Commodity Risk - Volatility and Volumetric 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. That piece gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. This article, the final of the risk series, will focus on two other important risks in the world of commodities -- volatility and volumetric risks.

These issues pose serious economic risks for participants in the raw material markets around the world.

Volatility risk is the risk that the effect of volatility is beyond acceptable limits. Volatility is the measure of the variance of markets. It is the range of prices from high to low. In the world of commodities, volatility tends to be much higher than in other asset classes. Commodities like natural gas, coffee, sugar and many others trade, over time, at very high levels of historical volatility. It is not unusual for these and other raw material markets to double or half in price over very short periods. When it comes to the price of stocks, bonds or currencies, this type of volatility is rare.

In early 2014, the price of natural gas futures contracts traded on the New York Mercantile Exchange moved from $3.953 per million Btu's during the week of January 6 to $6.493 by February 24, an increase of over 64% in less than two months.

In commodities, this is often the rule rather than the exception. Weekly historical volatility rose from 25% to over 90% -- daily volatility went even higher. There are so many examples of this type of volatility in raw material markets.

In early 2014, the price of another commodity doubled in a very short period.

Coffee traded at lows of $1.0095 per pound in November of 2013. By March of 2014, it was trading at over $2.15. During that period, weekly historical volatility rose from under 16% to almost 65%. Commodity markets move violently because of many reasons. Generally, supply side issues cause price spikes. Weather and other issues can turn these markets and cause volatility or variance to explode. They do not only act violently on the upside, sometimes moves down can be just as or more violent.

In 2008, in the wake of the U.S. housing crisis and global economic crisis, the price of crude oil moved from all-time highs of $147.27 per barrel in July 2008 on the active month NYMEX futures contract to lows of $32.48 per barrel in December of the same year. As the price dropped off almost 78% in less than six months, monthly historical volatility rose from 32% to more than 50%. Many times raw material prices take the stairs up and the elevator down meaning that volatility tends to spike higher during bear market periods when buying evaporates.

Volatility is the chief determinate of option prices. Historical volatility is the measure of market variance in the past while implied volatility is the perception of market participants of what it will be in the future.

When it comes to options, in commodities and all asset classes, implied volatility determines premiums or the prices for call and put options. As you can see, volatility can present many risks as well as opportunities for commodity traders.

Volumetric risk is the risk arising from changes in the volume of commodity supply or consumption. Volume often causes volatility. Prices tend to move explosively in raw material markets during times of market deficits or oversupply. A sudden weather event, such as the drought of 2012 that caused the prices of corn, soybeans, and wheat to rally to dizzying heights, is an example of an event where the weather caused supplies to decrease dramatically. On the other hand, a condition of oversupply or a market glut where production and inventories increase to a point where supply moves much higher than demand can cause the opposite effect.

In 2015, we have witnessed just this as the price of crude oil has moved lower throughout the year as global production and inventories have increased to a point where a glut developed.

Volatility and volumetric risk are two important risks faced by all commodity traders. This concludes the series on risks that physical commodity traders face each day as they buy, sell and finance commodity production and consumption around the world.