Everybody who works for a while in a certain industry gets once in a while the question. What do you actually do? When I get that question my thoughts are always going to a scene of a favorite movie of mine: Office Space. Here ‘the Bobs’ ask Tom. What would you say you do here? I find the movie scene hilarious but there is a point of truth in that question. Actually I find it rather difficult to explain to people who are not in the commodity industry. Yes that includes explaining to my family. I asked myself the question: Commodity trade, is it complex?
When I started to work in the commodity trade industry about 20 years ago, I did not have a clue either. Wondering why people did these complex operations and procedures. There was all kind of difficult terminology like hedging, market to market. When they mentioned position I got even more confused.
Commodity trade does have indeed its specific things, but basically they can be all brought back to a few simple concepts. The main concept in my opinion is to understand that commodities are prone to price volatility. It simply means that the price of a commodity can pretty much change every moment. The price actually does do that. That is somewhat a different situation than in most industries. Sure prices will always change but not with the speed it does when commodities are involved.
From our personal life it would be rather inconvenient when all prices would be volatile. I don’t want to pay tomorrow twice as much for a cup of coffee at Starbucks and next week half the price. Well for my cup of coffee I might not even be so worried, it would be different when it would involve the rent of my house. In general we can conclude that volatility creates insecurity and is not convenient.
The commodities and specially the agricultural commodities have a long history of volatility. Just because of supply and demand. Wheat prices moved up a great deal after a bad harvest also in the middle ages. Actually it moved sometimes so much that complete communities where depraved from bread for an entire season. Many farmers got bankrupt during a superb harvest, making the wheat almost worthless. Commodities though are mostly the resources for our existence, think of grains, sugar, rice, cotton etc. We are getting less worried when the new iPhone increases much in price. However I am not sure if that statement is still correct nowadays. Commodity prices do have a high impact on our daily life.
Until exchanges came around there was not a real mechanism to control the high or low peaks of the price. I find it fascinating that some people believe that exchanges are responsible for a very high or low price. The opposite is true. An exchange will cause lower volatility and allows people who don’t want volatility to protect themselves. These people are called hedgers.
Hedging is one of those words I found difficult to grasp in the beginning. It is making sure that you are not prone to volatility. Imagine you would produce a nice soda and you like to make a year contract with a large super market to deliver your soda each day. The super market would like to agree to a price for the whole year. For this reason they probably want a very attractive price as well. You would calculate your costs to make the soda and add some profit. A big component of the cost calculation is sugar. Unfortunately you cannot buy all the sugar for the entire year. Neither can you produce all the soda for the entire year at once. When the price of sugar the next month would be doubled. You probably see all your profit vaporize or even worse.
The right thing to do would be to lock in the sugar price at the moment when you make the contract with the super market. The exchanges provide tools for that. For example: futures or options. It is a good protection against a rising price. To be complete, it is also possible that the price would have gone down. That would create a higher profit for you as a soda producer. However, when you wanted to speculate on price. It would have not been necessary to produce soda in the first place. You could just gamble on the price with financial instruments. Saving the trouble of producing soda.
The basic concepts of hedging are easy, it is important though to keep a good administration. This can be on paper or with a specialized tool like Agiblocks (CTRM) Commodity Trade and Risk Management. Here you would find real time your market to market or position. When having the right tools, commodity trade doesn’t have to be complex.