By: Onkar Sharma

In the world of commodities, every step in the business process carries the potential for either incremental loss or profit due to the risks involved that can be related to 1) price, 2) quantity or volume (shortage of goods), 3) cost fluctuation due to service cost adjustments and 4) political, regulatory, geopolitical disruptions. This delicate balance necessitates a thorough understanding and meticulous evaluation of each phase to preemptively identify and mitigate challenges. With the global population exceeding 8 billion and ongoing challenges like pandemics and geopolitical conflicts, the stakes have never been higher. Despite this uncertainty, the commodities sector still generated over $100 billion in EBIT in 2023, highlighting the significant potential for profit. However, success hinges on the ability to adapt to the ever-changing market landscape and leverage emerging trends.

The Rise of CTRM functions in mitigating risks and identifying key trends

To navigate this complex environment, organizations have increasingly established dedicated Commodity Technology Risk Management (CTRM) functions. As outlined in a PwC whitepaper, these specialized teams apply consistent management practices across commodity supply and marketing, credit, and treasury. This approach has yielded significant benefits, including operational synergies, cost savings, and improved control.

Given the extreme volatility of commodity prices, which can swing by as much as 70% in a single year for some industries, CTRM departments play a critical role in developing and executing strategies to mitigate risk and ensure profitability. Key strategies employed by CTRM functions include:

• Hedging: Utilizing financial instruments like futures, options, and swaps to lock in prices for future purchases or sales.
• Contractual Agreements: Negotiating long-term contracts with suppliers and buyers to secure stable pricing.
• Inventory Management: Adjusting inventory levels to capitalize on price fluctuations, increasing stock when prices are low and reducing it when prices are high.
• Diversification: Spreading risk by sourcing from multiple suppliers or diversifying product offerings.
• Insurance: Implementing insurance policies to protect against unforeseen events like natural disasters and political instability.

Key trends shaping the Commodity Risk Management

According to a report by World Bank, while the quantity of commodities consumed has risen enormously, driven by population and income growth, the relative importance of commodities has shifted over time, as technological innovation paved way for new uses for some materials facilitating substitution among commodities. The study also underlines that commodity markets are heterogeneous in terms of their drivers, price behaviour, and macroeconomic impact on emerging markets and developing economies, and that the relationship between economic growth and commodity demand varies widely across countries, depending on their stage of economic development.

It is clear that the commodities landscape constantly remains in a state of flux, due to the reasons discussed above. This dynamic environment necessitates a proactive approach to risk management for businesses across various sectors, keeping a constant watch over the changing dynamics of the commodities risk landscape. Here are a few which are currently  in vogue:

1.     Rise in Flexible Contracts

There is an increasing trend toward adopting flexible contracts. Many of the geopolitical developments previously discussed have encouraged buyers to seek adaptable long-term agreements as a strategy to mitigate demand-related risks. However, this approach often comes with heightened exposure to fluctuations in global prices, as remaining volumes are usually aligned with prevailing market rates. A current example of this trend is the competition between Asia and Europe for additional LNG supplies. Gas prices in these regions are closely linked and are predominantly influenced by global factors, such as the worldwide LNG supply (largely determined by the regasification capacity available in the United States) and regional gas consumption.

2.     Emerging Opportunities from Commodity Interdependencies

The increasing interconnections among various commodities are paving the way for new trading possibilities. For instance, the evolving regulatory landscape around clean energy in the hydrogen sector is creating fresh links between oil, oil-derived products, and sectors like food and agriculture. Similarly, commodities like LNG and natural gas are finding use as raw materials for producing ammonia or hydrogen, essential for fertilizer production.

3.     Increased use of technology

The advancements in Artificial Intelligence and digital technologies are enabling commodities managers to mitigate broader risks and close leakages in the system. This has led them to not only avert losses but also predict demand trends. Advanced analytics, artificial intelligence, and machine learning are being widely utilized to improve risk forecasting, develop more sophisticated hedging strategies, and optimize supply chains.  

4.     Focus on ESG factors

Environmental, social, and governance (ESG) factors were, are and will be increasingly important in commodity risk management. As organizations and supply chain companies are committed to achieving their net zero targets, there is an increased focus on considering the environmental and social impacts of their commodity sourcing and consumption decisions.  

5.     Growing importance of data and analytics

As in the world of technology, it is a famous adage that data is the new oil. Commodities players are increasingly dependent on their historical and realtime data to predict and forecast. It allows them to effectively manage their inventories. Access to high-quality data and advanced analytical tools is crucial for effective commodity risk management.  

Well-run commodity businesses excel by continuously striving for operational excellence and foresight that can be achieved by keeping themselves in sync with the latest trends influencing the commodity risk management landscape.