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How to deal with market risk when you are a commodity producer

production risk
Posted by Svetlana Tokunova
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As a commodity producer your main focus might be production risk, but market risk can minimize your profit where you worked so hard for. When the product is traded on an exchange you can benefit by hedging the commodities. Often producers find this a difficult subject which in fact is rather simple.

When you have the possibility to hedge on an exchange you can consider market risk as just the price fluctuation, but actually market risk existing out of two parts. Price and so called basis. Basis is the relationship between a local cash market price and the futures price (Cash Price – Futures Price = Basis)

A good possible way to protect yourself is the short future hedge. It is the most basic risk management strategy for producers. A short position in futures is initiated as a temporary substitute for the eventual sale of the commodity to a counterparty. The short futures position can be placed well in advance and will provide price protection until the cash commodity is sold. Immediately upon the sale of the cash commodity, the short futures position should be closed out (offset). Since prices in the cash market and futures market generally move up and down together over time, a loss in either of these markets will be offset by a gain in the other – thus allowing the producer to lock in a price level in advance of the cash sale.

The advantages/ disadvantages of such a short future hedge are:

Advantages

• Eliminates risk of lower price levels
• Establishes a selling price level in advance of cash commodity sale
• Strengthening basis improves selling price
• Futures position guaranteed by the exchange

Disadvantages

• Weakening basis lowers selling price
• No benefit from higher price levels

A different way of protection is offered by the long put option hedge

The long put option position gives the producer the right (but not the obligation) to sell futures at a specific price level (strike price). If prices fall below this level, the producer (buyer of the put option) has the right to sell the underlying futures at the strike price level. Should prices rally above the strike price level, the producer is not obligated to the put option strike price, and therefore, can sell their commodity production at the higher market price. The long put position eliminates downside price level risk while allowing the producer to sell at a better price level if the markets move higher. In addition to the price level, the basis level will affect the actual selling price at the time of the cash sale, just as it did with the short futures hedge. A stronger basis at the time of the cash sale improves the selling price while a weaker basis will lower the actual selling price.

The advantages/ disadvantages of the long put option hedge are:

Advantages

• Eliminates risk of lower price level
• Establishes a minimum (floor) selling price level
• Benefits from a higher price level
• Strengthening basis improves selling price
• No margin requirements (put option buyers do not post margin)
• Option position guaranteed by the exchange (put option seller posts margin)

Disadvantages

• Weakening basis lowers selling price
• Premium is paid in full at time of put option purchase
• Transaction costs

Both mechanisms gives you the tools for protection, it must be said that there are more. However being able to play with both provides the assurance and stability you require to deal with market risk and when played right… secure additional profit.

 

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