Everyone knows that business is risk. Once we enter the business, some risks are acquired inherently - these would be business risks, like production hold-ups, quality issues, etc. In addition, all businesses face financial risks, which can be broadly categorised as follows:

Credit Risk - the probability of default of the counter partyInterest Rate Risk - caused by changes in the market interest rates which affect cash flows

Currency Risk - caused by changes in the value of the invoicing currency, or changes in the value of a competitor's currency, and

Commodity Price Risk - due to changes in the prices of a traded commodity.

Of these, commodity price risk is usually the most dangerous. This is because most commodityprices are substantially more volatile than currencies or interest rates.

What causes this huge volatility? The price of any commodity (including currencies and interest rates) are always determined by the imbalances in demand and supply. Physical commodities are intrinsically different from financial commodities in that they "grow" in specific regions, are vulnerable to spoilage, etc. Thus, their supply patterns are more unpredictable than most. Some of the key issues underlying the high volatility of physical commodities are as follows:

Concentration of the supply source: Usually, physical commodities grow in a few specific areas in the world. For instance, 30 per cent of the world coffee is grown in Brazil. The possibility of adverse changes in climate there - hurricanes, for example - creates tremendous uncertainty on the total produce that will come out of Brazil, and hence the total world supply.

Of course, markets do tend to factor this in, and new producing areas - like Indonesia, Malaysiaetc. in the case of coffee - may reduce this uncertainty to some extent. But, in general, such a huge fraction of supply coming from one location ensures that volatility will be high. This is also true in many other commodities, such as non-ferrous metals, petroleum, certain edible oils, etc.

Natural calamities: Even in cases where the supply is reasonably widely dispersed, natural calamities at any one site can squeeze supply dramatically. For instance, recently there was major flooding in a region of China which had large copper and tin mines.

Technological changes: New and better methods of production, which can not only improve the production and also affect the consumption pattern. Aluminium is produced from Alumina, the conversion of which uses huge amounts of electricity.

Changes in costs of power in a particular area - if, say, solar power were to become dramatically useable in the future - could alter the cost of production, and, hence, the price dramatically. Again, in thecase of aluminium, recent developments in the automobile industry have dramatically increased the amount of aluminium used in car bodies; this increases demand and hence price.

What is significant is that technological change can cause a quantum shift in supply, demand or cost - this threat leads to a higher volatility.

Political uncertainty: During the USA-Iraq war, oil supplies from Iraq were stopped as a result of which the price of oil shot up to an all-time high.

Investment Banks and Hedge Funds: These are high volume players punting on market views. They tend to be highly leveraged and hence can drive prices sharply in either direction.

Over the past decade or so, hedge funds have clearly added to market volatility - Hamanaka of Sumitomo was a loud example.

Thus, for a company with a commodity exposure, independent of whether they are a producer or converter or trader or processor, there is a substantial risk of dramatic changes in prices during the tenure they hold thecommodity.

Actually, price risk can arise in three ways:Tenor mismatch: Here, the quotational period (q/p) for input material might not match with the q/p of output material. This gap causes tenor risk. For example, a custom copper smelter buys concentrate, processes it over a two month period and sells the outputs (say, copper cathodes). Now, both the input and output prices are linked to the LME price of copper.

However, say he is buying the concentrate in July and selling the cathodes in October, the price he realises (per tonne of copper in the cathode) and the price he pays (per tonne of copper in the concentrate) could be dramatically different.

Hence, in the metals trade, the pricing mechanism is structured so that concentrate is usually sold with pricing terms fixed at "the average price of the month two months after month of shipment (2MAMA)". If then the company sells the outputs on basis cash LME two months after shipment, he has no price risk. However, things do not always workso smoothly - there is often an inventory build-up or a delay in production, which once again exposes the company to price risk.

Absolute risk: Either the input commodity content is insignificant as compared to final output price or you have no control over the output pricing. In other words, price fluctuations cannot be passed on. Consider an auto component manufacturer who commits to a fixed price for his product for, say, three years to an auto manufacturer.

During this period, the prices of input commodity (aluminium, in this case) will doubtless change dramatically.

The component manufacturer runs an absolute price risk and would need to hedge himself out to ensure his minimum profitability.

Basis risk: When the basis of input pricing differs with the basis of output pricing. For example, a refinery that imports crude oil from the Gulf - their input is priced at a spread over Dubai crude, while their output (say a mix of gasoline and heating oil) are priced at a spread overBrent - or, more correctly, at the crack spread minus Brent crude.

Now, assume the company hedges out the possible fluctuation in Dubai prices on the OTC market and the possible fluctuation in the Brent prices and the crack spread on the IPE.

However, he is still exposed to the risk that the spread between Dubai and Brent will narrow and his profit will fall. It is possible (in this particular example) to have a broker provide you a hedge against this particular basis risk; however, such transactions are difficult to structure and are usually quite heavily priced.

More importantly, most basis risks - another example would be a company hedging its cotton import prices against NY cotton futures, but finding that the price of the actual cotton they import moves in a different fashion.

Given all of the above, it is clear that companies with commodity price risk need to be able to understand their risk, quantify it, and, importantly, have access to hedging mechanisms through which they can secure theircash flows.

All hail the Gupta Committee, the government and the RBI for starting this process. More is needed and, no doubt, will be forthcoming.

(Authors are analysts with Mecklai Commodities, a division of Mecklai Financial & Commercial Services Ltd)