What Are Companies Doing to Stay on Top of Commodity Risk? (Part 4)

In the initial posts in this series (Part 1, Part 2, Part 3), we tackled a range of commodity risk management strategies. We'll continue the investigation today, starting first with a few tips around developing a localized global perspective on supply markets and commodity prices. For many folks who aren't engaged in managing commodities or tracking prices, it would seem normal that a commodity is a commodity is a commodity when it comes to pricing. But in reality, the price of a commodity (e.g., steel plate, copper sheet, coil) can now vary by 10-15% and more across geographic markets on any specific day. The good news that we've learned watching MetalMiner IndX is that prices in markets like China for steel are increasing, moving in a more correlated manner on a daily basis to prices in the West than they were in the past. Still, individual price points can vary by hundreds of basis points. In practice, traditional indices such as the LME or COMEX that only track prices in a single market, are insufficient on a global basis when it comes to improving contracting and reducing supply risk.

We're increasingly seeing a want (and a need) for companies to feed local prices for commodities directly into their ERP and spend analysis systems. This in turn can provide greater visibility to underlying commodity exposure as well as a means to actively manage contracts with suppliers (even though some suppliers these days, especially in Asia as one global sourcing VP in the textiles business recently told me, won't honor commitments to hold pricing that they made in prior months). Regardless, this brings me to my next subject: using price indexes to set and drive commodity strategy. MetalMiner and Spend Matters teamed up on a report a couple of years back titled Using Sourcing Intelligence to Combat Commodity Volatility -- The Price Index Advantage which is still a relevant today as it was then. In it, we describe different contracting scenarios where indexes and contract clauses can work together.

Consider the following example from the report: a company is seeking to tie a contract to an index to create greater transparency. In this case, a procurement organization might use a price index to establish formula pricing or deploy price escalator/de-escalator clauses. For this example, the index provides a way for a company -- and its suppliers -- to lock in the value-added elements of a contract but float the underlying commodity price elements (or to separately hedge these components through a futures or options contract, if available). Price indices have numerous advantages when included in a contract from the start. They can allow the buying organization to monitor when a supplier might request a price increase or when they should ask their supply base for a price decrease.

Of course price indexes have their limitations as well. In certain situations, there are better ways of taking risk off the table by having suppliers or third parties assume risk. This will be our next subject of investigation in this series.

Jason Busch