Managing risk in commodity trading for buyers and Sellers

Commodities can be complex markets to operate in: buyers are exposed to upward market spikes, and the opposite goes for sellers in that they are susceptible to falling prices. We often see market participants accept these risks, hoping that the market moves in their favor – this is called ‘unhedged.’ In non-jargon terms, this is the equivalent of being uninsured and thus obligated to cover all losses in an unfavorable outcome (i.e., the market does not move in your favor). This uncertainty directly affects profit margins, which can be positive or negative depending on the market movement. However, the point remains that the market participant has no control over this while unhedged.

This leads us nicely to the concept of being ‘hedged,’ whereby market participants can take an active role in eradicating price risk. It is worth mentioning that commodity markets, through time, have established standardized formats for their respective commodity. For example, Sugar has a minimum level of quality (in terms of polarisation) that buyers demand and thus provides the benchmark from which price is established.

This standardization has led to the introduction of futures markets, which is believed to have been established in 1876 to help farmers reduce crop price uncertainty. Over time, this has developed into screen-based trading whereby the futures exchange for the respective commodity market matches buy/sell orders (e.g., ICE #11 raw sugar futures).

Hedging can be implemented in a couple of ways:

• The buyer/seller has their own futures account.
• The buyer/seller will buy/sell futures via another buyer/seller’s futures account.

Many buyers/sellers in the Eastern & Southern African region will benefit most from the second option when looking to hedge; therefore, that will be our focus. A buyer’s physical sugar purchase of 2,000MT is the equivalent of 39 futures contract (1 futures contract equates to 50.8MT). A buyer can ultimately choose when to ‘price’ their sugar by instructing the seller (who has the futures account) to buy on their behalf.

Buyers may have a view that the market could crash, referred to as a ‘bearish’ market outlook, and can, therefore, benefit by delaying buy orders and pricing when the market has fallen. In an unhedged scenario, buyers would have bought at the time of purchase at a fixed price – unable to benefit from pricing their purchase later if the market fell.

In Part 2, we will introduce the notion of cash premiums and how these directly relate to futures market transactions.