CHAPTER 2

Assessing Price Risk Exposure and Risk Tolerance

As described in Chapter 1, commodity price volatility affects almost all organizations, either directly through their own purchases, or indirectly through their supply chains. Since commodity prices are usually outside the control of any one organization, supply chain professionals are rarely able to directly influence commodity prices. Instead, supply chain managers must understand their organizations’ exposure to price risk and decide if, and how, their organization should manage commodity price risk. Chapters 3 and 4 will explain how to analyze price movements and develop forecasts if the risk exposure warrants direct attention. Chapters 5 and 6 describe a variety of approaches for managing price risk for direct commodity purchases and value chain purchases, respectively, and when they are likely to be most effective. It is tempting to “jump right in” and begin using these approaches immediately. However, the successful implementation of many of these approaches takes time and can require a significant amount of organizational resources. For example, research is necessary for developing a deep understanding of a commodity to forecast its price movements in the short- and long-term, as explained in Chapters 3 and 4. Further, many of the risk management approaches require close cooperation and collaboration among departments within an organization and with other supply chain members. Thus, it is important to first assess your organization’s degree of exposure to commodity price risk and the risk tolerance of your management team before implementing risk management approaches.

In this chapter, we describe how to assess an organization’s exposure to price risk, its risk tolerance, and an approach for setting risk management objectives. The first step consists of estimating the firm’s overall exposure to commodity price volatility. This is determined by understanding the overall dependence of the firm on the commodity and the extent of volatility commodity prices exhibit. The importance of understanding corporate and business unit risk tolerance is examined. We explain how to set risk objectives providing direction as to which price risk management approaches may be congruent with the firm’s overall strategy, philosophical orientation, and capabilities.

Estimate Overall Risk Exposure

Almost all organizations are exposed to commodity price risk, typically from a number of different types of commodities. Supply chain managers need to assess the commodities their organization purchases, the degree of price risk exposure from each, and determine how to deploy their organization’s resources to attain the greatest financial benefit. Two key factors determine an organization’s exposure to commodity price risk: (a) the organization’s level of dependence on the commodity and (b) the extent of volatility in the commodity’s prices. As shown in Figure 2.1, if the level of dependence and price volatility are low, it is best to monitor the situation to stay current on potential new developments with the commodity’s market and not actively manage price risk. This is because the cost of actively managing price risk will outweigh its financial benefits. As dependence and price volatility increase, active management of price risk can have a positive impact on financial performance. Thus firms should apply the risk management approaches most appropriate to their situation, as discussed in Chapters 5 and 6.

Figure 2.1 Price risk exposure and risk management

Assess Dependence

Assessing an organization’s exposure to price risk requires determining how dependent an organization is on the commodity. Organizational dependence is determined by the amount of the commodity an organization purchases directly, the amount purchased by upstream suppliers, and the flexibility and ease of substituting one commodity for another.

The process begins by conducting an internal spend analysis. A spend analysis identifies how much an organization is spending on which commodities, by which organizational units, from which suppliers, and at what prices.¹ The spend analysis should include direct purchases in the bill of materials of the organization’s products and indirect purchases such as energy and transportation. Some commodities may be both a direct and an indirect purchase. For example, natural gas influences the price of plastics used in many different products and packaging materials both directly and indirectly. Figure 2.2 shows how natural gas is used both as an energy source and an upstream raw material for producing high-density polyethylene (HDPE) plastics used to make a wide range of products including bottles, pipes, and plastic sheets. Thus natural gas price increases can affect the price of HDPE in two ways.

Figure 2.2 The influence of natural gas and crude oil price movements on plastics²

For some organizations and commodities, doing a spend analysis may be a relatively easy task. For example, most trucking companies can easily measure how much they are spending on diesel fuel each year, and a cereal manufacturer should have a good understanding of how much corn they purchase each year. For other companies and commodities, doing the spend analysis can actually be quite a complex undertaking. Many firms have a multitude of products, production plants or service centers, and business units. It is possible that although each product only uses a small amount of a certain commodity, across the entire company the total commodity spend could be significant, exposing the company to price risk. The knowledge of how much is spent within each of the units may or may not be readily visible at the corporate level, especially in organizations with decentralized organizational structures. Corporate-wide enterprise resource planning (ERP) systems increase the availability of spend data and many e-procurement systems include modules for spend analysis. In addition, spend analysis can be done using spreadsheets or specialized software.

In addition to direct purchases, commodities are embedded in parts, components, products, and services an organization purchases from its suppliers. For example, an organization can both acquire copper as a raw material, as well as purchase parts made of copper from suppliers (i.e., wiring harnesses). What happens if copper prices increase? Some of copper’s price risk may already be managed (in part) by having firm, fixed contract prices with suppliers for the wiring harnesses (one of the management approaches discussed in Chapter 6). Even if the firm is not immediately affected by the increase in price of copper from the wiring harness supplier, if the price of copper becomes too steep, and the supplier itself does not proactively manage its exposure to copper price increases, the supplier experiences financial difficulties and may request price increases. Even if some of the upstream commodity spend from suppliers is temporarily protected from price increases, it becomes imperative to know how and when those circumstances may change—and whether additional measures are needed to manage risk. Thus, firms need to understand which commodities are used to a large amount within your organization and in the supply chain. This requires working closely with first-tier suppliers to understand their exposure to commodity risk and how risk is being managed. In addition, visibility upstream into the supply chain is needed to identify sources of risk from suppliers beyond the first tier.

The results of the overall spend analysis helps to determine if it even makes sense to actively pursue the risk management approaches described in this book. For example, if a firm has revenues of $2 billion with a cost of goods sold of $1 billion, but only has an overall average annual spend of $10,000 for a commodity, even a 100 percent price increase will most likely have minimal impact on profitability.

In addition to helping identify the degree of price risk exposure, understanding the overall commodity spend in the supply chain is necessary for implementing some of the risk management approaches. For example, developing favorable contractual clauses with suppliers or customers requires an understanding of overall anticipated spend and should be integrated with the overall sourcing strategy pursued by the organization.

To implement financial hedging using, for example, futures contracts requires estimating actual forecasted requirements in order to offset the appropriate amount of risk exposure of the commodity. Hedging involves the use of financial instruments such as futures contracts or options, such as those traded in the Chicago Mercantile Exchange (CME). Futures contracts are only sold in specified quantities for each contract, as discussed in Chapter 5. For example, contracts for Henry Hub natural gas futures are bought and sold in quantities of 10 million British thermal units (BTU).³ If the spend exposure for the firm is less than what is required to obtain a futures contract, then this technique for managing commodity price volatility would not be viable for the firm. Pooling together commodity requirements among the various products produced, production facilities, and business units can allow organizations to leverage their overall commodity requirements and utilize a broader range of price risk management approaches, such as financial hedging.

An organization’s dependence on a commodity is also affected by the organization’s ability to quickly and easily substitute another commodity for the same purpose. Either aluminum or copper can be used in wiring; packaging materials can be plastic or paper; and building materials can be plastic or plywood. If production processes are flexible, and customers are either open to the change or the change is not visible to customers, an organization can switch between commodities depending on price. However, relevant investments in research and development and market research may be needed to determine if substitution is technically and commercially viable. The price risk management approach of substitution is discussed in greater detail in Chapter 5.

Determine Degree of Price Volatility

As shown in Figure 2.1, the second factor affecting an organization’s risk exposure is the extent of commodity price volatility. If historically a commodity’s prices have not varied much and no major changes are expected in the future, exposure to price risk is low. In this case the situation should be monitored, but proactive management of price risk is not needed. Therefore, it is important to know if the price movements of a commodity actually have an effect on the firm now or in the future. Unforeseen natural disasters or political events such as hurricanes, earthquakes, war, or political strategies can affect commodity prices. However, the probability of such an event occurring in any given time frame is very low.

There are several techniques you can use to assess the amount of variation in commodity prices. One is to simply calculate the standard deviation of published weekly or monthly commodity prices over a year or greater period. If the overall standard deviation is relatively low in comparison with the mean (average) prices, then price volatility may not be a significant issue. Should you use weekly or monthly prices for this assessment? The time interval of weekly or monthly prices should be consistent with the frequency of commodity purchases, particularly from the spot market. If your organization usually acquires the commodity in weekly or more frequent shipments, then analyzing weekly price movements is appropriate. If the purchase schedules occur less frequently, then monthly data may be more appropriate.

Note longer time intervals typically show lower levels of price volatility because of the effect of averaging. For example, compare weekly and monthly natural gas spot prices (US$/million BTU) for 2015 at the Henry Hub delivery point. Analysis of data published by the U.S. Energy Information Administration⁴ is shown in Table 2.1. The minimum price is lower, the maximum price is higher, and the standard deviation is higher when the analysis is done using weekly prices, as compared to monthly prices. However, whether weekly or monthly data are used, an analysis of the standard deviation alone does not provide a complete picture of risk exposure.

Another technique for estimating price risk is to take the range of monthly prices (highest minus lowest observed price) in a year divided by the mean price of the commodity. This provides information with regard to the percentage change in the price of the commodity in relation to its average annual price. Table 2.2 shows an analysis of average monthly prices for natural gas (US$/1,000 cubic ft.) at the wellhead for the years 2006 through 2015. Note wellhead prices are different than the spot prices quoted at the Henry Hub and are in different units. To do the analysis, the minimum and maximum monthly prices throughout each respective year were first determined. Then the range (highest minus lowest price) was calculated for each year and divided by the overall monthly average for each year. This number was then multiplied by 100 to convert the number to a percentage.

The information in Table 2.2 shows significant price fluctuations for natural gas. The average annual price movement is 30.5 percent from 2006 until 2015, with a high of over 52.9 percent in 2006 and a low of almost 20 percent in 2012. In this example we see, as long as spend levels warrant direct intervention, it would make sense to proactively manage the commodity price volatility of natural gas due to its significant price movements.

Table 2.1 Variation in weekly and monthly natural gas spot prices for 2015⁵

Table 2.2 Estimating price risk: monthly wellhead prices (US$/1,000 cubic ft.)

Source: U.S. Energy Information Administration.⁶

Understanding Risk Tolerance and Setting Risk Objectives

After understanding the level of price risk your organization is exposed to, the next step is to assess your organization’s risk tolerance. Organizations have different levels of tolerance when it comes to the extent of risk they are willing to take in managing their supply chains and commodity spend. Risk tolerance depends on factors such as the firm’s philosophy, history, industry, stage of products in the product life cycle, customer base, experiences, and corporate leadership, to name a few. An organization’s risk tolerance can be generally viewed on a continuum from being risk averse, to risk neutral, to having a high-risk appetite, as shown in Figure 2.3.

Risk aversion refers to those firms preferring to engage in activities or decisions having a more certain outcome but lower returns, as compared with choices having less certain outcomes but higher expected value payouts. Likewise, organizations with a high-risk appetite are characterized by having a willingness to accept risk exposure and potentially adverse impacts from an event. As discussed by Cary⁷ and provided in Table 2.3, there are several questions that can provide insight to an organization’s risk tolerance and appetite.

Figure 2.3 Commodity price-risk appetite and tolerance

Table 2.3 Questions for analyzing risk appetite

The strategies you decide to pursue in addressing commodity price volatility need to be congruent with those of the business unit, the corporation, or both. For example, through market intelligence and forecasting, assume you estimate the spot price for a key commodity your organization purchases will increase by 10 percent in the next year. If your organization has a high-risk appetite, this potential price increase may not be considered significant enough to warrant actively managing price risk. However, if your organization is more risk averse you may be more inclined to manage price risk. Therefore, close coordination is necessary with a firm’s leadership team in determining which risk management approaches are appropriate for the situation.

As shown in Table 2.4, organizations should consider several factors when setting risk objectives. As commodity prices fluctuate, there may be times when commodity market prices are favorable for an organization. It could be spot market prices are lower than the prices used in budgeting or contract prices with suppliers are below market prices. In these circumstances, the immediate risk exposure may be low and no additional actions, other than continuing to monitor the market, are necessary. As the old adage goes, “Do not fix it if it is not broken.”

Table 2.4 Setting risk objectives

A second factor to take into consideration in setting risk objectives concerns understanding the market fundamentals of the commodity. As discussed in depth in Chapter 4, fundamental analysis consists of conducting a thorough analysis of what factors influence the overall supply and overall demand of a commodity—and whether or not those factors influence the price of the commodity. This requires gathering market intelligence from multiple sources, which involves taking a holistic snapshot of industry trends; understanding other industries having an influence on commodity demand, supply, and price; examining technological developments; and being aware of political and governmental interventions.

The price movement of silicon during 2006 is a classical case in this regard. For many years, semiconductor manufacturers enjoyed relatively low prices for polysilicon.⁸ Then supply-market events, in conjunction with new customers from different industries who began using polysilicon, significantly changed the market’s dynamics. First, the purchase of 51 percent of the ownership of Komatsu by Sumco⁹ shifted the power base of the supply market, so two companies (Sumco and Shin-Etsu Chemical SHE) each had over 30 percent of the overall production capacity. Second, the solar energy industry started to emerge as a large consumer of polysilicon, partly instigated by government grants to develop solar technology as an alternate energy source. This new customer base for significant quantities of polysilicon affected the overall market by increasing demand for polysilicon. Further, from the semiconductor industry perspective, the solar industry has lower quality requirements, and due to the assistance of governmental grants, was not as price sensitive. The emergence of the solar industry helped spur the combined demand (solar and semiconductor) for polysilicon in 2006 to 40,564 metric tons, which exceeded the polysilicon manufacturing capability of 38,680 metric tons.¹⁰ These industry and market effects increased polysilicon prices from $60 to $62 per kilogram, to $80 per kilogram for the semiconductor industry, and up to $200 to $250 per kilogram for solar energy applications. Therefore, understanding market fundamentals including the issues associated with consolidations, buy-outs, and the emergence of new customers in different industries can offer insight to potential price movements and provide key information for setting risk objectives.

In addition, we found, in several cases, organizations might differently interpret the abovementioned market trends, and might evaluate their risk exposure in different ways. For example, organizations in the bakery product industry have commonalities in terms of exposure to raw material price volatility. However, the different types of finished products they sell, the specific market positioning (in terms of final price and brand image), and their trade policies can lead to different perceptions of the risks. These aspects significantly influence the analysis of market fundamentals, the measure of risk exposure, and hence the adoption of mitigation approaches.

Setting risk objectives should not only be confined to the supply chain function, but should also encompass all key business functions and pertinent supply chain partners for developing an overall commodity price management strategy. Product price flexibility consists of the capacity and desire of the firm to change the prices of their products in relation to commodity price movements. If the price of the purchased raw materials increases for a commodity by $1.00, can the organization increase the product’s sales price to customers to maintain its margins and offset the overall cost increase? This product price flexibility may not necessarily apply to all products sold or to all customers; and therefore, it is imperative to understand the overall exposure and vulnerability of the organization to determine how much flexibility it has to change prices. For example, your organization may already have a firm, fixed price contract with a customer; thus, it would be very difficult to pass price increases on to that respective customer. However, the higher commodity prices can be considered when negotiating contracts with new customers.

Several of the factors in Table 2.4 interact with each other when setting risk objectives. For example, the ability of a firm to withstand potential margin erosion can be significantly affected by whether the price change is a short-term blip or a long-term trend. If the price increase is a long-term trend, the duration of the increase is an important factor. The monthly prices of crude oil for 2006 until 2016 illustrate how commodity price movements can include both short-term blips and long-term trends. As shown in Figure 2.4, from 2007 to 2008 prices increased sharply, which has been attributed to market fundamentals of surging demand and falling supply.¹¹ Further, the 2008 price spike has been attributed to the role of speculation in the trading of crude oil futures contracts by several sources;¹² although counterarguments have been made, it may have been a congruence of events outside of speculation causing this price spike. The sharp price decline beginning in October 2008 was a result of the global recession, which was followed by price increases in 2009 with the gradual economic recovery. Prices were relatively stable in 2010 until March 2011 when protests and political upheaval in Libya and other areas in North Africa raised supply concerns.¹³ Another price spike occurred in early 2012, attributed to potential supply disruptions in the Middle East.¹⁴ The dramatic drop in oil prices beginning in 2014 is attributed to over supply from increased North American and Iraq production and other countries such as Saudi Arabia continuing their production, coupled with slowing demand in Europe and China.¹⁵ Since June 2014, the oil market faced a strong downward price adjustment, which continued throughout 2015.

Short-term blips in price changes, such as those experienced with crude oil in 2008, are generally difficult to identify beforehand. Further, because they are generally short-term in duration, organizations are not likely to have the flexibility to rapidly alter their strategies in managing these price spikes before and after they occur. However, if short-term changes in commodity valuations can be quickly identified, and there is some degree of flexibility, such as with product requirements and scheduling, inventory levels, and financial liquidity, there may be an opportunity to take temporary advantage of those price movements. For example, if there is reason to believe there is an imminent price spike, an organization, if it has the financial wherewithal and physical stock capability, can purchase the commodity in larger quantities (forward buy) in order to avoid paying the higher future price. If the commodity valuation is currently experiencing a price spike, and if the organization has sufficient levels of the commodity in inventory, it can attempt to “ride out” the abnormal price and wait until prices decrease to normal levels before repurchasing. However, this strategy is very difficult to execute from a logistics, financial, and organizational strategy perspective unless the flexibility mechanisms are in place and considered to be cost-effective, given the potential organizational savings.

Figure 2.4 Monthly West Texas intermediate crude oil prices (US$/ barrel), 2002 to 2016

Source: U.S. Energy Information Administration.¹⁶

Returning back to understanding whether commodity price movements are a short-term blip or a long-term trend, it is imperative for firms to identify through market intelligence those factors temporarily affecting short-term prices as well as long-term pattern shifts and trends. Taking advantage of short-term price movements is difficult and requires a significant degree of flexibility. On the other hand, flexible organizations will often have more options to implement strategies to better manage long-term commodity price movements.

Summary

In Chapter 2, we have explored the role of gathering intelligence, both internally with regard to understanding risk tolerance and assessing overall risk exposure, as well as externally, in terms of market dynamics and relationships in the supply chain. These issues help us identify whether or not you need to take proactive measures to manage commodity price volatility, as well as to provide guidance to the most appropriate approaches and techniques to implement when direct intervention is warranted. The results of the short- and long-term price forecasts discussed in forthcoming Chapters 3 and 4, in conjunction with the insights provided in Chapter 2, provide the impetus for proactively managing commodity price risk for direct commodity purchases, as outlined in Chapter 5, and for value chain purchases (supplier commodity purchases) in Chapter 6.