Managing extreme price volatility

Building world-class capabilities in commodity risk management

How to reduce the impact of short-term changes in commodity prices using “out-of-the-money” call options

Extreme price escalation can be managed

Sharp fluctuations in commodity prices are creating significant business challenges that can affect virtually everything from production costs and product pricing to earnings and credit availability. This extreme price volatility makes it hard to run a business and to plan and invest for the future. It can also undermine a company’s profitability and competitiveness, and in some cases it can even threaten a company’s survival.

In an earlier article (“Managing rough waters”), we outlined the core elements of commodity price volatility and showed the impact that this volatility can have on a company’s earnings. We then presented a systematic approach that used multiple levers to address the range of volatility effects.

In this article, we focus on the increasingly common occurrence of extreme escalation in commodity prices over a relatively short timeframe (less than a year), and offer a specific strategy for handling them. Note that these extreme short-term price spikes are different than strategic shifts in commodity prices, which involve sustained price movements driven by fundamental changes in the supply/demand balance. This distinction is important because the methods used to address the different types of volatility vary significantly in terms of effectiveness, risk, and required execution capabilities.

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