Commodity Derivatives: Efficient Instruments for Price Risk Management

A couple of years ago, Maharashtra Solvex Ltd. (MSL), an edible oil and soy meal manufacturer, bagged an order to supply 60,000 MT of Soymeal to one of the leading poultry feed manufacturers from the South. Soymeal prices, once fixed in the contract, MSL needed to cover part of its costs from Soy oil sales (Soybean crushing gives 80% meal and 18% oil). With Soybean harvest on a lower side that year, prices were expected to remain firm. Realizing that lower arrivals and increasing prices could pose a threat to the profitability of the business, MSL approached to commodity derivatives market to hedge the price risk. Using the Soybean Futures, MSL was able to safeguard their margins of around Rs 7.5 Cr which otherwise would have made a loss of around Rs 8.7 Cr from the sale commitment.  

MSL’s example is one of numerous companies who have successfully used commodity derivatives for price risk management in their commodity businesses. Commodity price fluctuations may affect the price of the commodity procured, maintained as inventory (raw material or finished goods) or sold to overseas parties or even on domestic transactions.  This makes the producer or holder or consumer of a commodity vulnerable to price risks. While contract farming has been one of the measures to manage the price risks, it is limited to a few commodities and a few geographies.  

With the setting up of commodity exchanges offering derivatives contracts, price risk management has become much easier.  Currently, in India, two instruments viz., Commodity Futures and Commodity Options, are being offered by these exchanges. Both of these instruments are standardized, exchange-traded and enjoy settlement guarantee from exchanges. The basic difference between these two remains in the fact that while Futures give the buyer and seller both the right and the obligation to buy/sell at a later date at an agreed-upon price, the Options give only the buyer/holder the right (or option) but not the obligation to exercise the contract. The seller of an Option contract has the obligation to fulfil the commitment. These instruments, used as hedging tools, enable intermediaries/producer/consumer in the commodity value chain to “protect and preserve” the value generated from the underlying business against commodity price fluctuations. These instruments are increasingly getting popular as tools for risk management as they insulate the participants from volatile commodity price movements and stabilize their cash flows.

Mr. Niraj Shukla