Why commodity firms should prioritise FX risk management

The past year has been a turbulent period for the commodities sector. A combination of the war in Ukraine, the supply chain impact of China’s zero-Covid policy and high global inflation meant that volatility dominated commodity markets.

Spot gold, for example, is trading at its lowest level in two years, and has fallen by more than 20% from its peak of above $2,000/oz in March against rising US interest rates. Similarly, Iron ore prices are at their lowest level since early 2020, while prices of Aluminium are down 40% since peaking in March 2022.

Market volatility has significantly heightened the exposure of many commodity firms to currency movements. Despite this, many CFOs at commodities firms may have traditionally seen foreign exchange (FX) as second order; they transact in FX not because they ‘want to’, but because they ‘have to’ given the international nature of the industry.

However, with uncertainty set to persist throughout 2023, we believe commodity firms should implement effective risk management strategies against these threats.

 

FX and commodities: what are the challenges?

There are several factors that heighten the FX risk of trading commodities. These include:

• Location basis risk – Location basis risk arises when the underlying asset is in a different location from the where the futures contract is traded. This is especially prevalent in commodities which must be physically transported to where they will be used and safely held in a storage facility. For example, a natural gas producer in Texas holds locational basis risk if it decides to hedge its price risk with contracts deliverable in California. If the Texas contracts are trading at $2.90 per one million British Thermal Units (MMBtu) and the California contracts are trading at $3.10/MMBtu, the locational basis risk is $0.20/MMBtu.
• Supply and demand - Unlike other asset classes such as stocks or bonds which are stored electronically, commodities are physical assets which are transported from where they are produced to where they are used. This makes them highly susceptible to supply chain disruption which can cause strong price fluctuations. For instance, China is one of the main global drivers behind iron ore demand, but its zero Covid-policy has significantly reduced imports, causing prices to fall.
• Climate / weather - Commodities come from natural resources, meaning the weather and climate can affect their production and transportation, which has a knock-on effect on prices. A clear example of this is the Texas power grid failure of 2021; when a winter storm broke the system, spot natural gas prices jumped by roughly 100 times their regular levels.

 

How can commodities firms enhance FX risk management?

Fortunately, there are a number of steps that these firms can take to mitigate the impact of currency movements. These include:

1. Compare the market - Having the ability to put trades up for competition is central to ensuring access to the best price, which is key to effective risk management. However, many commodity firms may be hampered by their inability to access Tier 1 FX liquidity, meaning they often rely on a single bank or broker to meet their hedging requirements. New technology-driven solutions are tackling this problem, enabling commodity companies to access rates from multiple banks whilst reducing the operational burden associated with this kind of market access.

2. Use of Transaction Cost Analysis (TCA) - TCA was specifically created to highlight hidden costs and enables commodity firms to understand how much they are being charged for the execution of their FX transactions. Ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance.

3. Outsourcing - There is a growing recognition that outsourcing does not necessarily mean less transparency or reduced quality of FX activities, and when using the right partner, firms can improve transparency and execution quality. Outsourcing can enable commodity firms to dedicate more time to core business matters, which is all the more important in the current volatile climate.

4. Strong governance – Since commodities must be stored and transported physically, the market holds a high level of operational complexity and risk. Commodity purchasing managers must take into account the scheduling, tracking and settling of purchases, in addition to monitoring transportation and logistical movements. It is therefore difficult to maintain transparency due to the number of different steps in this process. Harnessing solutions which can strengthen governance will help many commodity firms improve the cost, quality and transparency of their FX execution.

our FX challenges in 2023.