What Are Companies Doing to Stay on Top of Commodity Risk? (Part 5)

In the first four posts in this series (Part 1, Part 2, Part 3, Part 4), we examined a range of strategies that companies are deploying to actively manage commodity risk. The last topic we dug into was a primer on the role of using commodity price indexes to help implement and drive escalation/de-escalation clauses. Yet for more advanced companies or in cases where you can't pass price volatility on to end-users, price indexes and pass-through contracting agreements alone might not be the right answer. Your organization might find that rather than pegging the raw material component of a contract to an underlying index that a better strategy might be to have your vendor assume pricing risk. For example, what premium, if it were even possible depending on the circumstance, would a supplier or distributor charge to lock in prices for a certain time period (e.g., 1 month, 3 months or 6 months)? It's worth asking the question.

Now granted, some suppliers would laugh at if you brought this up currently (in Asian supply markets especially). Yet if your vendor does come back with their premium to lock prices for a period of time, it will raise other interesting questions, such as whether the quoted figure is less than the implied volatility would suggest. Or, perhaps, rather than assuming the commodity price risk yourself or having the supplier assume it, it might make sense to have a third party take it on. Depending on the commodity, there are many options (pun intended) in this case, including forwards/futures, exchange traded funds (ETFs) and, in certain cases, physical-backed exchange traded funds that take delivery -- and/or maintain access to -- the underlying material in their portfolios.

While we've hopefully impressed upon you so far that a commodity is not simply a commodity based on where it is in the world and where it's used/consumed in production -- prices, lead-times and availability may differ dramatically based on the market. One thing that is certain is that parties who have better access to information than their partners (suppliers, counter-parties, etc.) are likely to come out on top over the long run with their commodity risk management strategies. So before you get to tactics, think about your information architecture for commodities. Where will local prices come from? How will they feed into your systems of record? How will you aggregate demand and understand exposure up and down your supply chain?

Next up in this series, we'll look at what some best practice procurement and finance organizations are doing on both a pragmatic and philosophical level to take commodity risk by the reigns.

Jason Busch

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