Adapting to Volatility: Dealing with Increased Commodity Risk

Published: November 09, 2023

In a trading environment beset by all manner of challenges, managing commodities risk requires treasury responsiveness and flexibility. Luke Roberts, Head of Commodity Sales, Lloyds Bank Corporate & Institutional Banking, looks at risk mitigation best practice.

As macroeconomic conditions continue to fluctuate and the overall economic climate is characterised by uncertainties including geopolitical tensions, inflationary concerns, and ongoing ramifications from the Covid-19 pandemic, commodities are bound to be impacted. Increased price fluctuation means treasury departments need to be agile and adaptive in their commodity risk management strategies.

Whilst volatility has decreased since reaching historically high levels in late 2022 and early 2023, commodity supply and demand remains stressed, with consumers having to navigate both supply-side production cuts and end-user demand stifled by recessionary fears.

Positioning under such uncertainty, where markets are hanging on to every central bank decision or news headline, can be challenging. An ongoing concern for the market participants of the commodities and futures markets is behavioural bias. The speed at which prices are moving and the heightened potential for exogenous shocks have created an environment that fosters behavioural errors which can ultimately affect decision-making – and may even require unpleasant conversations with governing boards.

As a result of these conditions, corporates are increasingly seeking out commodity hedging solutions and guidance. This trend is being driven by corporates in all sectors, including those that are not traditionally seen as being exposed to commodity price risk, such as hospitality and business services. Whether it be to increase supply chain reliability, stabilise cost structures, or protect margins, mitigating risk appears to be leading the corporate agenda.

Client demand demonstrates that the industry is waking up to the need for effective and comprehensive treasury functions, as well as innovative solutions in the face of new challenges. Treasury departments can ensure they are set up for success in a number of ways.

Agility and adaptability

In order to manage commodity risk effectively in today’s environment, treasury departments need to be agile and adaptable. This means having robust treasury processes with enhanced oversight, automation, and control in place.

Clients have already become more mindful of volatility, treating it as a determinant for markets in 2024 and becoming more reactive to its effects. Consumers looking at higher input costs are responding to this volatility by utilising limit orders with aspirational target levels that may have seemed questionable in previous years but today are within the daily trading range.

This helps to reduce ‘buyer regret’ to an extent, but deciding what those levels should be remains difficult. Energy prices, for example, continue to keep treasurers up at night – it’s not just about how high it can go, but also how long it takes to come back down.

An effective treasury function also means being able to incorporate new technologies and data sources into risk management strategies. For example, as generative AI and machine learning become more adaptive, they can be incorporated into predictive analytics, which helps to identify patterns and trends in commodities markets. This can complement traditional Value at Risk (VaR) analysis, allowing treasury departments to make more informed decisions and adjust their strategies accordingly.

Shared view

Centralising the treasury function can help corporates to achieve a more holistic view of their balance sheets. This can be especially beneficial for companies with diverse operations, portfolios, and risk management processes. Ensuring treasury departments become less siloed such as by incorporating corporates' procurement operations means that managers have an aggregate view of their cash flow and risk positions.

The recent energy crisis, for example, has meant that many treasury departments and procurement teams have worked together closer than ever before, upskilling all parties in the management of physical and financial risk factors.

An operational framework and infrastructure linking a company’s diverse operations, portfolios, and risk management processes ensures that even regional treasury departments have the agility and robustness required to respond to highly unstable markets.

Flexible arsenal

While hedging instruments remain largely static, treasury departments should remain open to new and improved strategies. Where possible, having a 360-degree view of exposures, including interest and exchange rates, continues to be best practice.

From a risk advisory perspective, volatility modelling accounting for interest rates, FX, and relevant commodity outlooks has certainly become a mainstay solution for clients, allowing for the construction of layered hedge strategies.

While fixed price commodity contracts continue to appeal to treasurers, given their focus on budget certainty, optionality has grown in popularity, given its embedded flexibility. The airline industry, for instance, resorted to optionality after finding itself with large exposures to energy prices following the pandemic. Not only does optionality infer a limited amount of risk for the buyer, but profit potential is also unlimited. Compared to futures, it provides corporates with the opportunity to generate value from uncertainty.

Stay alert

Looking ahead, geopolitics, seasonality, and hiking cycles will be top of mind for treasurers seeking to mitigate the risk of commodity price volatility. It appears that capacity across financial markets has expanded to accommodate the rising demand from companies expanding their commodity hedging portfolios or venturing into commodity hedging for the first time.

Many financial institutions have broadened their capabilities in commodity trading, as well as raising credit limits, to facilitate this kind of business, recognising the potential for continued growth, such as by supporting the industry in energy transition.

While nothing is guaranteed, we expect that the road to net-zero will create additional opportunities in the commodities space. Increased demand for metals such as copper, steel and lithium will likely engender additional hedging from corporates, and related policy developments have the potential to redirect pricing. It is possible that we arrive at a moment when decarbonised raw material pricing and carbon credit trading become part of the day-to-day.

Heightened market fluctuation has led corporates to reassess their risk management strategies, and those that can proactively and efficiently handle their risk will outperform their competitors. The environment may have stabilised and prices may have come down, but as global uncertainty continues to rise, corporates should stay alert: budgeting season is around the corner and the urgency to implement commodity hedging programmes may return at any point.