The world commodity prices are characterized by cyclical moves and volatility, creating significant price risk for producers and consumers. There should be implemented special methods of price risk management in order to avoid negative consequences.
The main distinguishing feature of the first characteristic - price cycles, is about the sharp transition from the rising phase to the phase of decline in prices. This feature is a major problem for price risk management. There is an asymmetry in the price cycle: for most commodities the decline phase lasts longer than phase of recovery. There is no stable form for the rising phase or the decay phase. For most commodities, the probability of rising phase closure as well as the finish of the decline phase is regardless of its length. The turn-around can happen at any time, regardless of the duration of the phase.
The second major particularity of world commodity prices is volatility. Under the volatility you should understand the short-term fluctuations in prices. Quantitatively, volatility is measured as the standard deviation of timely series of percentage changes in prices. But let us understand more in depth what is volatility about:
Market volatility is the amplitude of the fluctuations in price over a certain period of time, which means not the horizontal direction of the trend, but the swing of the vertical jumps, swing of intraday highs and lows. For example, when during the trading session the price of the exchange tool varies within the range of 1% to 1.5%, the asset is considered to be low-volatile. As opposed, when the morning price grows to +15%, and in the evening it falls to -10%, and finally is closed at + 5%, this stock asset can be safely called volatile. In other words, market volatility is a measure of how much the price is "jumping" and how active is the trading instrument.
The main rule of volatility
The fluctuation of any asset falls under a single law that is unlikely to change once: after periods of high volatility, there will inevitably be its extinction, the market calms down and then comes the low volatility period. After a period, the phase of low volatility is again replaced by a highly volatility. Thus, the overflow from one state to another occurs continuously. In conclusion, the longer the period of high volatility, the more likely that it will soon begin a period of low volatility. And the longer the market is dominated by low volatility, the more likely that there will soon be a period of high volatility. Narrow ranges are replaced by broad and broad ones by narrow.
Volatility in global commodity prices has increased significantly over the past 30 years. The increased volatility greatly complicates and devalues long-term forecasting of commodity prices. The most significant increase in volatility over the last decade can be referred to the prices of oil, as well as to those types of commodities, the prices of which have a high correlation to oil prices. In the context of ineffective price forecasting, the practice of hedging price risks is particularly important. Foreign companies have developed a vast arsenal of price risk management methods, and the countries with advanced economies developed a special infrastructure of both exchange and OTC management.
All the methods of price risk management can be divided into traditional and market. Traditional methods include: the creation of commodity reserves and cash funds, long-term contracts with suppliers and customers, diversification of activities, as well as subsidies from government authorities in the event of adverse price movements for the company. These methods are widely practiced by companies of different levels in different countries. To market methods you can include the use of forward, futures and option contracts, commodity and basis swaps, and commodity loans and bonds.
Forward contract is an agreement to buy or sell a specified quantity of goods at a certain price on a specific date in the future. Generally, forward contracts require physical delivery. Payment is made at the appointed day for the calculation. In addition to forward contracts for the supply, there is the so-called Commodity Non-Deliverable Forward, the payment being done without physical delivery. If the actual market price at the date of settlement is higher than the forward price, the buyer makes a profit, and vice versa. The main advantage of forward contracts is that they eliminate the price changes risk for both the buyer and the seller. Probably the most well-known and developed forward markets are the gold forward market and oil market – Brent. Both markets were formed relatively late – in ‘80s, in response to price shocks of the global financial system in ‘70s and early ‘80s.
The forward price of gold is the price at which is agreed a forward contract for purchase/sale of gold. There is a special formula which the price is calculated with. Futures contracts on gold are traded on the New York Stock Exchange - NYMEX, on the Tokyo Stock Exchange - TOCOM, in Chicago on CBOT, as well as in Istanbul, at Istanbul Gold Exchange. However, the experts believe that the OTC gold forward market is several times larger than the futures exchange market.
A futures contract on the commodity is the obligation to buy or sell a certain amount of goods in the future at a price fixed in the contract: the so-called futures price. Futures price differs from the contract price. Unlike forward contracts, futures contracts are traded only on regulated exchanges and are therefore not exposed to credit risk. A detailed description of futures contracts and the mechanism on stock trading can be found online.
Commodity futures are divided into the following categories:
- Contracts for agricultural products, such as futures for wheat, soybeans, corn, orange juice, etc;
- Contracts for livestock products, such as futures on pork bellies, live cattle, and so on.
- Contracts for energy commodities, such as crude oil futures, heating oil, unleaded gasoline, propane, natural gas;
- Contracts for industrial metals, such as futures on copper, aluminum, zinc, tin;
- Contracts for precious metals, such as gold futures, silver, platinum, palladium, etc.
One of the major oil future markets is the WTI - West Texas Intermediate, which was launched as an oil commodity futures index for the Chicago Mercantile Exchange in 1986.
What is affecting the commodities prices?
Well, there are more main factors that are decisive for the prices, but the most important ones are:
- Supply of commodity goods. You can name here as examples the oil production, gold supply, and so on.
- The demand is also an important factor, and when there is overproduction, the ratio is changed.
- The geopolitical nuances and changes are essential because the decisions of particular countries or organizations can affect the market.
- Strong dollar in relation to international currencies can increase the prices for other countries and create an imbalance.
- Climate changes can affect especially the agricultural products.
In conclusion, there should be mentioned that commodities are very attractive for traders, and for very good reasons. Here are some of the main advantages of commodity trading:
- There is a wide selection – you can start trading on various commodities such as precious metals (gold and silver), agricultural products (corn and sugar) and oil.
- The opportunity to profit from the rise and fall of commodity prices.
- The possibility of profiting from the international geopolitical tensions.
- The ability to take a short position and profit from a possible decline in commodity prices.
- Benefit from market information in real time, as well as the knowledge of analysts.