What can you do in your business about commodity price volatility? I’ve written recently:

Commodity Prices: Basics for Businesses That Buy, Sell or Use Basic Materials

Commodities Prices: Why Do They Shoot Up And Then Collapse?

Commodity Price  Volatility: What Should Producers Do About It?

This article addresses the concerns of businesses that purchase commodities. The price they pay can change sharply, putting the company’s economic viability at risk. Can commodity users hedge away the problem? And if they can, should they?

As with the earlier articles, investors also may find the underlying analysis useful.

A number of companies are not in the commodity business per se, but commodities are important to them: car companies use a lot of steel, battery companies use a lot of lead, airlines use a lot of jet fuel. The price of the commodity will vary much more than the price of the finished product.

Timing purchases cannot solve the problem. It would be nice to always buy when the price is low, and to buy enough that the company can coast through times when the price is high. However, no one can predict commodity markets well enough to do this. If you can, forget about making a physical product and just become a speculator.

One alternative is to always hedge. For example, at the first of the month the company might commit to buy some of its upcoming need, using futures, forward trades or options. That will smooth out the company’s actual prices, though it cannot eliminate price risk.

Before engaging in a hedging program, though, it is vital that corporate management understand the challenge. Delta Airlines, for example, hired a seasoned commodities expert to run their fuel cost hedging program. They thought he was great when oil prices rose; his hedges limited the company’s exposure to the price increase. Then they thought he was inept, when prices fell and the hedges cost the company money. That’s the essential nature of hedging, though. You gain from the hedge when price moves against you, but you pay when the price moves in your favor. Unfortunately, some executives don’t think that the “pay” part of the hedge should ever occur. If that’s the level of understanding of your management team, do not hedge your cost exposure.

What are your competitors doing? Let’s take the airline industry as an example. If you see your competitors raising and dropping prices as fuel goes up and down, then it probably makes sense to not hedge and let your price move with everyone else’s price. However, if they are hedging to smooth our price fluctuations, you probably should do the same.

A modified hedging program could reflect the commitments you have already made to customers, but not the sales you expect in the future. Let’s say that an airline sells this month half the seats that it will fly next month. This would be a good time to hedge half of the fuel needs. If the price goes up tomorrow, you can raise ticket prices tomorrow. Because you cannot raise prices on the tickets you’ve already sold, those customers’ fuel needs should be hedged.

Finally, long-term relationships should be worked out with your major customers. Ask the buyer of your products, would you like to see prices that rise and fall with commodity prices, or would you prefer that we stabilize them? You will, of course, pass the cost of the hedging program onto your clients. They may prefer the stability, or they may decide that it’s not worth the money to them. Either way, you are meeting your customers’ needs.