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It’s a long hot summer for commodity prices

Commodities are keeping corporates on their toes this summer. US rate hike uncertainty, ongoing bad news from China and the strong dollar are driving movements in prices of oil and other commodities. And so are expectations, intentions or beliefs about future events. CFOs are asking themselves how volatile their margins are and if they can afford not to hedge.

Commodity price volatility has risen, making producers like mining and oil companies very nervous. They are reducing CAPEX spending and cashing in their ‘in the money’ hedges, using the proceeds to buy hedges further down the curve at above-market levels.

 

Jens Vrolijk, head of commodity derivatives at ING

 

“For many companies that hedged themselves against a slump in oil prices, the downturn offers a chance to cash in their ‘in the money’ hedges or extend their protection,” says Jens Vrolijk, head of commodity derivatives at ING. Instead of just pocketing the cash, some companies could use the funds to shield themselves against a further market slide by buying swaps and options above current market prices and longer tenors.

 

Store today, sell tomorrow

Commodity traders and refiners stand to benefit from the volatile situation. The bear market allows traders to generate higher returns by buying and storing cheap oil today and at the same time sell oil forward at higher prices (contango play) without price risk.

“All sorts of sectors - from car manufacturers, shipping companies and airlines to brewers and cement companies - need to buy commodities to run their businesses. The margins have come off in some of those sectors and a profit can easily turn into a loss when prices go up. There is always that energy and metal component to consider. Moreover, the landscape these companies operate in has become very competitive,” says Vrolijk.

 

Hamza Khan, head of commodities strategy at ING

 

Hamza Khan, head of commodities strategy at ING, expects the slump in commodity prices to last a year. “In the last big sell-off in 2008-2009, prices were depressed for about 12 months after hitting their lows,” he notes. “Assuming we saw lows in January of this year, that leaves six more months of price stagnation.”

Uncertainty about a US interest rate hike is keeping the markets on its toes, while on the supply side, Khan sees companies pulling back and reducing CAPEX. For base metals, production expenditure is falling, which means that supply won’t be able to keep up with rising demand, setting the stage for price rises longer term.

 

Pricing benefits

Vrolijk advises corporates to take a detailed look at their commodities exposure. “CFOs must ask themselves how volatile their margins are given the swings of commodity components in their COGS or sales (for producers). Can they afford not to hedge? And don’t forget that commodity hedges can give a big advantage over the competition in some cases. Hedging can lower your costs, especially if you compare the current prices to those of e.g. a year ago. Irrespective of where commodity prices go from here (nobody knows), consequent and consistent hedging would in any case reduce volatility over time and improve the predictability of your cash flows.”