Commodity Risk- Accounting, Compliance and Correlation Risks

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In a recent article, I gave an overview of the topic of risk in commodity markets. In that piece, I described the difference between assessed and non-assessed risks. Over the course of the next few months, I will write a series of articles that briefly outline the different kinds of risks that commodity traders, producers, consumers and others involved in the raw material business face every day when dealing with these volatile markets.

The first risk we will focus on in this piece is accounting risk. When running a business is it an imperative to keep track of not only the proceeds for selling a product but the costs involved in mining, manufacturing or securing that product. In the world of commodities, so many cost factors go into production or consumption of raw materials. Therefore, proper accounting for those costs and proceeds will result in an accurate picture of profitability or losses and the ultimate determination of whether a business makes or loses money. The correct application of generally accepted accounting principles (GAAP) to any business is therefore an imperative and there is always a risk that mistakes can occur. Therefore, accounting risk is a key concern for management in the commodity business, or any business at all. Let us take the example of a commodity producer that sells a call option against future production.

They will receive the option premium immediately upon the sale of the call option. For the sake of this example, we will look at a three-month option priced at $3. The option has risk; if the price rises, the seller will have to deliver the commodity at the strike price. When accounting for this premium, the accounting risk arises when the decision becomes whether to declare the premium as a profit immediately, to amortize the premium over the life of the option or to wait until expiration to declare the profit.

As you can see, there are many choices, each of which is an accounting risk. Accounting risk is present in every action a company takes where there is cash flow involved.

The second risk for this piece is compliance risk. This is the risk that internal procedures, systems or actions may cause a breach of regulations. Those regulations can be the result of internal company policy itself or outside regulators. An example of a compliance risk these days would be strict adherence to procedures as dictated under the Dodd Frank Wall Street Reform and Consumer Protection Act. A company trading commodities on futures exchanges and on the over-the-counter markets today that is domicile in the United States must pay attention to the myriad of regulations outlined in the act. Compliance risk has increased over the past few years with the introduction of more stringent rules and regulations in financial and commodity markets that followed the financial crisis of 2008.

The final risk to examine in this article is correlation risk. This risk is the probability of loss from a disparity between the estimate and actual correlation between two assets, currencies, derivatives, commodities, instruments or markets.

An example of a correlation risk would be gold or any other commodity that is present in one location (a long position) and owed to another party in another (a short position). Let us say that a firm holds 1,000 ounces of gold in London and owes 1,000 ounces of gold in Hong Kong to fulfill an obligation. Even though the firm is flat -- they have no risk position, as they are long and short 1,000 ounces of gold, they have a correlation risk. While there is a very high correlation between the price of gold in London and the price of gold in Hong Kong, a risk is present. There is a chance that the impact of a change in the correlation moves beyond expected or acceptable limits. If the price of gold in Hong Kong moves much higher than the price of gold in London and the firm cannot transport the gold from London to Hong Kong, there is a problem and that problem arises because of correlation risk between the gold in each location.

Stay tuned for the next article where I will describe and explain more pitfalls that comprise the galaxy of risks in the world of commodities.