Why do commodity traders hedge? - Agiboo

In the context of the complexities of the commodity trade, we’ve recently talked about the question ‘what is it that you exactly do?’. Which is something you might be asked in any line of work, really. Today, we’d like to address a question that relates strongly to that question: what is it that we actually make, here at Agiboo? Or more specifically, the questions that usually follow. Because when we talk about creating specific software solutions for specific industries – such as cocoa, coffee, sugar, grains –, they ask (with or without a Joker grin) ‘Why So Specific?’. Well, it’s because our clients run not only a day to day administration, but also a derivatives administration, for hedging, we say. So, then the question becomes: ‘Why do commodity traders hedge?’ Now, that’s a proper question, isn’t it?

Derivatives administration

Indeed, why are they doing that? We then go on to explain that they – the traders, buyers, sellers – must protect themselves, their assets and/or their investments against market price fluctuations. Which is usually where you start to lose your audience. If not there, then probably when diving into futures, options, OTC’s and position management. This is where they will definitely try to escape from the conversation. Which is also why they will still not be able to answer why one runs a derivatives administration.

The question itself remains very valid. All too often, we – as in, ‘the business’ – take for granted that everybody wants to ‘hedge against market price fluctuations’. Shouldn’t a company focus on its added value, instead of speculating (gambling?) on price moves? Well, taking it for granted appears to be not so obvious after all.

commodity-hedging

Instruments to protect yourself against the risk

Commodity traders – as well as most other traders – tend to be risk averse. That is to say, they prefer situations with low uncertainty over situations with high uncertainty. Or better yet, no uncertainty at all. However, in economics and finance, as well as in life, things are never one hundred percent certain, nor do the most certain outcomes yield the best results. Luckily, there are tons of tools to deal with uncertainty as a solution to your risk aversion.

Commodity traders, sellers or buyers have access to these instruments to protect themselves against risk too, but there is a limited number of commodities which have these instruments. Is a cocoa trader luckier than a quinoa or saffron trader? As there are instruments for cocoa, but not for quinoa or saffron? And why is it that there are no risk tools for these commodities, but there is for many others – like wool, cement, bananas, chemicals… The list is endless. The reason is very technical, as such commodities require standardization in a contract, and a liquid market. The latter means that it is necessary to have [enough] people who buy and sell to be sure of it getting bought or sold at all.

A simple explanation for a ‘liquid market’ can be offering up for sale your self-made painting on eBay. Someone might like it and buy it, but it might just as well be that it never gets sold at all. Which is to say, self-made paintings – for those of us not quite Rembrandt or Van Gogh – are an example of a non-liquid market. Standardization is also easy to explain: when you’re asked how you like your coffee, you might respond by saying ‘black’, ‘with milk’ or ‘milk and sugar’. You don’t really question the coffee itself, unless you’re very picky about the beans and demand real arabica. With tea, it’s a different story. Earl grey, breakfast tea, green tea and so, where most of them are underlying blends of multiple types. This is why we usually opt for commodities that can be standardized. On a coffee exchange, there are two main types: Robusta and Arabica (or at least, two types that you can standardize).

In the past, there have been initiatives to create contracts for non-liquid markets. We’ve seen salmon futures, and plastic ones, but often liquidity was a problem. Historically, there have been many more. A potato futures market in Amsterdam was still active until the 90’s. Something that became quite topical in the early months of the corona pandemic, when we witnessed farmers handing out potatoes to the public as they had become virtually worthless due to massive drops in demands (with bars and restaurants closed, the Dutch were consuming significantly fewer fries, for one). Would these farmers have protected themselves, had risk management instruments been available to them. Due to the pandemic, prices dropped. What would have happened if prices skyrocketed? They would have taken the profit, and we probably wouldn’t have heard about it. The essence here is that these farmers are gambling on the price, as they actually have no other option. You could say then, why go through all this trouble of growing them? Sell the tractors and thee land and use the money for some speculation on the exchange as you are gambling anyway? Save yourself the trouble and hard work, right…?

The futures market has been founded to avoid these situations.

The futures market

The same problem we’ve recently witnessed with potatoes also existed for grains, metals, sugar, et cetera in the past. In that sense nothing is new. Some exchanges are more than 200 years old. In its simplest form, the forward future contract protects you against a higher price in the future when you are a buyer and lower price in the future when you are a seller. 

In the years that exchanges existed, people invented many additional derivatives which can make it difficult to comprehend what is there, and probably even more difficult to process in the administration, but the basics can nevertheless be understood quickly. Talking about administration, it also explains why a CTRM (Commodity Trade & Risk Management) system is much more than an ERP (Enterprise Resource Planning) system. The CTRM system for commodity traders is specialized to deal with these futures and options and matches them against physicals to check if you are really hedged – which is called position management.

Protecting your selling or buying price is probably the difference between failure and success. Admittedly, it requires extra work and knowledge but it is definitely worthwhile. It will at least avoid having to hand out your crop for free to the public. If you’d like to learn more, there is tons of education material available from the exchanges, or browse the knowledge section on our Agiboo website.

Now, we’ve probably answered the question ‘why hedging’, but we still didn’t figure out why people won’t do so when the instruments are available. They must have their reasons.

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