What it means
Commodity risk comes in two directions. Input risk hits buyers when the price of wheat, steel, resin, diesel or electricity rises faster than they can raise their own prices, and output risk hits producers when the price of what they sell falls below the cost of producing it.
A single company can face both, as a food manufacturer does when grain costs rise while retail prices are locked by an annual contract. There are subtler forms as well.
Volume risk arises when a supply disruption means the material cannot be bought at any price, and basis risk arises when the hedge used does not track the actual material purchased, for example hedging with a benchmark crude when the business buys refined diesel. Correlation matters too, because commodity moves often arrive with currency moves that either amplify or offset them.
Measuring the exposure is the necessary first step and is usually neglected. The practical method is to quantify annual usage in physical units, multiply by a plausible price movement, and compare the result with operating profit, which immediately shows whether the risk is an irritation or an existential threat.
A business whose worst-case commodity swing exceeds its profit is running an unmanaged risk regardless of how well it buys. The response options form a ladder.
The cheapest is commercial: pass-through clauses in customer contracts, index-linked pricing, or simply the ability to reprice quickly. Next come fixed-price supply agreements with suppliers, then financial hedges such as futures, forwards, swaps and options, and finally structural changes like redesigning a product to use less of the material or qualifying a second material entirely.
The important nuance is that hedging does not remove risk, it exchanges price uncertainty for a fixed outcome plus new obligations. A fully hedged business that has locked in high prices will look foolish when the market falls, and a hedge with a cash margin requirement can create a liquidity problem even when it is working exactly as intended.
Most companies therefore hedge a proportion, often somewhere between 50% and 80% of expected volume, and leave the rest floating.
In practice
Real-world examples.
Example
An electronics assembler discovers that copper accounts for 9% of its bill of materials and that a 30% price rise would cut gross margin by nearly three percentage points. It negotiates an index-linked clause with its two largest customers so that copper moves above a threshold are shared rather than absorbed.
Example
An airline hedges 60% of its expected jet fuel for the coming year using swaps. When oil falls sharply, its hedged portion looks expensive, but the finance director defends it on the grounds that the policy exists to make budgets reliable, not to predict prices.
Example
A furniture retailer selling at fixed catalogue prices for a six-month season buys forward its timber requirement before publishing the catalogue. Locking the input cost is what makes committing to printed prices for half a year commercially safe.
Think of it
“Commodity risk is the danger that raw material prices will move against you-like fuel costs for airlines.
Formula
Calculation
Exposure is measured as: Commodity exposure = Volume used x Price change per unit, and the residual after hedging as: Unhedged exposure = Volume used x (1 - Hedge ratio) x Price change per unit.
A bakery group uses 12,000 tonnes of wheat a year at a current price of $260 per tonne, so its annual wheat spend is 12,000 x $260 = $3,120,000. Management stress tests a 15% price rise, which is $260 x 0.15 = $39 per tonne, giving an exposure of 12,000 x $39 = $468,000. Against operating profit of $1,400,000, that single risk would remove a third of the profit.
The group hedges 75% of its volume, fixing 9,000 tonnes at $260 and leaving 3,000 tonnes floating. If wheat does rise 15%, the extra cost is limited to 3,000 x $39 = $117,000 rather than $468,000, a saving of $351,000. The trade-off is symmetrical: had wheat fallen $39 per tonne instead, the group would have captured only 3,000 x $39 = $117,000 of the benefit and forgone the other $351,000.Case study
Seen in the real world.
This is an illustrative and fictional example. Verity Beverages, an invented soft drinks producer, bought 6,000 tonnes of aluminium a year for cans at $2,400 per tonne, a spend of $14,400,000 against operating profit of $5,000,000. The board had never formally quantified the exposure because purchasing was handled by the operations team as a routine buying task.
A new finance director ran the numbers and presented a single line that changed the conversation: a 25% rise in aluminium would add $600 per tonne, or 6,000 x $600 = $3,600,000, consuming 72% of operating profit. Verity adopted a policy of hedging 70% of expected volume twelve months ahead and inserted a metal pass-through clause into contracts with its three largest supermarket customers.
Aluminium subsequently rose 18%, or $432 per tonne. The hedged 4,200 tonnes were unaffected, the unhedged 1,800 tonnes cost an extra 1,800 x $432 = $777,600, and the pass-through clauses recovered roughly half of that from customers. The illustrative point is that Verity did not forecast the price better than anyone else; it simply measured the exposure, then decided deliberately how much of it to carry.
Watch out
Common mistakes.
- Assuming commodity risk only affects mining, farming and energy companies. Any business buying packaging, fuel, electricity, plastics or metals carries it, often without ever naming it.
- Hedging 100% of expected volume. Full hedges remove all flexibility, punish the company if volumes come in lower than forecast, and leave it stranded at above-market prices for the whole period.
- Ignoring the cash flow demands of a hedge. Exchange-traded positions require margin to be posted when prices move against them, which can drain cash from a business whose underlying exposure has not yet been paid.
Questions
People also ask.
What is basis risk?
It is the risk that the instrument used to hedge does not move exactly in line with the material actually bought, leaving a residual exposure even when the hedge is in place.
Should a small business hedge commodity exposure at all?
Often the better answer is commercial rather than financial: fixed-price supplier contracts, index-linked customer pricing and the ability to reprice quickly usually achieve more for less complexity.
How do I decide the right hedge ratio?
Start from how much profit volatility the business can tolerate and how quickly it can pass on costs, and set the ratio so that a plausible adverse move leaves profit intact rather than trying to predict the price.
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