Skip to main content

Managing Risk In Commodities Markets with Hedging Strategies

Few, if any, people can answer these questions with 100-percent certainty — what will the price be for a barrel of oil in six months? Units of natural gas? Soybeans? Global events continue to prove that a business can do its best to analyze the markets and forecast trends, but there is no true crystal-ball strategy for predicting the future cost of commodities. Instead, producers and consumers alike can introduce more clarity into their businesses and protect their margins with hedging strategies.

As recent trade turmoil, supply chain upheaval and post-pandemic inflation showed, economic volatility spurred by widespread crises can surface unexpectedly and endure indeterminately. Commodity hedging is a popular and important method for reducing risk in what can be particularly sensitive markets, including energy, metals or agriculture.

How Hedges Work

Oil Barrels

Similar to interest rate hedging, commodity hedging enables businesses to lock in prices on vital commodities. Typically, a hedge is a derivative contract made with a lender that establishes how much a producer must sell a commodity for or how much a consumer must spend to purchase a commodity. Hedges last for specific periods and apply to certain percentages of commodity transactions performed in that time, with companies often having multiple hedges in place at varying terms.

Hedges create stability and enable a business to better forecast and manage their margins. In turn, decision-makers can worry less about negative price swings and focus more on core business needs and future investments.

Hedging For Producers

Concerning producers, hedging guards against any potential drops in the price of the commodity they produce and bolsters creditworthiness when securing financing. An oil company, for example, may lock in a hedge to sell the oil it drills at $60 per barrel for the coming year, knowing it is greater than the profit break-even point and upholding confidence it can sell its production at that price. Hedging at that price means the producer forgoes any extra profit if the price of a barrel increases above $60 per barrel, but it has the benefit to protect against losses if it drops below that price per barrel while ensuring it will have a strong revenue stream.

Hedging for Consumers

Commodity consumers, conversely, use hedges to protect against price increases. In the energy sector, typical consumers can include transportation companies, utilities, manufacturers and logistics firms. These businesses often have natural hedging strategies in place — if fuel prices increase, costs are passed through to the end user. However, amid inflationary periods and when commodity prices remain higher for longer, customers may have less appetite for increased product or service prices. Given the prevailing environment, then, it can benefit an energy consumer to establish a hedge while the commodity is at a lower price to decrease their own costs and reduce pass-through impacts to end users. If the commodity prices go up, the hedge itself will instead pay back the extra cost incurred by the consumer.

Regardless of whether a business is buying or selling a commodity, hedging is a valuable tool for reducing risk and promoting a stable balance sheet. Hedges are not cookie-cutter, however, and businesses should work with an experienced institution to customize an effective plan.

 

Amid uncertainty over recent market volatility, inflation and tariffs, hedging is likely to become an increasingly valuable strategy. FNB’s Capital Markets team has an emerging specialization developing hedging strategies for companies in the oil and gas industry. Visit fnb-online.com/capitalmarkets to set up an appointment.

________________________________________________

 

Managing fluctuations in interest rates, including through rates hedges, is also key to mitigating risk. Check out the FNB Knowledge Center article “Growing Through Changing Rate Environments” to learn more today.

0 items in your cart

Cart Proceed to Checkout

Product video