Commodity Price Risk or Scarcity of Materials

What Is Commodity Price Risk or Scarcity of Materials?

Commodity price risk is the potential for an increase in the cost of raw materials to affect a company’s profitability. 

Scarcity of materials can affect commodity price risk as well as have direct downstream implications — such as business interruption — and other indirect consequences.

Why Is Commodity Price Risk or Scarcity of Materials a Top Risk for Organizations Today?

Every organization has a range of dependencies that have a direct influence on their success or failure as a business. For many organizations, commodity price risk or scarcity of materials are chief among these dependencies and can significantly affect profitability, cash flow and competitiveness. As such, managing commodity price risk has long been a top priority for business leaders. But the past few years have tested many companies’ ability to hedge their risks and respond quickly. Challenges have included disrupted supply chains and wild fluctuations in consumer demand.

Coming out of the pandemic, companies are keeping a watchful eye on volatility in commodity prices. Rising input prices may force organizations to deploy additional capital to manage the volatility — capital that could otherwise be used to invest in growth or day-to-day business operations.

Several examples demonstrate how increasing levels of macroeconomic and geopolitical volatility have made this risk a more pressing concern for business leaders around the world.

The Energy Transition

Many commodities, such as oil and gas, are natural resources with a finite or diminishing supply, the scarcity of which will likely intensify over time. Renewable- and alternative-energy sources depend on a different portfolio of natural resources (such as copper, lithium and cobalt). But the feasibility of a transition from fossil fuels to renewable energy is dependent on the price and availability of the new materials, which can be difficult to predict given sudden shortages and supply chain issues.

One example of the current risk of scarcity of materials is lithium, a critical element in electric-vehicle batteries. Spiking prices due to a supply shortage in 2022 limited the capacity of car manufacturers to meet market demand.  A number of companies fell short of production and sales goals, which took a toll on their share price. 

Lithium prices have dropped significantly this year, and the U.S. Department of Energy has committed $3 billion for grants to establish a domestic battery supply chain. In addition, the U.S. Inflation Reduction Act of 2022 offers credits for battery production. The coming years could see further volatility in the price and supply of lithium as battery manufacturing ramps up.

The Conflict in Ukraine and its Impact on Agricultural Commodities

Markets and supply chains have increasingly become global in nature, but disruptions in specific regions can have a pronounced effect on prices and supply. 

For instance, over the past two decades, Ukraine has emerged as an important global supplier of grains, vegetable oil and other agricultural commodities. After Russia’s invasion of Ukraine in 2022, prices for commodities from wheat and palm oil to fertilizer surged, in part due to falling supply. Ukraine’s output of wheat, barley, corn and other commodities during the 2022 – 2023 agriculture season has been down more than 30 percent from the previous year’s level.

The conflict has also resulted in significant disruption for countries that relied on Russia’s energy exports. In the five months following the invasion, the increased cost of energy for buyers and consumers rose to approximately $2.7 trillion as short supply drove up prices.

Oil Prices and the Knock-On Effects for Industry 

In September 2023, global oil prices hit a 10-month high, spurred by falling shale oil production in the U.S. and a decrease in production by Saudi Arabia and Russia. The impact of rising oil prices reverberates across nearly every industry due to the commodity’s many uses. Oil is a critical component in many parts of the modern economy, from inputs for manufacturing, processing and transportation to plastics for packaging. And despite the focus on the energy transition, oil and its attendant price fluctuations will continue to be a factor in strategic planning for decades to come.

Why Is Commodity Price Risk or Scarcity of Materials a Top Risk for Organizations in the Future?

Commodity price risk or scarcity of materials will maintain its position as a top risk in the future for largely the same reasons as in the past. Dependencies on commodities and the scarcity of certain raw materials are unlikely to go away anytime soon. As the world’s developing economies continue to grow, demand for traditional commodities and materials required for large-scale economic progress, such as the development of critical infrastructure, will continue to climb. 

Supply-and-demand dynamics will likely change over time and intensify in certain areas as organizations and countries transition away from oil and gas to renewable-energy sources. This shift to a low-carbon economy will depend on a different portfolio of natural resources (such as copper and lithium), which will shift the focus of materials, making commodity pricing and materials relevant for the foreseeable future.

As regulations and ESG initiatives drive organizations and countries to adopt more sustainable models, supply-and-demand dynamics will intensify the impact commodity prices have on businesses. 

How Can Organizations Mitigate the Impact of Commodity Price Risk or Scarcity of Materials?

One typical method of managing commodity price risk is for an organization’s treasury or finance department to use derivatives and other hedging techniques. Where possible, companies have tried to diversify their portfolio mix to help offset volatility.

Although mitigation techniques may be tailored to a given commodity, the general approach to managing this risk is consistent with risk-management best practices; it involves using analytics to help identify, quantify and determine the most appropriate risk-mitigation and management techniques.

Insurance tends to have a limited direct role to play in management techniques for commodity price risk, but insurance solutions do exist and can be deployed to address the downstream consequences of scarcity of materials and how they contribute to business interruption in particular.  

Quantifying a business interruption event at the same time as modeling its supply chain risk profile will provide an organization with a better understanding of the potential financial implications of this risk and the appropriate mitigation measures. This can also help in the design of bespoke financing solutions to help manage associated volatility. 

General Disclaimer
This document is not intended to address any specific situation or to provide legal, regulatory, financial, or other advice. While care has been taken in the production of this document, Aon does not warrant, represent, or guarantee the accuracy, adequacy, completeness or fitness for any purpose of the document or any part of it and can accept no liability for any loss caused by reliance on it. Any recipient shall be responsible for the use to which it puts this document. This document has been compiled using information available to us up to its date of publication and is subject to any qualifications made in the document.