Commodity Price Risk - Explained
What is a Commodity Price Risk?
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Table of ContentsWhat is a Commodity Price Risk?How Does Commodity Price Risk Work?Groups affected by Commodity Price RiskFactors affecting commodity pricesAcademic Research for Commodity Price Risk
What is a Commodity Price Risk?
Commodity price risk refers to financial losses that may occur to both the consumer, and the producer when there is a change in commodity prices. A risk for the buyers is that the prices for commodities may be high. Take an example of the carpenters. They have to buy wood to make furniture. If the wood prices go up, it will also mean that the costs of buying furniture will be higher. The producers will have lower profits because there will be few buyers.
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How Does Commodity Price Risk Work?
Generally, producers face the risk of low commodity prices. For instance, if in the first year of planting the prices of crops are high, the farmer plants more hoping for higher profit margins. What will happen when the prices suddenly fall? The farmer makes losses. Commodity price risk does not happen just like that. Factors including weather, technology, politics, market conditions, and seasons affect commodity prices. Financial instruments like futures and options are now in the market to control commodity price risk.
Groups affected by Commodity Price Risk
- Producers including farmers, mining companies, oil companies, and car manufacturers face price risks on their production inputs
- Consumers face price risk when the prices go up as this affects their demand for commodities
- Imposing tariffs on exports causes prices to go up. Exporters also experience hardship in the markets when this happens
- Governments face price risks, especially when it comes to revenue generation. An increase in prices causes the government to generate more revenue
Factors affecting commodity prices
An increase or decrease in commodity prices can occur due to political factors. In the USA, for example, manufacturers import steel and aluminum from foreign countries. In 2018, President Trump imposed tariffs on the imports. The tariffs' goal was to increase the prices of aluminum, and steel in the USA compared to other countries. China did not take this lightly. They later imposed their tariffs on agricultural products from the US. The low demand for agricultural produce from China meant the crops had to be bought by other countries. As a result, the crop prices in the US market reduced in 2019.
- Weather conditions
Change in seasons and weather conditions largely affect the prices of commodities. Farmers harvest plenty of farm produce towards the end of summer, making prices fall in October. The fluctuation of prices during the major seasons' causes crashes in the stock market. Seasons like drought and floods temporarily lead to a hike in the prices of commodities.
- Transportation and storage costs
The type of commodity will determine its storage mechanism. The commodities that have a physical form need storage spaces before distribution. The cost of storage always affects the overall price of a commodity.
Technology has an intense impact on commodity prices. Improvements in technology can cause the prices of a commodity to drop. Take an example of aluminum. It was a valuable metal until new procedures were developed to isolate it. Its value then dropped, and its price in the market decreased.
- Production costs
Capital, labor patterns, raw materials, and production tools have a great influence on the commodity's final price. If the cost of production is high, the commodity price will also be high. However, if the production cost is low, the commodity price will be low. Using hedging futures to control the prices of a commodity Futures markets protect consumers and producers against price fluctuations. A producer faces the risk of prices going down, while consumers face the risk of prices hiking. Hedging protects both parties against financial loss. Futures contracts have periods, and consumers and producers get to choose according to the risks they face. Investors, traders, speculators, and other people in the market can use the futures markets.