Commodity price risk, profits, and value creation

Date01 July 2019
Published date01 July 2019
Trends in Risk Management
Commodity price risk, profits, and value creation
Alex Krainer
Altana Wealth Limited, Monte Carlo, Monaco
Alex Krainer, Altana Wealth Limited, Monte Carlo, Monaco.
KEYWORDS: commodity price risk, hedging, risk transfer
In 1921, Chicago economist Frank Knight published Risk,
Uncertainty and Profit.The book is widely considered as
one of the 20th century's most influential economics texts.
As a central part of his thesis, Knight makes the critical dis-
tinction between the concepts of risk and uncertainty.
Frank Knight hypothesized that in competitive markets,
only true uncertainty can be the basis of a firm's ability to
earn positive economic profits on a sustainable basis. The
key aspect of uncertainty Knight was referring to was price,
which he regarded as the most important factor determining
a firm's profitability: the most important fundamental deter-
mining fact in connection with organization is the meeting
of uncertainty. The responsible decisions in organized eco-
nomic life are price decisions; others can be reduced to rou-
tine…” (Knight, 1921).
Below we look at three different cases underscoring the
heavy impact of price on profitability of commodity
1.1 |Case 1: Gold miners
From 2003 to 2010, AngloGold Ashanti, at that time the
world's third largest gold mining company accumulated
$2.41 billion in losses by hedging its exposure to the price
of gold. AngloGold Ashanti's hedge locked the firm into for-
ward gold sales at below $450 per ounce during the time
when the price of gold rose more than three-fold, reaching
$1,400 in 2010 (Kaminska, 2010; Exhibit 1).
In 2013, Barrick Gold, the world's largest gold mining
corporation posted a quarterly loss of $8.6 billion when gold
prices crashed from nearly $1,700 per ounce to just over
$1,200 (Wilson, 2013; Exhibit 2).
Barrick Gold's error was the opposite of AngloGold
Ashanti'sthey did not hedge their exposure to the price of
gold and consequently suffered when the price collapsed.
These gold mining firms' cases were severe, but they
were by no means exceptions. Almost daily, the financial
press publishes stories about firms reporting either windfall
profits or losses because of changes in commodity prices or
currency rates.
1.2 |Case 2: Oil and gas producers
A few years ago, we looked at the hedging practices among
nine independent North American oil & gas producers.
of theseKerr McGeedecided to hedge 70% of their 2004
crude oil production, fixing the selling price for their North
American production below $28 per barrel. The other eight
firms hedged on average only 25% of their production
(Marsh, 2004; Exhibit 3).
As oil price continued to rise through 2004, the year's
average price reached $41.41 per barrel on NYMEX. Kerr
McGee's aggressive hedge deprived the firm of $13.72 in
extra revenues per barrel, totaling $500 million in 2004. In
the stock market, Kerr McGee's shares lagged by over 33%
compared to other producers, resulting in a $3.5 billion
shortfall in market capitalization. In other words, Kerr
McGee's hedge contributed to the destruction $3.5 billion in
shareholder value (Exhibit 4).
It is true that Kerr McGee market cap shortfall might
have been the result of many other factors, but given the
high correlation between the oil price and these firms'
market cap and the sheer magnitude of oil price rise in 2004,
it is fair to say that oil price and the firms' relative exposure
to it certainly played the predominant role.
Received: 19 April 2019 Accepted: 23 April 2019
DOI: 10.1002/jcaf.22395
J Corp Acct Fin. 2019;30:8389. © 2019 Wiley Periodicals, Inc. 83

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