How should commodity traders now think about geopolitical risk?

In 2009 political scientists Ian Bremmer and Preston Keat defined geopolitics as “the study of how geography, politics, strategy, and history combine to generate the rise and fall of great powers and wars among states.” Given its importance to the running of the modern global economy, nowhere is this more vividly observed than in the battle for energy resources and in particular oil.

A cursory look at a simple oil price chart reveals a series of bumps. Each of these can be pinpointed to wars and conflicts, whether it was the Iranian revolution or the first and second Gulf wars. More recently, Arab Spring related uprisings in Libya, Egypt and Syria as well as violence in Iraq and the Ukraine have resulted in escalating geopolitical tensions across many key energy production and transit countries.

Geopolitics has come back to the forefront in recent weeks following Saudi airstrikes on rebel positions in Yemen. Although there appears to be little risk of any oil production actually being affected the bigger risk concerning the market was that the Bab el-Mandeb strait (a transit route for around 7% of the world’s crude) could be blocked and more broadly that the conflict might represent the opening exchanges of a broader conflict between Saudi Arabia and Iran. The oil price jumped about 5% on the news, only for it to give back those gains within a week.

How should commodities be priced under conditions of high geopolitical uncertainty? As a non-income producing asset commodities are only worth what individual people are prepared to buy and sell at any one time. Commodity markets, like every other financial market should in theory at least, act to constantly reflect the opinions of buyers and seller regarding demand, supply and the future direction of the price. However, they are also influenced by the emotions and perceptions of risk of those who trade them, including producers, consumers, traders and investors. And here the key factor is the perception of scarcity.

Take oil as an example. You can say that much of it is in the hands of nations that we can’t rely on, but what does that make it worth? The same factors were just as relevant when oil was around $40 per barrel in December 2008 and they were equally true in July 2007 when oil reached $147 per barrel. In the end the commodity is only worth what someone is prepared to pay for it. The markets perception of scarcity today in April 2015 means that traders are only willing to pay half what they paid for it a year ago.

Looking for examples of what prices could do from previous events is instructive of the fear and the extent to which prices can move, but they don’t provide a hard and fast rule for how future geopolitical events will play out. Take the first Gulf war in 1990, the oil price doubled and then once the US led military response started oil prices gradually fell back so that within 9 months the spike had subsided. More recent actual disruptions to supply have tended not to result in a significant impact on prices. Only a few years ago news of pipeline blowing up in Nigeria would have caused a sharp rise in the price of oil. High inventory levels amid a supply slut in oil and many other commodities mean that there is now a much healthier buffer stock in place against potential disruptions. The perception of scarcity is now much lower.

Geopolitical events are by their very hard to predict and are often destabilising, in a sense they could be termed ‘black swans’ in that they are low probability, high impact events. A negative geopolitical event will tend to increase the risk premium and alter the direction of asset prices. However, when a geopolitical event also depresses economic growth and changes the course of inflation, then the effect on commodity markets is likely to be more sustained.

The effect of a geopolitical shock might also be very different from what was originally feared. Taking the example of a disruption to oil tanker traffic in the Bab el-Mandeb strait, it’s worth considering that the route is also the major route for container traffic between Asia and Europe and so any disruption would act to slow world trade and global economic growth, depressing oil demand and prices.

The commodity whose supply is under threat from a geopolitical event will tend to increase as perception of its scarcity increases. Gold and to a lesser extent other precious metals tend to benefit in times of uncertainty. The impact on other commodity markets is more mixed. If oil supply is under threat, other commodities that are very energy intensive and so also highly correlated may also rise. However, if the broader impact results in a loss of business and consumer confidence and a slowdown in economic growth then demand and prices for other commodities may fall.

Geopolitical events can appear to surface out of nowhere. Although we routinely focus on issues that are in our immediate field of vision, new developments that radically alter our perception often emerge out of left field. The trouble with geopolitics, however, is that it often appears as noise until it suddenly becomes a crisis. To quote Warren Buffet “In the business world, the rear view mirror is always clearer than the windshield”. As the perception of scarcity has diminished the impact of geopolitical events in today’s commodity markets is now more nuanced than we’ve seen for quite some time.

First published on Oilprice.com

What is commodity risk?

Whether it is a farmer deciding what crop to plant for the next harvest, a manufacturer deciding whether now is the best time to purchase the commodities it needs, or an investor taking a position in coffee futures in anticipation of a drought in Brazil, all these decisions consists of dealing with the future.

And as it’s difficult to make predictions, especially about the future dealing with risk is essential.

Commodity market risk comes in many forms and can mean different things to different people.

The main risk is price. Whether you buy, sell or trade commodities the risk foremost in most minds is that the price moves against your position resulting in a loss.

Second, there is a supply risk if the commodities don’t arrive on time and to the condition expected. This may mean price is a secondary thought, especially if the perceived or actual risk of a disruption to supply is high.

Third, career risk (or not having skin in the game) is another factor. A manager may not care much about gains, especially those in which they won’t share in, but may be afraid of losses that could cost him or her their job.

Fourth, a lack of liquidity or cash flow could mean that an investor or physical trader can’t take a position or pay for a hedge that they might otherwise make. This means opportunities are missed and / or risk, that could have been insured against is not meaning risk could actually increase.

Finally, there is a reputational risk. Ensuring the supply of commodities is from a sustainable source (i.e. environmentally or socially) is essential to avoid the risk of bad publicity but also the risk that factors outside your control disrupts supplies.

Price volatility is often used as a measure of risk, a catchall for everything from the risk of supply disruptions to inventories being damaged to there being an unexpected surge in demand.

Long periods of low volatility (much like the last few years) can lead market participants to believe that risk is low. This can inadvertently lead to behaviour that actually increases risk, perhaps by taking on too much leverage in expectation that prices will stay within a tight band or never fall below a certain level.

But as ever it is impossible to boil anything down to one metric and risk and commodity price volatility is no different. Risk exists only in the future and it’s impossible to know for sure what it will hold.

Go back a few years, investors and commodity buyers were fearful that the commodity super cycle was in full flow and prices would continue to rise. Now, the same people may be concerned about missing the bottom but also being wary about catching a falling knife. Here our attitudes to and calculation of risk become blurred by emotion and psychology.

Properly understanding and controlling for risk can be summarised by two quotes. The first “Risk means more things can happen than will happen” and second “Pigs get fat, hogs get slaughtered”.

Or always think in terms of risk and return (or loss) and never get too greedy.

Related article: Top 8 mistakes in commodity buying and risk management

Related article: 6 ways manufacturing companies can manage commodity price risk

Top 8 mistakes in commodity buying and risk management

1) Limited understanding of commodity risk

Many companies are failing to quantify their risk exposure to commodity prices. They often rely on ambiguous assumptions about price volatility and how and when movements in commodity prices impact on their bottom line.

2) Monitoring and preparing for ‘black swan’ events

Only a small proportion of firms actively look to monitor emerging commodity price pressures and and put in place plans to address high impact low probability risks.

3) Inadequate commodity procurement performance measure

Most companies measure their own commodity price performance against their own budget, leaving them unaware of how they compare with their competitors. With tight margins and weak pricing power commodity price volatility offers an opportunity to gain a competitive advantage over your competitors.

4) Renegotiation’s driven by expiry date of contracts

Most companies leave commodity price renegotiation until their contracts are about to expire leaving them exposed to whatever commodity markets are doing at the time. Companies that carry some flexibility in their overall procurement spend may be able to utilise commodity market insights to gain a better deal and a competitive advantage.

5) Static hedging strategies

Many companies adopt the same approach to contracts and hedging risk whatever the conditions in the commodity markets they are operating in. A flexible approach may be able to better capture additional value taking account of market conditions and the balance of risks in terms of price direction.

6) Incomplete or biased information on commodity markets

Many firms do not try to get an overview of what is happening to commodity prices key to their business. Just as worrying a significant number of companies list their raw material supplier as their main source of opinion on how commodity prices may develop.

Related article: Commodity market insights give companies a competitive advantage

7) Buyers not taking account of full material cost breakdown

There can be considerable information asymmetry between buyers and sellers. Suppliers will have a full cost breakdown of the raw materials they supply, information which is difficult for the buyer to obtain especially when there is a degree of value add to the underlying commodity being supplied.

Related article: 6 ways manufacturing companies can manage commodity price risk

8) Not considering Cash at Risk (CaR) as well as Value at Risk (VaR)

The VaR is associated with the underlying value of the commodity that the buyer is seeking to manage in some way and is therefore a very short term indicator. By its very nature the VaR is very difficult to monitor and predict. However, since a commodity buyer will generally want to take delivery of the commodity at some point the business needs to consider the impact that its risk management strategy will have on cash flow. By considering CaR businesses should bear in mind both the value of the commodity that they are purchasing and the sales price of the product that the commodity will be manufactured into over the lifetime of the hedging period. By doing so they should be able to more effectively manage their cash flow and be able to adapt more easily to unforeseen events.