Financial Hedging for Commodities
Updated: Feb 1
The news has recently been advising investors about rising commodity prices resulting partially from sharp changes during and after the pandemic. Mid to late 2020 saw prices fall significantly in response to falling demand while the world was quarantined. However, with the world gaining ground in the recovery and demand soaring, so must the prices of raw materials so producers have enough capital to meet those demands.
Companies involved directly in the supply chain of raw materials would do well to enhance their risk management strategies by learning about how to protect their downside by hedging, especially with elevated volatility in commodity prices. Many of these commodities are trading similarly to stocks with some markets being just as accessible to even retail investors. Let us introduce you to the tools available to you so you can find out how to start implementing protective hedges, which can be as simple as opening an account and placing a trade.
The modern financial markets exist for the sole purpose of making it easier for those with monetary and non-monetary assets to come together and do business. It is easier now than ever before. With few exceptions, anyone with a computer, internet access, and a bank account can log into a brokerage and buy a corn futures contract, for example, by clicking a few buttons. Even though this article is for companies whose business depends on these commodities to make revenue, it is important to understand the markets are accessible to nearly anyone.
Hedging? What Is that?
A “hedge” is simply a protective position. It is usually one with a low likelihood of being profitable to the owners of the hedge, but it is cheap enough that the profits from a core position do not suffer that much. The classic example is auto insurance – the core position in the car, and the insurance is the hedge. Auto insurance is very minimal as compared with the value of the car, but if the car is in an accident, the auto insurance minimizes the cost to repair or replace it.
Who Needs to Hedge Commodities?
To answer the question, any firm or business whose profits depend on the price of a particular commodity should seriously consider implementing a hedge in the commodity markets. While implementing a hedge might take away from the potential profits received by not doing so, a hedge will provide far more stability to total revenues by providing protection in the event of a collapse in prices. One example is the event of April 2020 when the price of crude oil plummeted into negative territory for the first time in history. Companies like Hess Corp and Cairn Energy, however, had implemented hedges to protect the price of their oil, and it paid off handsomely as they were able to maintain higher prices despite the crash (Reinicke, 2020).
Alternatively, the commodity markets are also actively traded by speculators who use information and expertise about a particular commodity to make profits. These investors tend to use complex strategies, including hedges, to protect core investments in a portfolio.
My Company Deals In Commodities. How Do I Hedge?
The way hedging is accomplished depends heavily on how much of a company’s revenues are linked to a particular commodity. For a smaller company, it may be enough to engage a small investment company to handle hedging on their behalf. For a larger company, they may have an entire trading floor with commodities experts actively trading in the derivatives markets (options and/or futures) to protect the company's revenue every day.
To provide some details of the hedge itself, we’ll consider both a hedger and an investor. The hedger is protecting the commodity involved in the company’s primary revenue stream while the investor is hedging to protect the core portfolio positions. In both cases, the best tools might be either the options market or the futures market. While a contract in both options and futures markets expires at defined intervals, the commodity futures contracts are generally more actively traded than options contracts and provide more liquidity because of the increased volume. This means that you have a higher chance of your order being filled on a futures contract than an options contract. While the futures contracts have a higher volume than options, the options contracts are quite a bit cheaper and offer a more effective hedge.
Either way, the hedge is usually accomplished in a similar way. We provide an example below to illustrate some of the important parts of a hedge. This is provided as an example only and we recommend further instruction into the ways of the commodities markets before trying to hedge for your company.
Example of Hedging: Lumber
With lumber prices soaring, let us use it as an example of the hedge and the investor to show how a hedge may be accomplished. For reference, lumber futures are currently trading more than 200% above their price in 2020.
A large housing development company depends on lumber to build houses. When he was hired in 2020, the new CFO implemented a plan to add a bullish lumber futures position to protect the company if lumber prices rose in 2021. He bought lumber futures contracts in November 2020 at $484 expiring 16 January 2021. Imagine he bought 10 futures contracts. A lumber contract is standardized at 110,000 feet of boards, and the price of $484 is quoted per 1,000 feet of board. This means that the $484 is multiplied by 110 to get a contract value of $53,240 per contract. At ten contracts, the company’s position totaled $532,400. When the contract expired in January 2021, assuming the CFO closed the positions on Jan 4 (the first trading day of 2021), the quoted price was $700, so the value of the position had risen to $770,000, or a gain of $267,600. While their business was hurt by the rising price of lumber, the CFO was able to reduce that loss of revenue by $267,600 by implementing a hedge in lumber futures.
An investor, on the other hand, might have a bullish core position in lumber futures. He will buy futures then when the expiration day approaches, sell the current contract off and buy the next expiration month. At the same time, he may keep short positions in options where the underlying companies are connected to the price of lumber. This might include companies such as Home Depot, Lowe’s, or our housing development company in the example above. If he has a long position in lumber futures, but lumber prices were to fall, then the companies mentioned would have a likelihood of falling as well. Imagine the Home Depot (ticker: HD) options cost $5.60 per share of HD, and each option contract is a standard 100 shares of HD. This means that a single put option (or short) contract costs $560. If the investor were to sell 100 shares of home depot stock instead of the option, assuming a price of $300 per share, this investor would have to invest $30,000 instead of only $560 for the put option.
Wrapping It Up
It is obvious that hedging is not only widely used by companies involved in the commodity markets, but it is also critical for those companies and investors to consider implementing hedges to protect against wild price changes. There are many tools with which to hedge, but to do so without education or experience could increase the risk rather than decrease it.
Nasdaq, 2021, https://www.nasdaq.com/market-activity/commodities/lbs