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Dealing with the high volatility of commodity prices

The volatility in all commodities has led to a revolution in the sector practice
17.03.2023
reading time: 6 min

Corporate clients’ awareness of the risk from changes in commodity prices is rather recent.
Unlike other financial risks, commodities risk has been recognised, addressed and actively managed only in the last twenty years approximately. While the risk arising from purchases/sales in currencies other than the core currency (exchange rate risk) or the risk arising from variable-rate indebtedness (interest rate risk) have always been quite evident, the risk arising from increases/decreases in the price of commodities used has been slow to appear in the 'Financial Risks' section of Corporates’ Financial Reports.

Today, commodity prices often appear in the headlines due to high volatility. While currently it is almost normal to see prices registering +10%/-10% within the same day, in the past, the market situation was different. For extended periods of time, in fact, producers and consumers enjoyed a context of prices with manageable volatility, a factor that allowed and fuelled the adoption of fixed-price purchase or sale contracts. The last few years have represented a significant turning point. The strong volatility in all commodities, triggered by the chain of events that have marked the last few years, has led to a revolution in the sector practice: whereas before it was the buy-side's choice to opt for a fixed- or variable-price offer, now it is rather a forced choice, since it is the sell-side that presents a single variable-price offer option. This paradigm shift is symptomatic of the new perception of commodities risk: a major risk that no one wants to bear any longer. And it is exactly in this context that the usefulness of the financial products offered by Intesa Sanpaolo's IMI Corporate & Investment Banking Division to its corporate clients is fully realised.  The impossibility of negotiating a fixed price with the supplier of a given commodity does not imply, in fact, that it is not possible to avoid bearing the variability of its cost over time and that it is not possible to synthetically transform that same price from variable to fixed through a derivative product.

The approach with which we assist our corporate clients involves a specific process to acquire all relevant information also in order to identify the best possible hedging. If requested by the client, an analysis of physical commodity purchase contracts is carried out aimed at identifying an explicit price benchmark as well as its price formation mechanism. Not all commodities that exist in nature have a financial correspondent, so it may be a perfect hedge if there is a perfect match between the physical commodity and the financial commodity, or a proxy hedge if the financial commodity being hedged is not the same as the physical commodity but is highly correlated.

Subsequently, the assessment of the possible hedging instrument is conducted. For those companies that prefer a certain fixed price, it could be preferable to opt for a Fix Payer Swap, through which the Corporate pays a fixed price and collects a floating price from the bank. This instrument does not allow to benefit from any bearish scenarios, since the lower outlay in the physical market is offset by the fixed price of the derivative agreed upon. In order to have a more flexible hedging, thus allowing the company to benefit from favourable scenarios while maintaining protection from adverse ones, it is necessary to range in the area of options. Through the purchase of a Call Option, for example, the company sets a maximum purchase price and remains free to benefit from any market downturns. The increased flexibility, however, comes at a cost, represented by the premium that must be paid when the option is purchased. This premium can be absorbed through the sale of another option, thus creating a Zero Cost Collar.

Through a tailoring structure, Intesa Sanpaolo's IMI Corporate & Investment Banking Division offers the best products to manage commodities risk exposure given the specific case and client’s needs.

DISCLAIMER 

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In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act and Directive 2014/65/EU on markets in financial instruments (MiFID II) Intesa Sanpaolo encourages you to read and understand the material information regarding:

  • all categories of swaps1 traded by Intesa Sanpaolo in the following link
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1   Swaps means generally over-the-counter (OTC) derivatives, except for forex spot.


CONFLICTS OF INTEREST

The Intesa Sanpaolo Banking Group provides its services in the banking and securities industry, carrying out activities in particular related to investment banking and corporate finance – through its companies having the necessary authorizations, where required -, finance & investment – through merchant banking and proprietary trading activities -, financial advisory, securities issuance, placement, reception and transmission of orders, execution of orders for clients and dealing for own account in financial instruments, portfolio management, including the management of collective investment schemes and the management of multilateral trading facilities.  

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