Commodity Management and Strategic Sourcing — Strategies When Contango Rules the Day

Here at Spend Matters, we believe the skill sets required of sourcing professionals and commodities traders are beginning to blur -- at least as it relates to the knowledge and technology that procurement organizations must adapt to survive in today's volatile age. In a post from earlier this week on Spend Matters' sister site, MetalMiner, Lisa Reisman shared a number of strategies that commodity managers might deploy in a situation where commodity markets are in moderate to deep contango, citing steel as an example. But perhaps we should first start by explaining contango, which Wikipedia defines as "the market condition wherein the price of a forward or futures contract is trading above the present spot price."

Consider a situation when the forward market for hot rolled coil (HRC) for Q1 2012 has a bid price of $780, yet a spot price of $730 or $700 (as it was in recent weeks). Lisa suggests that there are multiple scenarios where procurement organizations can use these markets to their advantage. Consider, for example, "If your steel intelligence suggests to you that steel prices today may appear in a seasonal trough or sit lower than one might expect prices to go later this year, one can buy HRC close to $700 ton today. At the same time, the buying organization (distributor or otherwise) would buy $700/ton physical coil and sell the futures contract for Q1 at $780, locking in $80/ton. Assuming the cost to carry this physical coil, financing plus warehousing costs at five dollars per month, you could lock in $50/ton virtually risk free."

Yet such a move is not without caveats. "That statement contains an assumption so the buying organization would have to evaluate if it could indeed finance and warehouse metal at five dollars per month," Lisa also mentions. Yet a more realistic scenario is that as "a physical steel player who say sits on inventory (we'd posit that either larger industrial companies and/or distributors often sit on inventory) in a falling spot market, that organization could sell forward the Q1 futures contract at $780/ton and protect the company's profit...almost like insurance. Playing this angle more from a risk mitigation standpoint, if a company's inventory exceeds its order book, it could sell forward a portion of its inventory via a futures contract to 'lock-in' a favorable margin."

Yet another option, in this case, if you have no current positions, "but believe the spot market will pick up and/or sentiment will change sometime before Q4 you can buy Q4 futures at $740/ton and sell Q1 at $780/ton and lock in a $40 dollar time spread." In other words options -- no pun intended -- abound. But you need to look at the total cost picture, commodity price forecast assumptions, accounting implications, inventory costs, warehousing and third-party charges, scheduling and all related factors before diving in. For further insight on how commodity management technology can help in situations like we outlined above, we encourage you to read our latest Compass series paper on the topic: Advanced Sourcing Technologies and Platforms to Broaden a Portfolio.

Jason Busch

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