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Most sectors need to manage commodity price risk

Most sectors need to manage commodity price risk

Many people think that only commodity producers, traders, processors are affected by commodity price volatility and hence need to manage the commodity price risk. The reality is that almost all the sectors are directly or indirectly exposed to the commodity price risk, because they might be either using commodities directly or the derivatives of the commodity as raw material.

The movement in commodity markets does affect the price trends in other markets such as bonds and equities. However, commodity markets themselves are largely immune to the effects in these other markets. This does not mean that they are not affected by these movements at all. This just means that the degree of this effect is much smaller.

Also, the reason behind this is fairly obvious as well. Commodities are largely used for consumption purposes, they are necessities. Therefore, if their prices rise, a larger portion of the budget of the consumer is spent on them leaving little room for other expenditure. Since this article is brief we are not mentioning many sectors but picking up Auto sector in which the reader of this magazine have exposure and interest.

Auto Industry: The automotive sector is the backbone of any economy. It is a heavy manufacturing industry and employs a large number of people highly skilled to semi skilled. The automotive sector uses a large amount of commodities as inputs. The basic raw material used is metal. Therefore, if mining companies hit a lean patch and are unable to mine enough metal, the prices will rise. The auto industry will have no alternative but to pass on this price rise to the consumer.

Auto industries also use Rubber in various forms but mainly as tyre. Even in tyre not only natural rubber is used but also synthetic rubber and carbon black. While natural rubber is a natural biosynthesis polymer obtained from rubber plants, synthetic rubber is man-made polymer derived from crude oil and carbon black is also a derivative of crude oil. Carbon black is mainly used as reinforcing filler in tyres. Carbon black is considered a petrochemical because it is made from natural gas or petroleum residues. Thus one can see that Auto industry is dependent on the price of commodities like metal, rubber, crude etc, the price of which is highly volatile because global demand and supply factors affect the price and when it swings in any particular direction the speculators magnify the effect because they can take financial leverage and keep huge positions on either long or short side of the market depending on the direction of price swing.

If commodity price can be managed well then there would not be unnecessary hike in the final price of the automobile and this would help large number of stakeholders, the one who are directly employed in the auto companies and the other who are employed in auto ancillary units. The whole logistics industry is also dependent on the price of the commercial vehicles.

How does industry manage the price risk of the commodities?

They make a forward contract with the vendors thus they think they have transferred the risk on to vendors. If vendors do not manage the commodity price risk through commodity exchanges, they tend to default in case of extreme price volatility which is not uncommon. This is not efficient way of managing the commodity price risk and it has a chain reaction of defaults.

Some players price their input by linking the price of the commodity as prevailing on the commodity exchanges. The price could be decided in advance say in December 2018 for deliveries in August 2019. Since there is risk in future price for both buyers and sellers the price could be decided with the help of the commodity exchange like ICEX Rubber August future plus premium or discount depending on the quality of rubber being traded. This premium or discount is also called differential. Now, the day the vendor purchases the rubber he sells ICEX future and when he delivers to the tyre company he buys back the future. Thus he has no obligation on the exchange. He can deliver rubber to his client and remain protected through hedging on the exchange. The exchange pays the price to him if the price moves against him in the physical market because on exchange he takes reverse position i.e. if he has bought in the physical market he sells in the futures market to protect himself till he finds the final buyer.

Real Estate: Real estate is a huge sector in any nation. It is also amongst the largest employers. Therefore, a slowdown in real estate is bound to have ripple effects. However, real estate uses a lot of commodities as inputs. They use commodities like cement, iron and steel, cables and wires, plastic pipes etc. Therefore, if the prices of these commodities rise, an immediate effect is seen in the prices of real estate. This causes the sales to fall causing a decline in bank credit creation, default by the real estate companies to both home buyers as well as bankers. Also, the wages paid to workers decline during this period further accentuating the cycle. A fall in the real estate market will also affect these commodities since there will be less demand.

Commodities are thus integral part of all the industries and utmost importance should be given to the commodity price risk management. Commodity exchanges are the platforms which help in commodity risk management but very few stakeholders are using it due to lack of awareness or there is myth that commodity exchanges are for speculators. The reality is that commodity exchanges are highly regulated by the regulator SEBI and are transparent. Second level of regulation is maintained by the commodity exchanges and all the regulation happens online and is system driven and manual interference is not there. Surveillance is done on line as well as off line. The exchange members are thoroughly audited.

Now warehouses of the exchanges are further regulated by independent regulator WDRA. Repository system has also been introduced in commodities like stock markets. Hence there is solution available for the commodity price risk management. It needs to be popularized. It would help in inflation management and save many industries from price shocks.

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