary significantly as shown in the chart below.

Source: Fastmarkets MB

Brand risk has elements of both quality risk and political risk and is generally only an issue in metals markets where units are branded by the producing company and their non-perishability allows them to persist within global inventory indefinitely.  An example of this occurred in April 2018 when Russian aluminium producer Rusal became embroiled in US-led sanctions against a number of Russian entities.  The London Metals Exchange (LME) responded by suspending permission for Rusal branded material to be delivered into their warehouses or placed on warrant.  As a result, any trader with Rusal-branded physical inventory outside of the LME warehouse system became unable to deliver this material against maturing short LME forward hedges, with significant financial implications. In oil markets a similar situation could occur with oil originating from a sanctioned regime – such as Iranian Oil under recent US sanctions.

Location risk exists when the delivery point of a hedging contract differs from the location of the commodity being hedged.  This location mis-match can be known at the outset of the hedge, such as in the case where an Algerian oil producer hedges its production with Brent crude oil futures (which have a North West Europe delivery point).  Or, it can be unknown until maturity of the hedge such as with non-ferrous metals traded on the LME where the buyer of the contract can receive warrants for material at any of the warehouses registered globally, at the contract seller’s discretion.  The chart below shows the premium for Mid-West Aluminium as assessed by Platts, ranging between approximately 7.5 cents/lb and 22 cents/lb. This physical premium almost tripled over a year , driven by a combination of Russian sanctions and the US/China trade war, adding over 15% to the overall price of the physical commodity.

Platts’ Aluminium MW US “Transaction Premium” – A US location premium

Data: Platts, CME, TradingView

These risks are significant but can be monitored with a good inventory management system.  The more common location or quality risks can sometimes be hedged with basis swaps, although this may require a bilateral Over-The-Counter (OTC) arrangement which introduces additional credit, legal, liquidity and margin considerations.

In addition to the types of basis risk just described, commodities trading can incur a slew of additional idiosyncratic risks.  Some lie hidden in plain sight.  For example, a commodities trader may have a differential or spread position where she is short German power futures and long Dutch power futures in expectation of their price differential narrowing.  A purely quantitative approach to risk measurement of such a position could miss the inherent political risk that this spread entails. Specifically, a deterioration in political relations between the EU and Russia could result in the restriction of Russian gas exports: German power generation is much more dependent on imported Russian gas than is Dutch power.

Away from these market-related risks, traders of physical commodities encounter operational risks such as potential environmental accidents, production and delivery risks relating to natural catastrophe, and political risks such as asset expropriation. Whilst the initial financial impact of most of these can be hedged with insurance contracts, the long-term reputational damage of an environmental disaster or delivery failure may never be erased.

The objective of this paper is to provide a high-level introduction to commodity risk factors .  Inside Out Advisors are available to discuss any of this content in greater depth and if needed can help you map out the precise risks faced by your organisation and generate a framework for their effective management.

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