Commodity price risk & hedging

Many products depend on raw materials whose prices swing: palm oil for soaps and snacks, crude-linked plastics for packaging, steel and aluminium for appliances, copper for cables. If palm oil jumps 30% in a quarter, a soap maker’s margin can disappear before prices to customers can be raised.

Hedging fixes or limits the future price, so cost becomes predictable. Common tools:

• Fixed-price supply contracts: agree the price for the next 6 to 12 months with the supplier.
• Forward contracts: a private agreement to buy a set quantity at a set price on a future date.
• Futures: standardized contracts traded on exchanges, such as MCX in India or international metal exchanges, used to offset price moves in the physical purchase.
• Index-linked contracts: don’t remove the swing, but make it transparent and shared.
• Natural hedges: for example, buying raw materials in the same currency you sell in.
• Pre-buying stock when prices are low, at the cost of holding inventory.

The key idea for interviews: hedging reduces volatility; it doesn’t promise a lower average price. If prices fall after you’ve locked in, you pay more than the market. That’s the price of certainty, not a mistake. Companies typically hedge a share of expected volume (say 50–70%) on a rolling basis, with clear limits so procurement doesn’t drift into speculation.

A futures hedge in numbers

Options: insurance with a premium

A call option gives the right, not the obligation, to buy at a set price. Suppose a strike of ₹95,000 with a ₹3,000 premium:

• If the price rises to ₹1,10,000, the company effectively pays ₹95,000 + ₹3,000 = ₹98,000.
• If it falls to ₹75,000, it lets the option lapse and pays ₹75,000 + ₹3,000 = ₹78,000.

The option caps the price but keeps most of the benefit of a fall, at the cost of the premium, like insurance.

A layered programme

Rather than hedging everything at once, many companies hedge in layers: for example 70% of next quarter’s needs, 50% of the quarter after and 30% of the third, topping up each month. Price changes then flow into costs gradually, which gives time to adjust selling prices, and no single decision bets on the market’s timing.

Practical details

• Basis risk: the futures contract’s grade and delivery location rarely match what you actually buy, so the hedge isn’t perfect.
• Margin calls: futures are marked to market daily; a hedge that will pay off later can demand cash now.
• Exchanges: in India, MCX lists metals and energy and NCDEX lists agricultural commodities, both regulated by SEBI; international exchanges list contracts such as crude palm oil futures in Malaysia.

Hedge accounting

Futures and options are marked to market, so without special treatment their gains and losses hit profit each quarter, while the purchases they protect show up later. Hedge accounting under Ind AS 109 (which follows IFRS 9) lets companies match the hedge’s result with the hedged purchase, provided the hedge relationship is documented and shown to be effective. Without it, a sound hedge can make reported earnings more volatile, not less.

Governance prevents speculation

A hedging policy approved by the board typically sets:

• which commodities and currencies may be hedged, and which instruments are allowed,
• maximum and minimum hedge ratios by time horizon,
• who can trade, with separation between the people who trade, confirm and account,
• limits on positions and losses, and regular reporting.

Hedging more than the real exposure, or trading on a view of where prices are going, is speculation. Well-known corporate derivatives disasters, such as Metallgesellschaft’s oil hedging losses in the early 1990s, are reminders that cash needs for margin calls and the funding of a hedge matter as much as its economic logic.

Your competitors’ positions matter

If competitors don’t hedge and prices fall, they can cut selling prices while you are locked into higher costs. If they do hedge and you don’t, a price spike hurts only you. Some companies therefore hedge roughly in line with industry practice, or prefer contracts that pass index changes through to customers, so their margins move with the market rather than against it.

Currency is part of the exposure

Many commodities are priced in US dollars. An Indian buyer of palm oil or copper is exposed to both the commodity price and the rupee–dollar rate, and the two can move together or offset each other. Hedging programmes usually treat the combined rupee cost as the exposure.

Physical alternatives

• Formulation flexibility: recipes that can switch between oils, resins or metals when relative prices change.
• Supplier contracts: fixed or capped prices, or index links with collars that limit moves in either direction.
• Stock building when prices are favourable, within storage and shelf-life limits.
• Pass-through pricing to customers, where the market accepts it.