Essay About Commodity Risk And Price Volatility

Identify the Commodity Risk That Rio Tinto Group Is Exposed to and How the Group Is Managing That Risk
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Identify the Commodity risk that Rio Tinto Group is Exposed to and How the Group is Managing that risk.Word Count: 1475In the world of increasing price volatility, it has become more important for business enterprises to effectively manage their price risk than ever before (RUSNÁKOVÁ 2014). This essay discusses the price risk management issues associated with commodities by taking one of the world largest mining companies, Rio Tinto Group (RTG), as a case study. After identifying the company’s potential commodity risk, it analyses and evaluates the risk management strategies of the company. This essay also points out some potential problems of RTG’s risk management strategies, and gives some recommendations for future improvement.RTG is a multinational corporation listed in London and New York Stock Exchange with focusing on finding, mining and processing the Earth’s mineral resources (RTG Annual Report 2015). Under the current business environment and global economy, RTG is exposed to various risks such as interest rate risk, foreigner exchange risk and commodity risk. However, this essay mainly focus on RTG’s commodity price risk, as its main productions are commodities including aluminium, copper, and other mineral resources. According to CPA Australia (2012), commodity risk represents that fluctuated commodity price will adversely affect a company’s financial performance. RTG, a producer of commodity, is primarily exposed to commodity risk; thus, falling commodity prices will reduce company’s cash flow, limiting profitability and dividend payments (RTG Annual Report 2015). Zsidisin and Hartley (2012) further stated that two key factors determine an organization’s exposure to commodity risk. The first one is its level of dependence on commodity. The higher level of a companys dependence on commodity, the higher exposure risk to commodity it faces. As mentioned above, RTG produces various kinds of metal commodities, therefore, RTG is exposed to commodity risk to a large extend. The extent of volatility in the commodity’s prices is the second key factor. Commodity prices are influenced by supply and demand as well as by trading and speculation, which means that commodity prices are highly volatility (Shields 2012). Furthermore, over the past few years, the commodity prices in metal such as copper have decreased significantly because of the unstable economic conditions of world (Knoema 2016). When it comes to forecast the future trend of metal prices, Statista (2017) shows that they will fluctuate continuously. Based on the high volatility of commodity price and the historical and predicted future direction, it can be found that RTG is largely exposed to commodity risk. In other words, if commodity prices fall, RTG will suffer from a loss without the risk management strategy. According to RTG’s financial review in 2015, for example, a decrease of 10% in aluminum prices would result in a reduction in net earnings of $739m in full year average, excluding impact of commodity derivatives. Consequently, RTG should take certain hedging strategies to against the possible loss caused by the decrease of commodity prices.To overcome the threat of volatile commodity price risk, managers should use risk management tools to control their exposure to physical commodities (Hammer 1991). RTG’s management policy for commodity risk is to sell its products at prevailing market prices without trading and speculative purposes. On this basis, RTG has two strategies used for hedging commodity risk (RTG Annual Report 2015). Firstly, as RTG has a diverse portfolio of commodities, its exposure to commodity risk is mitigates by the virtue of its broad commodity base, which is called natural hedge. In other words, RTG can reduce the commodity risk by its normal operating activities. Diversification is one of the more useful strategy to reduce risk and uncertainty by having m.re than one product in businesses (CPA Australia 2012). However, to make diversification to be most effective, companies need to ensure that the alternative products do not suffer the same or similar price risk (Jang 2015). Besides, (Hendrick 2002) further stated that flexible, as a subset of diversification, is also very important. An institution that seeks diversification without flexible will create additional risk. A flexible producer has ability to change the production processes in line with changing market conditions and pricing movement (CPA Australia 2012). Therefore, there are potential problems for RTG to use diverse commodities base as a natural hedge. RTG’s mining business including aluminium, copper and iron, as well as energy usually exposes to the same price risk. Additionally, it is difficult for RTG to change its production processes to satisfy the flexible purpose.Secondly, because of the defects of natural hedge, RTG chose financial hedge strategies as well. Financial derivatives including forward contracts and options are used to hedge RTG’s commodity risk. Since companies do not have one hedging structure for hedging all commodities, they need to hedge each commodity separately. Specifically, companies have various actions for only one risk; thus, this part mainly use aluminium that is the main products of RTG in analysing the hedging strategies. According to RTG Annual Report (2015), the company used aluminium forward contracts to offset $5m loss arising from movements of aluminium price. Forward contracts are an agreement between two parties to buy or sell a specific amount of a commodity on a fixed future date at a predetermined price (Hammer 1991). When the forward contracts designed as hedge, they enable the seller and buyer to lock a fixed price in future delivery and protect against adverse commodity price movements (CPA Australia 2012). For example, RTG bought aluminium forward contracts for hedging purpose, therefore, the company can successfully hedge a loss when the future spot price of aluminium decreases lower than the fixed price on the contract. However, if the future price has a favourable movement at delivery, RTG may receive a loss of profit. Another problem of using forward contracts to hedge is that they are illiquid (Singh 2004). If RTG discovers that there is no aluminium, then the company no longer need the contracts. In this case, RTG has to buy back the contracts, which is difficult and expensive given the illiquidity of forward contracts. Additionally, as forward contract is non-standardised contract between two private parties and traded via over the counter (Poitras 2013), RTG may face the potential counter-risk when uses forward contracts as hedging strategy.Furthermore, in 2015, RTG also bought put options to reduce Group’s exposure to movement in aluminium prices. In the commodity market, option contracts offer the buyers of the contracts the right, but not the obligation, to sell or purchase a specific commodity at a predetermined price (strike price), on or before a specific date (RUSNÁKOVÁ 2014). There are two types of option, put option and call option. Put options provide the buyer with a hedge against potentially decreasing prices while call options provide the buyer with a hedge against potentially rising prices (Mercatus 2016). RTG hedges its commodity risk with put options which allow the Group to mitigate the exposure to declining aluminium prices as well as retain the ability to benefit from potentially higher prices. Specifically, depending on the prices movement, RTG decides to accept or leave the guaranteed aluminium price. Smith, Anderson, McCorkle and O’Brien (1998) stated that the buyers only pay a premium to protect against possible loss and they have no further obligations. If the market price goes up, RTG can sell their products in the cash market and abandon the put options. On the contrary, when the market price goes down, RTG can exercise the right of put options to protect against the potential loss.