Commodity Risk Management

Theory and Application

Geoffrey Poitras

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136262609
• Edition: 1
• Topic: Commerce
• Subtopic: Matières premières

Commodity Risk Management goes beyond just an introductory treatment of derivative securities, dealing with more advanced topics and approaching the subject matter from a unique perspective. At its core lies the concept that commodity risk management decisions require an in-depth understanding of speculative strategies, and vice versa. The book offers readers a unified treatment of important concepts and techniques that are useful in applying derivative securities in the management of risk in commodity markets. While some of these techniques are well known and fairly common, Poitras offers applications to specific situations and links to speculative trading strategies - extensions of the material that not only are hard to come by, but helpful to both the academic and the practitioner.

The book is divided into three parts. The first part deals with the general framework for commodity risk management, the second part focuses on the use of derivative security contracts in commodity risk management, and the third part deals with applications to three specific situations.

As a textbook, this book is designed to appeal to classes at a senior undergraduate/MBA/MA levelof training in Finance, financial economics, actuarial science, management science, agriculturaleconomics and accounting. There will also be interest for the book as: a monograph for research libraries, a handbook for individuals working in the commodity risk management industry, and a guidebook for those in the general public interested in topics like farm risk management or the assessment of hedging practices of publicly-traded commodity producers.

Part 1

Commodity Risk Basics

1.1	The Commodity Risk Management Landscape
	A.	Basic Definitions and Concepts
	B.	Commodity Characteristics
	C.	Studies on Commodity Risk Management
1.2	A Brief History of Commodity Risk Management
	A.	From Antiquity to 16th-century Antwerp
	B.	From Amsterdam to Chicago
	C.	Speculation and Manipulation
1.3	Recent Commodity Risk Management Debacles
	A.	Copper Market Manipulations
	B.	Operational Risk in Oil Markets
	C.	Commodity Funds and Regulatory Confusion

Throughout its long history, futures trading has been primarily associated with commodities having major seasonal patterns of production and inventory accumulation and liquidation. Prices of seasonally produced commodities are speculative.

Thomas Hieronymous (1977)

An investment operation is one which upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

… It is only where chance plays a subordinate role that the analyst can properly speak in an authoritative voice and accept responsibility for the results of his judgments … the value of analysis diminishes as the element of chance increases.

Benjamin Graham and David Dodd (1934, p.54, p.26)

1.1

The Commodity Risk Management Landscape

A. Basic Definitions and Concepts

What is a Commodity? A Legal Definition

Definition and bibliography are essential elements of effective scholarship. Unless key concepts are accurately defined, it is not possible to situate the contribution within the landscape of journal articles, books and other media related to the subject. The value added of any individual research contribution is, at best, only incremental. Improvement is measured relative to the bibliography of sources used to assemble the project. With this in mind, commodity risk management requires a number of key definitions, such as: what is a commodity and what is commodity risk? Using a legal definition, a commodity could be defined by the Commodity Exchange Act (7 U.S.C. 1a):

COMMODITY.—The term “commodity” means wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, and all other goods and articles, except onions as provided in Public Law 85–839 (7 U.S.C. 13–1), and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.

The phrase “and all other goods and articles” involving “contracts for future delivery” includes a much larger universe of products than those listed, such as: food and fiber products, e.g. cocoa, coffee and sugar; metals, e.g. gold, silver and copper; energy products, e.g. crude oil, natural gas and propane; and financial securities, e.g. stock indexes and fixed income securities.

Legally, the definition used to identify a commodity in US law provides a binding limitation on the authority of the Commodity Futures Trading Commission (CFTC). A decades-old conflict with the Securities and Exchange Commission (SEC) over jurisdictional authority is founded on the definition of a commodity. Are financial securities to be considered as commodities? Is a derivative contract on a stock index different from such a contract for wheat or copper? Is commodity risk distinct from financial risk? Do theoretical tools useful for financial risk management also work for managing commodity risks? And so it goes. Failure of the CFTC effort in 1998 to extend authority over OTC trading in financial derivatives—a key element in the financial market collapse of 2008–2009—can be attributed to a definitional dispute over what constitute “commodity futures” and related derivative security contracts. This failure reflects the limitations of using a legal definition to capture essential elements of contracts associated with commodity trading activity.

The legal definition of a commodity embodied in the CEA is driven by the types of contract associated with the trading of commodities. An alternative to the legal definition of a commodity is to isolate the essential features that distinguish commodities and financial securities. More precisely, in contrast to financial securities, commodities are physical goods that are costly to store and produce. As a consequence, commodities can generate a convenience yield for stocks of the commodity. The behavior of the convenience yield will differ across time and commodities. In a derivative security pricing context, factors such as costs of storage and convenience yield fundamentally restrict the execution of long dated cash-and-carry arbitrages for physical commodities. This has direct implications for the liquidity and price discovery properties of long dated derivative security contracts. The limit of the definition is provided by commodities such as gold that have near zero storage costs, a plentiful stock of gold available for lending to short sellers, and cash and carry yields that are close to those of financial securities. In turn, the strategic risk management problems confronting, say, a silver mine operator are similar to those of a copper mine, not an investment bank. Something more is required of the definition.

What is a Commodity? A Functional Definition

The definition of a commodity used in this book distinguishes between financial securities and physical commodities. This distinction has fundamental implications. For example, the cash-and-carry arbitrage conditions that determine derivative security prices differ substantively. While the subject of financial risk management has been exhaustively considered in a seemingly countless parade of academic journal articles, books and other contributions, there is a comparative absence of sources on non-financial commodity risk management. In turn, the bulk of these sources seek to extend to nonfinancial risks techniques developed for managing financial risks. The result—financial engineering or portfolio management with physical commodities—is primarily of use to investment bankers, market makers, and others involved in intermediating the risk management and investment products on offer to retail and institutional investors. An airline seeking to manage the price and volume risk of future jet fuel purchases receives little guidance. Similarly, a corn farmer or feedlot operator worried about future price movements for corn receives only general guidance with little practical impact. Even the general guidance being given can sometimes provide dubious recommendations that fail to capture key economic impacts of the risk management decision on the underlying strategic business decision problem.

Requiring a commodity to involve costly production and storage provides essential structure to the search for optimal risk management solutions considered in this book. Financial “commodities” such as stock indexes, sovereign government debt securities and Euro-currency deposits are specifically excluded from this definition. The dividing line between financial and physical commodities is provided by the physical commodity with the greatest financial use, gold, which is considered a physical commodity in this book. In other words, in this book “commodity” is used as a shortened form of “physical commodity.” Examining commodities coming within this definition reveals other common aspects, such as being consumable, costly to produce and having variation in supply. In more technical terms, the commodity risk management decision can involve both price and quantity risk. There are also elements of Keynesian uncertainty associated with the production, storage and consumption decisions involving specific commodities that fundamentally impact the risk management decision. Included in these elements is the increasing financial securitization of commodity transactions, especially storage, for certain commodities that has had unintended consequences for the individuals and firms directly involved in those markets, e.g. United States Senate Permanent Subcommittee on Investigations (USSPS 2007, 2009).

Elements of Commodity Risk

Developing a framework for adequately identifying and managing the range of commodity risks confronting the non-financial corporation is not possible. There is too much variation across the types of risk encountered by the numerous commodity producing and consuming firms that a general framework is unhelpful at best, and could be misleading. Some method of simplifying the process is needed. One possible method is to classify the types of risks encountered. The modern approach to risk management typically proceeds by classifying risks into the following categories: business or commercial risks; market risks; credit risks; liquidity risks; operational risks; and legal risks. Of these categories, commodity risk management is fundamentally concerned with the interaction between commercial risk and commodity price risk, whereas financial risk management is concerned with the interaction of financial price risk, credit risk and liquidity risk. While non-financial corporations involved in the production and consumption of commodities do recognize financial risks in the financial statements, it is commercial and commodity price risk that are the central elements of the “commodity risk management” decisions confronting such firms.

For example, consider each of these categories that appear in the listing of risks from the 2010 Annual Report (2011) for BHP Billiton, one of the largest mining companies in the world. In approximate order of appearance, these risks are: fluctuations in commodity prices and impacts of the global financial crisis (market risk); currency exchange rate fluctuations (market risk); commercial counterparties may not meet their obligations (credit risk); failure to discover new reserves, maintain or enhance existing reserves, or develop new operations (business risk); reduction in Chinese demand (business risk); actions by governments or political events in the countries in which BHP operates (legal risk); health, safety, environmental and community incidents or accidents and related regulations (operational and legal risk); reduced liquidity and available sources of capital in financial markets may impact the cost and ability to fund planned investments (liquidity risk); breaches in information technology (IT) security processes (operational risk); and breach of governance processes may lead to regulatory penalties and loss of reputation (operational and legal risk). It is not pedagogically possible for “commodity risk management” to deal systematically with all such risks.

The degree to which specific firms are severely impacted by a particular type of risk can vary dramatically. Consider the difficult environmental and regulatory risks of the Canadian mining company Galactic Resources operating the Summitville gold mine in Colorado. The breach of a heap-leach mining pad in 1989 led in 1993 to the company filing for bankruptcy due primarily to Summitville environmental risk liabilities. Another Canadian mining company, First Quantum Minerals, faced severe political risk with the expropriation of the Kolwezi, Frontier and Lonshi projects by the government of the Democratic Republic of the Congo in 2009 and 2010 under mysterious circumstances.¹ These types of specific risk can be contrasted with the weather-related risks faced by wheat farmers during planting time or to the risk for cantaloupe growers associated with the listeria outbreak in October 2011. It is not possible to deal in a systematic fashion with all such elements of commodity risk. As a consequence, in what follows attention will focus on the strategic interaction of market risk and business risk for nonfinancial firms involved in the production and consumption of commodities. While some attention is given to FX risk, the essential element of market risk is associated with the variation in commodity prices.

Methods of Commodity Risk Management

Stretching back to antiquity, forward contracts with option features have been used to manage commodity risk. The need to acquire sufficient future supply of a commodity by consumers, and the assurance of a profitable price for risky, costly and time-consuming production can provide strong cash market incentives to engage in the use of such contracting procedures. More generally, the economic basis for the use of contracts with contingencies arises from the process of exchange in commodity markets. This process involves two steps. First, a buyer and seller agree on a market clearing price for the goods involved in the transaction. Second, the transaction is completed, typically with a cash payment being made in exchange for adequate physical delivery of the goods involved. In small rural markets and bazaars, both steps occur at the same time. In many large commercial transactions, time can separate the pricing agreement, the cash settlement or the delivery of goods. For example, a forward credit sale involves immediate pricing, delivery at a later date as specified in the forward contract and settlement dates dependent on the credit conditions extended by the seller.

The traditional subject of “risk” management as portrayed in financial economics, e.g. Merton (1993), Tufano (1996), Poitras (2002), Chance and Brooks (2010), emphasizes controlling risk through diversification, hedging and insurance. Applications of “free standing” derivative securities to risk management situations are emphasized. This approach is somewhat misleading, as it disguises the problem of specifying the risk management situation, and gives the appearance that the risk involved can, somehow, be managed in a systematic and unambiguous fashion using derivative security contracting. In emphasizing pro-active management techniques, methods needed for risk avoidance and risk absorption are often not examined. The various risk management approaches also differ in applicability to specific cases. In some situations, such as the Tufano (1996) gold mining sample, the firms involved may have little opportunity to exploit diversification opportunities to manage risk. Situations vary and the identification of an optimal risk management strategy depends on the objective function specified. Similarly, the management of “risks” disguises the importance of the “uncertainty” contained in random future events. It is difficult to formulate general rules. Even if general rules can be derived, such rules rely crucially on information about the properties of the relevant random variables, i.e. the types of risk being managed.

The “insurance principle” approach used in actuarial science provides an excellent source of general insights into certain types of risk management problem, e.g. Trieschmann (2005). By design, the insurance principle approach examines situations where only the chance of loss or no loss is considered. This is a restriction on the properties of the random variables being modeled. As such, there is only partial overlap with the situations of commodity businesses, where the random variables involved in risk management, such as corporate profits or changes in shareholder wealth, can take both positive and negative values. Whereas insurance problems seek to reduce risk, it may be desirable to increase certain commercial risks if the potential gains significantly outweigh the possibility and size of loss. Given these qualifications, Vaughan (1982) suggests the following insurance principle methods for handling the risks faced in actuarial science: risk can be avoided, e.g. by forgoing the writing of a policy; risk may be retained, e.g. by self-insuring; risk may be transferred, e.g. through hedging; risk may be shared, e.g. through the purchase of reinsurance; and risk may be reduced, e.g. by increasing audit surveillance.

The contrast between the actuarial science approach and that suggested by financial economics is revealing. There are some close correspondences. Risk reduction can be equated to diversification, risk transference to hedging, and risk sharing to insurance. This leaves risk avoidance and risk retention not counted. These omissions are significant. Financial economists tend to approach risk management by emphasizing applications of th...