A commodity is a basic raw material or agricultural input used by a business to produce output. And due to the diversity and breadth of today’s production, a wide range of commodities are utilized by businesses throughout the world, from steel and copper, to coffee and wheat. A business’s reliance on commodities in its production process exposes it to fluctuations in the prices of these commodities.
This exposure is generally translated into volatility in profit margins or changes in product pricing, or both. The graphs below illustrate the movement of the combined prices of major world commodities over the 6 and 24 months ending July 1, 2011. As evident, commodity prices fluctuate significantly over short periods of time, reacting generally to external influences and news, and trend upwards over the long-term, responding to the sustained pressures of population increases, industrialization of emerging countries, and growth in spending power.
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Although the long-term price trends of input can be matched by steady increases in output pricing, many businesses find it difficult to match the short-term fluctuations in commodity prices because customers prefer consistency in pricing, and because product pricing relies on other factors such as competition and demand elasticity. This leaves the majority of businesses unable to avoid absorbing such short-term price fluctuations into their profit margins, and exposing cash-flows and net-income to high volatility.
The financial markets have a number of tools designed to help businesses stabilize cash-flows and net income by eliminating the short-term fluctuations in commodity prices, leaving the exposure only to the long-term price trends. These tools are contractual in nature, and do not require taking delivery of the actual underlying commodities, thus removing the costs of storage and expiration. Businesses can lock-in the prices of commodities on a desired point in time through the contractual purchase of such commodities, and allowing the gains from the transaction to off-set the price increases of their physical supplies purchased for delivery.
The end result is that a business can use its foresight and experience in purchasing its relevant commodities to better manage the cost of its products by securing the input at better prices.
The charts below demonstrate how a business can obtain favorable pricing over a significant period of time by spreading its purchases over the year (demonstrated by the 200-day Moving Average (MA)).
Sample commodity price movements over the last 12 months and their 200-day moving average: