The era of stable prices and low interest rates in the U.S. could be behind us. Amidst aggressive rate hike expectations from the Federal Reserve and global commodity price spikes, businesses are facing a volatile rate environment for the first time in years.
“It’s a very interesting environment,” says Darrell Fletcher, Senior Managing Director of Commodities at Huntington. “For the past five years at least, we’ve been in a stable commodity price environment with very low interest rates. People got used to that. There’s been a complete undercapitalization and investment of many commodities globally, which has changed everything.”
Commodity prices are no longer predictable, and rates are expected to keep rising. Risk mitigation strategies, which businesses might have paused or not considered at all during the previous years of stability, are now going to be essential. Understanding new areas of risk and strategically managing them could make the difference for businesses as they adjust to this new environment.
The state of rising rates and commodity prices
Countless factors play a role in today’s fluctuating commodity prices, including the COVID-19 pandemic and subsequent lockdowns, Russia’s war in Ukraine, and global unrest. Supply chain disruptions worldwide make it a challenge to manufacture and ship goods and equipment, and the global energy crisis is creating a high-risk situation for natural gas and oil that has led to prices rising to a 13-year high, explains Fletcher.
“Whether it’s the base metals market, energy markets, or agriculture, many prices are at five- to fifteen-year highs right now,” says Fletcher. “Companies that hadn’t been concerned about their exposure, whether with diesel, aluminum, or steel, are worried now as they see these numbers rise.”
In the U.S., efforts to address inflation and shrink the Federal Reserve’s nearly $9 trillion balance sheet have led to the biggest jump in interest rates in two decades. Increased consumer spending – and the demand that comes with it – could only add to inflation pressures.
While these rapidly heightened rates and prices are unprecedented, businesses should be prepared for this situation to continue into future and begin exploring risk mitigation strategies to control what they can.
“Businesses are going to have to get used to these price levels to an extent,” Fletcher says. “They’re not going to change anytime soon.”
Hedge against commodity volatility
Risk from price volatility can be managed through commodity financial hedging, a protective strategy that allows companies to lock in a rate for a commodity over a defined period. In today’s market, where commodity prices are surging to record highs, hedging offers predictability by helping smooth out prices over a determined amount of time.
Businesses considering hedging should begin by reviewing the commodities most important to their operations and understanding the effects of a sudden price spike, Fletcher says.
“Businesses need to first understand their exposure and what it means for their operations,” explains Fletcher. “For example, what are they burning in gallons, pounds, or tons per month? Running a risk analysis can help define cash flow risk for specific commodities.”
Understanding what could be at risk can lead businesses to make decisions about what risk is acceptable and how it might affect their liquidity needs. Answering the question, “What do these exposures mean for our operations?” can help better position businesses to develop a hedging strategy to combat today’s commodity volatility. Or, at the very least, it can help them understand their current risk and begin considering opportunities to hedge in the future.
“You might decide to hedge now and take that risk off the table, because at least you’ll know what the cost is going to be for a period of time,” says Fletcher. “If companies aren’t comfortable hedging now because prices are too high, they can deal with the cost now and look out to the next few years when hedging conditions are more favorable.”
Manage interest rate risks with derivatives
Any interest rate volatility can impact earnings and borrowing costs. Derivatives are one of the most cost-effective options for businesses to protect themselves against interest rate exposure. Interest rate derivates are hedging solutions that can minimize or eliminate risks related to rate fluctuations. Businesses can consider derivative strategies using interest rate swaps, caps, or collars to limit volatility and reduce their risk profile.
The unpredictable fluctuations in the market right now can have a significant impact on a company’s finances. Companies with future commitments, such as procuring equipment or constructing a new building, can turn to derivatives to fix rates at current levels rather than risk higher costs down the road.
Interest rate swaps, which enable companies to manage variable rate exposures, are an attractive solution as the benchmark rate climbs. With this type of derivative, a company can lock in a rate on all or a portion of its floating rate exposure for a specified period of time. Although it’s not clear exactly how high rates will rise nor when they will stabilize, fixing a rate now is one less risk factor for businesses to worry about.