Commodity Price Exposure

Commodity price exposure is the sensitivity of a company's costs, revenues, cash flows or balance sheet to changes in the price of a commodity, such as crude oil, natural gas, electricity, copper, wheat or coffee. An airline is exposed to jet fuel, a food manufacturer to grain and sugar, a miner to the metal it sells and a utility to fuel and power prices. The exposure can hurt or help: rising prices raise a buyer's costs but increase a producer's revenue.

Managing the exposure is a task for treasury, procurement and risk teams, often under a board-approved policy. It sits alongside foreign exchange risk, because many commodities are priced in US dollars, and it is a major input to measures such as cash flow at risk. Companies reduce it through contracts, operational choices and derivatives traded in the commodities market.

A bakery buys flour every week. When the price of wheat jumps, its costs rise, but it cannot easily raise the price of bread straight away without losing customers. The bakery is exposed to the price of wheat: its profit depends partly on something it does not control.

Every business that buys or sells raw materials faces this. The question is how big the exposure is, how long it lasts and what to do about it. A bakery might agree a fixed price with its miller for the next six months, keep extra stock, or accept the risk because wheat is only a small part of its costs.

• Direct exposure. The company buys or sells the commodity itself, as an airline buys fuel or a refiner sells petrol.
• Indirect or embedded exposure. The commodity is built into the price of something else, such as packaging, freight or components whose suppliers pass on metal and energy costs.
• Economic or competitive exposure. Price changes alter demand or the company's position against competitors, as when high fuel prices reduce travel or favour rivals with more efficient fleets.
• Balance sheet exposure. Inventory, reserves in the ground or long-term fixed-price contracts change in value as prices move.

The starting point is the net volume a company will buy or sell over a period and how much of it is not already price-fixed. A simple estimate of the effect on earnings is:

• $Q_{\text{unhedged}}$ is the volume bought and not yet price-fixed or hedged, which is negative for a net seller.
• $\Delta P$ is the change in the commodity price.
• $k$ is the share of the cost increase the company can pass on to customers.

Suppose an airline expects to buy 100 million gallons of jet fuel next year, has hedged 60 per cent and can pass on 25 per cent of any cost increase through fares. If fuel rises by $0.50 a gallon, the impact is −40 million × $0.50 × 0.75 = −$15 million. More advanced measures simulate price paths, taking into account volatility and correlations with currencies and demand.

Companies combine commercial and financial tools. Commercial tools include fixed-price supply agreements, price indexation or pass-through clauses in customer contracts, holding inventory, and changing suppliers or materials. Some exposures offset each other within the business, giving a natural hedge. Financial hedging uses:

• Futures contracts traded on exchanges, which lock in a price for standard quantities.
• Forward contracts and over-the-counter swaps, which can be tailored to the company's exact product, location and dates.
• Options, including caps and collars, which protect against adverse moves while keeping some benefit if prices move favourably.

Hedges carry basis risk when the hedging instrument, such as crude oil futures, does not track the exact product, such as jet fuel at a particular airport.

Without special treatment, changes in a derivative's value hit profit immediately while the hedged purchase is recognised later, which creates volatility. Hedge accounting under IFRS 9 and US GAAP ASC 815 lets qualifying hedges of forecast purchases or sales be treated as a cash flow hedge, deferring gains and losses until the hedged item affects profit. IFRS 9 also allows a company to hedge a separately identifiable and reliably measurable risk component of a non-financial item, such as the crude oil element of a fuel price. Companies trading commodity derivatives may face reporting and position limit rules, overseen in the United States by the Commodity Futures Trading Commission, although commercial end users usually benefit from exemptions.