Commodity risk most commonly refers to price fluctuations for raw materials like steel, wood, gas, grains, coffee, and similar products. Price changes in either direction comprise a risk: a price increase is a risk for commodity buyers who use the materials to create their products. But for commodity producers, a price decrease is a risk. For example, if your company needs lumber to build homes or other products, the price increase can be a considerable risk. On the other hand, if reduced demand results in a price decrease, sellers (producers) risk losses.
Recently, Commodity Prices Have Surged
In 2021, many commodities experienced price increases, led by energy and metals. The historic lumber shortage of 2021 was created by a combination of several factors working together. First, sawmills cut production in 2020 at the onset of the pandemic due to concerns about a potential drop in demand for housing. Instead of a housing crash, demand soared. Interest rates stayed low, driving up prices as homebuyers looked for new construction and more room for their newly-necessary home offices. At the same time, Americans realized a sudden need to renovate, exacerbating the demand for lumber products. As a result, the cost of lumber shot from under $500 per thousand board feet in January 2020 to over $1,500 per thousand in May 2021.
Commodity Price Swings Significantly Impact Company Earnings
According to a study published by strategic consulting firm Oliver Wyman, commodity price volatility is the second-largest contributor to earnings uncertainty in publicly traded companies (with the largest being macroeconomic factors). In addition, raw materials comprise almost half the cost for consumer products companies, yet these expenses are traditionally difficult to control.
Aside from the recent examples of wood and energy products, some commodities that are historically considered volatile include sugar, soybeans, coffee, and precious metals (notably gold and silver).
What Causes Commodity Price Volatility?
There is no single answer to the causation question. As you can see from the lumber example, several circumstances combined to create the perfect environment for a tremendous price increase. Other commodities react to different stimuli. For example, crude oil, one of the commodities most subject to price fluctuations, responds to supply and demand, political influences, seasonal demands, production changes, supply disruptions, global warming, and regional political conflicts. Cotton, which is relatively stable over time but experiences periodic sharp spikes, responds to other factors, including climate, oil prices, the dollar's value, the popularity of alternatives, and the status of stockpiles.
Hedging Risk with Futures and Options
Commodity producers, consumers, and investors in both types of companies are all interested in managing the risks associated with volatility. One way that some try to do so is by hedging their investment through futures and options. Buying commodity futures is speculative, with high risk and potentially high reward. A futures contract is a commitment to buy or sell a commodity at a set price on a specific date in the future. If you agree to purchase the product for less than the available price on that date, you can profit.
Conversely, if you are committed to paying more than the price on that date, you incur a loss. In addition, futures can lock in a price for an expected purchase. Options give the investor the right to purchase at a specified price but carry no obligation.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Trading futures involves the risk of loss and is not suitable for all investors. Please consider carefully whether futures are appropriate to your financial situation. Only risk capital should be used when trading futures. Investors could lose more than their initial investment. You must review customer account agreement prior to establishing an account. Past results are not necessarily indicative of future results. The risk of loss in trading can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition. Options are not suitable for all investors. There are risks involved in any option strategy. Individuals should not enter into option transactions until they have read and understood the option disclosure document titled "Characteristics and Risks of Standardized Options," which outlines the purposes and risks of option transactions. This booklet is available from your Financial Advisor or at http://www.theocc.com/about/publications/character-risks.jsp. Supporting documentation of claims will be supplied upon request.
