Commodity Price Risk Management: For the Many, Not the Few

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Spend Matters welcomes this guest post from Tom Lawrence, director at Flow&Ebb. 

Commodity markets affect us all. Wild swings in commodity prices affect how much we pay for groceries, how much we pay for aluminum cans for our organic soda, how much we pay for electricity. Yet traditionally only large businesses had the budgets to pay for, and enough clout to embed, commodity price risk management into their supply management strategy.

The next tier of businesses lacked the budgets, skillsets, information and tools to manage this risk. A multinational coffee distributor could afford to pay for commodity traders to monitor the robusta futures market every day. A chain of regional coffee shops could not. Many businesses therefore allowed their suppliers to manage commodity price risk on their behalf, making do with fixed-price contracts where the odds of picking the right day are 1 in 365.

In some industries, chains of fixed-price contracts from raw material to finished good were developed. These allowed for stability but minimal visibility of, or control over, market prices. In other industries, supply contracts passed through commodity market price chains from field to plate. Some businesses used a mix of the two, depending who was more dominant, the buyer or supplier, at each stage of the supply chain.

For finished goods made from several commodities, a hodgepodge of commodity risk management techniques existed, stymieing the finished goods manufacturers’ ability to manage commodity risk. Take for example a widget maker using several commodities. The diagram below shows just how complex risk management can be through the supply chain:

What’s Changing?

For the widget maker to have full control of its commodity risk it needs to reach up the supply chain and implement new arrangements — something that manufacturers, retailers and other businesses are realizing that they need to do to stay competitive.

And thanks to two mega trends, trends that have fundamentally changed the relationship between business and commodity markets, managing commodity price risk is now possible and affordable to every business with a significant commodity exposure:

  1. The information age has lifted the veil on commodity markets. Twenty years ago a buyer would have to trawl expensive industry reports, speak to a limited network of other market participants, see delayed market prices and rely on suppliers for information. It would take days and be heavily influenced by suppliers. Today, that buyer can simply log in to a work station and access tick-by-tick market price movements, granular weather reports, dozens of price forecasts from respected experts, supply and demand data as its reported and advanced technical charting tools. Thanks to the web, a buyer has continuous and immediate view on markets.
  2. Booming emerging markets are straining the world’s supplies of commodities. Hungry factories in China and India have led to miners, farmers and smelters scrambling to meet supply. Sometimes they meet demand, sometimes they don’t, and sometimes they overproduce. This has led to a blossoming of price volatility, pushing companies that would have been happy with fixed-price contracts to look for ways to control their costs.

The surge in commodity prices running up to 2008, the subsequent collapse of prices, and the rapid ramp up of prices immediately afterwards, left many companies reeling, especially since technology allowed them to see exactly how these price movements were affecting them. Many companies hedged at the highs in 2008 out of fear, others failed to hedge at the lows in 2009. Companies realized that taking their eye off these markets and being unable to manage commodity price risk was having a severe impact on their bottom lines.

Looking to the Future

With easy access to commodity market information, increased market volatility and pressure from management to actively manage commodity market risk, companies can no longer ignore commodity markets. Increasingly, companies are building advanced strategies to stabilize volatility and implement the necessary processes, systems and governance to manage price risk.

The likelihood of a move back to a world where long-term pricing contracts and commodity market opacity is the norm is next to none. Commodity price risk management is something every company in any competitive industry that has commodities influencing their cost base should consider to not just remain competitive, but to survive.

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