Commodity Risk - Reserve and Settlement Risk

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Previously, I gave an overview of the topic of risk in commodity markets. In that article, I described the difference between assessed and non-assessed risks. That piece gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. Reserve and settlement risks are both important things to consider for those trading in physical commodity markets and associated derivatives.

Reserve risk is the risk that there are insufficient reserves, or large challenges in extracting sufficient reserves by reason of geology, technology or market conditions to support the value of a project. We can look at reserves in two-ways. The actual reserves of a commodity in the ground or the financial reserves that a company possesses in the bank needed to finance economic production. The bear market in commodities that began in 2011 and picked up steam in 2014 has presented many commodity producers around the world with this risk. There have been many reasons for lower commodity prices. A stronger dollar, which is the pricing mechanism for commodity prices, has caused prices for raw materials to move lower. Increasing output because of the bull market conditions in the years leading up to 2011 caused an increase in output; lower prices have caused inventories to build. At the same time, the peak in commodity prices caused demand to decrease.

At first, this was a function of higher prices. Classic economic theory teaches us that as prices rise, demand tends to decrease. As those prices decreased, a slowing global economy had a further negative effect on demand.

China, the world's second largest economy and the number one commodity consumer in the world, experienced a slowdown in their growth in 2014 and 2015.

This important factor weighed heavily on demand for commodities. Many commodity producers around the world suffered as prices moved lower. Commodity currencies like the Brazilian real and the Australian and Canadian dollar as well as the Russian ruble decreased in value. The raw materials rich nations depend on revenue flows from commodity sales, a decrease in revenues resulted in lower cash flow for these countries. Specific producing companies also suffer because of a decrease in commodity prices. The price of oil company shares decreased as the price of oil dropped from over $100 per barrel in 2014 to under $50 in late September 2015. Shares of some of the largest commodity producing companies in the world, Glencore PLC, BHP Billiton and Rio Tinto also fell along with commodity prices. Lower commodity prices resulted in lower revenues for most companies in the natural resource sector. Only those companies with significant reserves will have the ability to weather the bear market in commodity prices. Many of these companies have taken steps to increase reserves and bolster their financial position during the period of lower prices. As an example, in September, Glencore PLC suspended the dividend on their shares, diluted shareholders with an equity sale and suspended production at certain loss-making projects in order to pay down debt and build reserves.

In the current bear market for commodity prices, only those companies that have reserves will be able to survive the environment of lower prices and lower cash flow. As you can see, reserve risk is ​a major risk for any entity involved in the production of raw materials.

Settlement risk is also lag-time risk. This type of risk arises when a settlement payment expected from a counterparty to a transaction in a different time zone does not arrive this risk at the correct time for the destination time zone. Settlement risk rises the longer the lag time between the time a transaction executes and when final settlement occurs. In many commodity transactions, there is a lag between when parties to a transaction agree upon a price and when the transfer of commodity and payment takes place. While trading technology has improved and price dissemination and transaction times have decreased in recent years, settlement procedures have not improved expediency to the same degree.

New settlement infrastructure via blockchain technology could emerge in the years ahead to improve settlement risks for all parties to commodity transactions. Blockchain technology is a result of cryptocurrencies such as bitcoin. Recently, many financial institutions have been investing in blockchain technology for just this reason.

Reserve and settlement risks are risks that physical commodity traders and trading entities face all the time when it comes to the flow of raw materials around the world.