Although metal, energy, and agricultural commodity contracts are popular targets for speculators, they’re also valuable to hedgers. Whether you’re concerned about inclement weather cycles or rising inflation, commodity futures can offer insurance against the unknown.
Why Hedge with Commodity Contracts?
A commodity contract is a futures issue based on a specific quantity of an underlying earth-borne asset. They are standardized, exchange-traded financial instruments. West Texas Intermediate (WTI) crude oil, gold, silver, corn, and soybeans are a few examples of commodity futures contracts.
Several attributes make commodity futures attractive to people interested in mitigating risk. Here are two of the most important:
- Physical value: Unlike purely financial assets such as fiat currency, commodities have a physical value. Further, commodity futures contracts give the holder the rights to a specific quantity of a raw material at a forthcoming point in time.
Subsequently, the contract has a tangible, physical value. As the old saying goes, “gold has never been worth nothing.” Well, this concept is true for all commodities, whether it’s a bushel of corn or barrel of crude oil.
- Volatility: Commodity contracts are priced according to the perceived strength or weakness of an underlying spot market at some future point in time. Accordingly, commodity futures are especially sensitive to anything that can disrupt the evolving supply-and-demand relationship. This opens the door to a wide variety of market drivers, including scarcity, geopolitics, and economic cycle.
At the end of the day, the physical value and pricing volatility of commodity contracts make them ideal hedging vehicles. Let’s take a look at two ways in which these products are used to limit exposure to financial and production risks.
Addressing Financial and Production Risk with Commodities
In reality, hedgers need to be aware of many risks, but two of the most significant ones are financial and production. Fortunately, commodities may be used to mitigate the negative impacts of each.
Financial risk is a catch-all term used to describe the possibility of losing money. It represents the potential downside liability for businesses, institutions, and individuals.
One of the key drivers of financial risk is inflation. Inflation is the increase in the prices of goods and services. It attacks the wealth of the consumer by reducing purchasing power and the relative value of local currency.
A powerful way to hedge against financial risks posed by inflation is to buy commodity contracts. During inflationary cycles, commodity prices typically rise. By assuming long positions in metals, energies, or agricultural products, a hedger is likely to secure market share. The gains may then be used to reduce losses related to the rising prices of goods and services.
Production risk is the chance of sustaining a loss because of an operational disruption or unfortunate market downturn. Because large capital investments are regularly made by producers, significant resources are also dedicated to avoiding catastrophe.
For many producers, incorporating commodity futures into their hedging game plan is an ideal way of reducing risk. As an example, U.S. soybean producers regularly sell September and November CME soybean futures (ZS) to hedge against falling prices come harvest time. The gains realized from the short soybean commodity contracts may be used to offset subpar cash market performance.
Preserve Market Share with Commodity Contracts
Hedging isn’t just for fund managers and corporate farmers. It is a great way for small businesses and individuals to preserve their hard-earned wealth. If you’re interested in boosting your risk management IQ, check out the Daniels Trading online hedging suite. Featuring timely market analysis and expert advice, the DT hedge portal is an ideal place to begin building your risk management strategy.