Understanding corporate finance: derivative contracts: commodity risk
Managing commodity risk
The price of basic commodities - such as agricultural produce, timber, ferrous and non-ferrous metals, oil, natural gas and other energy sources such as electricity - continually fluctuates as a result of factors over which companies that produce or consume such commodities have very limited control, or no control at all. Examples of such factors include the weather, political tensions in regions where the commodity is grown or extracted, and worldwide demand for the commodity.
Companies use all the types of derivatives previously discussed to hedge commodity risk:
- Forward contracts: it is common for a farming company, for example, to contract to sell a specified amount of wheat, potatoes or some other crop at a pre-agreed price for delivery at a specified future time.
- Traded futures: there is an example at CFM13170of a company using futures to hedge the amount it has to pay for natural gas.
- Options and swaps: various over the counter option products, and swaps, are used particularly in the oil industry to hedge exposures to the price of crude oil or various refined oil products.