CHAPTER 5

Managing Commodity Price Risk—Direct Commodity Purchases

Overview of Risk Characteristics and Approaches

This chapter builds on the overarching concepts discussed in Chapter 1, the assessment of risk exposure and risk tolerance influencing the effort needed for managing price risk discussed in Chapter 2, and the short- and long-term forecasts developed in Chapters 3 and 4 through technical and fundamental analysis, respectively. The approaches we propose in this chapter help you to select and implement an appropriate risk management strategy when you expect commodity prices for direct purchases to increase in the short-term, long-term, or both. We define a direct commodity purchase as one in which the commodity itself is transformed as part of the bill of materials in the products sold to customers. Commodities purchased by suppliers, which are transformed into components and subassemblies, construe value chain purchases. Approaches for managing the price volatility of value chain purchases are discussed in Chapter 6.

There are different approaches supply managers can use to manage price volatility with direct purchases, as shown in Figure 5.1. These are: (1) building in financial slack, (2) forward buying, (3) staggering contracts, (4) switching suppliers, (5) financial hedging, (6) cross-hedging, (7) improving product designs and production systems, and (8) developing a substitution strategy. Thus, there is a certain degree of flexibility in selecting the best approach for each specific situation.

Some of the approaches are most appropriate for the short-term, while others are better applied in the long run. Short-term alternatives include purchasing a larger amount to cover known future needs—using forward buying, substituting approved materials in the bill of materials, and using alternative energy sources in operations. Long-term decisions, regarding commodity price risk management, can include hedging using futures contracts to offset price movements, negotiating contractual escalator clauses with suppliers and customers to share the risk burden, and modifying product designs and production processes to provide sourcing flexibility. Further, several of the long-term approaches facilitate the execution of short-term ones. For example, substituting materials in the bill of materials or energy sources is a short-term approach for managing commodity price risk. However, this approach is not possible without first developing flexible product designs and production processes, which often takes time and a significant amount of resources.

Figure 5.1 Approaches for managing commodity price volatility—direct purchases

In the remainder of this chapter, the viability and effectiveness of each technique are discussed in depth from the buying-firm’s perspective. The approaches are discussed in order from the least to the most complex to implement. Several factors affect complexity, including the skills needed and the number of different business functions and firms that should be involved in decision making. For example, some approaches can be implemented quickly by one supply chain professional while others require cross-functional participation and approval, and some need cross-organizational inputs, from suppliers, customers, third parties, nongovernmental organizations (NGOs), governments, consumers, and other key stakeholders. Resource requirements, a third factor contributing to complexity, can include the amount of personnel time consumed in analysis and decision making, monitoring, the use of third parties, various approval processes, accounting documents, capital equipment, setup times, additional inventory, transaction costs, and negotiating and relationship costs.

Building in Financial Slack

Building-in financial slack consists of creating additional financial “slack” to absorb the risks related to unexpected cost increases, including commodity price increases. This is possible by ensuring an internal retention—through the allocation of funds in the balance sheet or in the purchasing budget—of extra costs related to unexpected negative fluctuations of commodity prices. When there are exceptional variations in raw material prices or component prices, these fluctuations are absorbed by contingencies or transferred into the final price of the product. These decisions are often the provenance of the finance department, working with supply management. In the case of price increases, sales and marketing must agree to the decision. A firm implementing this approach must also have the luxury of being in an industry or niche where attaining high-margins allow firms to have more slack than companies in low-margin industries, such as many food product and packaging firms.

Forward Buying

Forward buying involves acquiring commodities well in advance of anticipated need during times when prices are considered very favorable but are forecast to increase in the future. A forward buy locks in the prices of future purchases. Companies such as Caterpillar buy materials in advance.¹ In another example, an office-furniture manufacturer reduced the prices paid for steel in the short-term from a forward buy.² This company purchased as much steel as it could buy in response to forecasted price increases during the fourth quarter of 2004. As a result, its inventories of steel increased 15 percent before it was put on allocation by suppliers. This allowed the firm to ensure steel availability for the production of office furniture as business was ramping up, while also paying a lower price for steel.

Forward buys are possible if firms acquire commodities via spot market purchases and have the capital and capability to acquire and store the material. However, there are several distinct disadvantages to this strategy. Forward buys are not compatible with lean supply chain practices. Inventory held because of forward buys ties up capital, hides potential operating problems, increases storage and handling costs, and increases the chance for damage, obsolesce, and spoilage. In addition, forward buys are based on forecasts, and if the prices decrease rather than increase, your firm may have higher costs than competitors who use a different risk management strategy. In addition, it is largely impractical for perishable commodities. For these reasons, firms need to carefully analyze the price advantage relative to cost before forward buying, given uncertain future prices.

Forward buying is almost always focused on short-term needs, and more often implemented as a method to assure supply continuity rather than in response to anticipated price increases. Firms engaging in forward buying often use it selectively, and for very specific commodities. For example, a food manufacturer we have worked with uses forward buying only when financial hedging or contract agreements cannot be used.

To determine if a forward buy is a viable option, ask if your organization has the capability or desire to hold additional inventory for a period of time. This often depends on how the commodity is consumed in the organization, whether it is part of the bill of materials, or if it is used in support of other activities or processes. For example, Hershey Foods investigated the feasibility of buying, storing, and subsequently distributing diesel fuel through a volume-leveraged purchase agreement as one strategy for managing fuel surcharges passed on by its carriers.³ Although Hershey Foods had some ability to store fuel, it did not have the capacity to meet the full requirements of its carriers. This strategy raised other issues outside the scope of the company’s capabilities, such as managing fuel distribution and getting the fuel to the appropriate carriers and trucks, all while conducting these operations effectively and efficiently.

If your firm has the capability, both in terms of finances as well as in physical resources to purchase larger stock quantities in advance of actual need, a cost–benefit analysis is absolutely essential. If the results of cost– benefit analysis are not favorable, other risk management approaches may be more appropriate.

Staggering Contracts

Staggering contracts by using contracts for different quantities and time periods is another way to manage commodity price volatility. To reduce risk, one of the firms we studied uses fixed-price contracts staggered throughout the year, with more contracts locked in as the time for the actual material purchase approaches. Generally, about one quarter prior to the start of production, 100 percent of its contracts are locked in at fixed prices.

Among different contractual agreements, companies often use escalator clauses, which will be described in Chapter 6. By using these clauses, companies can adjust commodity prices with their suppliers or customers. The extent of the adjustment is defined during the contract negotiation, as long as the time periods and quantities.

Switching Suppliers

Switching suppliers is also sometimes done to reduce commodity prices. This technique is simply moving purchases among approved suppliers for the commodity. The companies engaging in supplier switching tend to have long-term agreements in place with suppliers but flexibility within the contract to shift volumes among these suppliers. Although this approach may be viewed as transactional, we have noticed in our research some of the companies implementing this approach emphasize the importance of maintaining long-term relationships with a limited number of prequalified suppliers that can meet their quality, delivery, and other requirements. Therefore, even though there is switching among suppliers, due to temporary price changes, buying firms using this approach have some flexibility by being able to “shop” for the lower price, given all else is equal.

Financial Hedging

Financial hedging consists of acquiring futures, options or other derivatives to offset anticipated future commodity price increases. Firms engaging in this practice utilize financial instruments solely as a risk management approach, and not as a speculative tool. Firms utilizing this approach frequently create highly structured decision-making processes, often requiring executive approval for use. This approach is mainly used for high-volume purchases, and hence, as described in Chapter 2, is only merited when there is significant spend, high risk exposure, and high price volatility. However, in our research, we have also found although these three conditions hold, some firms prefer not to participate in financial hedging because of the nature of their purchases or due to the lack of knowledge and experience with this strategy.

One of the primary drivers for financial hedging appears to be associated with established industry practices. For example, we have discovered many firms in the food production industry using financial hedging to a significant extent to offset price increases for agricultural products such as coffee, wheat, and corn. These commodities have a rich history of trading in financial markets and are clearly defined with regard to their specifications, and generally have high futures market liquidity.

A futures contract is a financial tool, which is an agreement between two parties to buy or sell a commodity at a particular time in the future for a particular price. Contracts are standardized with respect to quality, quantity, delivery time, and delivery location. The only variable is price, which is determined by trading in organized commodity exchanges. One of the most popular exchanges in the United States is the Chicago Mercantile Exchange (CME; www.cmegroup.com), which trades contracts for a variety of agriculture, energy, and metal commodities. The intention of a futures contract is to be a financial instrument, not a primary source of the physical commodity, and very few of the futures contracts created actually result in delivery.

There are two types of participants in the futures markets: speculators and hedgers. Speculators do not produce or use the actual commodity but instead are trying to profit by correctly forecasting a commodity’s price movements and then buying or selling futures contracts at the right time. Depending on their beliefs about the direction of price movements, speculators will either buy or sell futures contracts now and do the opposite transaction later, before the contract’s delivery date, in hopes of making a profit. Assume, as a speculator in July 2016, prices for March 2017 corn futures are $4.35/bushel, but you expect prices to increase to a higher level before March. You buy corn futures now with the intention of selling them at a higher price before the delivery date of March 2017. If in January 2017, futures prices increase to $4.45/bushel, you sell the futures for a difference of $0.10/bushel. By selling the contract before its due date, your obligation to take delivery of the physical commodity is canceled.

Hedgers, who are producers or users of a commodity, participate in the futures market to reduce exposure to price risk. Hedging is possible because for commodities, prices in the futures market and the spot market tend to move parallel to each other. Normally though, futures prices are higher than the price in the spot market until it gets close to the delivery month. So how does hedging work? Take for example, farmers who face the risk of a price decrease from the time they plant their crops until the crops are harvested and sold. To reduce this risk, farmers hedge by selling futures contracts now and buying the contracts back at a lower price near harvest time. The gain in the futures market offsets the loss from the price decrease in the physical market. Users of a commodity face the risk of a price increase from the time they contract with their customers until the commodity is actually purchased. To hedge, users of a commodity buy futures contracts now and then sell them later, before the due date, when the price has increased. Again, the gain in the futures market offsets the loss from the increased price when the physical commodity is purchased.

To clarify the hedging process, let’s review a simple example summarized in Table 5.1. A snack food company purchases large amounts of corn to produce tortilla chips. In October, the company enters into a contract with a large grocery chain to delivery tortilla chips for a Cinco de Mayo promotion the following May. The snack food company’s supply chain manager needs to purchase 52,000 bushels of corn in March to meet the May delivery date. Forecasts suggest the price of corn will rise from its current spot price of $4.25/bushel in October, which was used as the basis of pricing the tortilla chips to the grocery chain. The snack food company does not have the space to forward buy and store corn in inventory. Instead, in October, the company buys 10 corn futures contracts (5,000 bushel per contract) for a May 2017 delivery at a price of $4.35/bushel. As expected, the price of corn increases in both the futures and spot markets. In March, the price for May 2017 corn futures is $4.55/bushel. The company sells the futures contracts and buys corn in the spot market at the prevailing price of $4.50/bushel. The gain in the futures transaction is $0.20/bushel ($4.55/bushel—$4.35/bushel). The loss in the spot market is $0.25/bushel, which is the price paid ($4.50/bushel) minus the price in October ($4.25/bushel) that was the basis of the pricing to the customer. The hedging-transaction gain reduced the overall loss from $0.25/bushel to $0.05/bushel. The actual loss to the organization will be slightly more than $0.05/bushel because the gain from hedging must be reduced by its transaction costs. These costs include broker’s fees and the cost of capital for the money needed to purchase the futures contracts.

Table 5.1 Hedging example

After reviewing this example, the natural question is, why didn’t the snack food company buy corn futures for March 2017 and take delivery of the corn? There are several reasons this may not be practical. The most important one is the company has no control over the type or quality of corn received. The CME contract specifications for corn futures state the corn delivered could be one of three different grades of corn.⁴ For many products, the grade and even variation within a grade are important factors influencing an end product’s quality. The snack food company most likely has developed partnerships with key corn growers to ensure the corn they receive consistently meets its product specifications. Thus, rather than taking delivery from a random source, the snack food company would rather buy from its partner growers.

The delivery time frame, amount, and location are also problematic for futures contracts. The delivery date for corn futures traded on the CME is the second business day following the last trading day of the month, and there are five trading months: September, December, March, May, and July.⁵ Many futures contracts are not traded every month. So the date when the commodity is available for delivery may not be when it is needed. The amount of commodity delivered is fixed by the contract specifications. For example, corn futures contracts are traded and require delivery in increments of 5,000 bushels. In our example, the snack food company needed 52,000 bushels, so it would be 2,000 bushels short if it took delivery on the futures contracts. Another problem is the delivery locations are specified by the commodity exchange. The buyer must arrange and pay for transporting the commodity from the delivery location to their facility. The cost of transportation can be much higher than if the commodity was sourced locally. Thus, for most commodities, the futures markets are used simply as financial instruments, and the actual physical commodity is purchased in the spot market.

One benefit of hedging compared to forward buying is cash flow. For example, to forward buy a commodity, a company must pay for the entire amount of the commodity when it is purchased. To buy or sell futures contracts, only a percent of the actual purchase price is tied up. Opening an account with a commodities broker requires a deposit of a percent of the overall cost of the futures contract. This deposit is called an initial margin or performance bond. The initial margin is established by the commodity exchange following government regulations. Commodities with higher levels of price risk typically have higher margins. A futures contract for soybeans traded on the CME is for 5,000 bushels, and the price for May 2017 delivery is $10.89/bushel (on June 15, 2016). The actual total cost of this contract is $54,430, but to open the account to buy or sell futures, you only need to put up the initial margin of $4,477 per contract ($2,300 maintenance plus 0.04 maintenance volume times contract cost) as required by the CME.⁶ As you own the contract, the daily settlement prices change, and the account will be debited or credited based on the price movements. However, if the amount in the account drops below the maintenance margin level, which for soybeans is $2,300, then money must be deposited to bring the account back up to the initial margin level.⁷

In this subsection, we have described financial hedging using futures contracts. Futures options can also be used for hedging. An option is the right to buy or sell a specific amount of futures at a specific price and during a specific time frame. As hedging with futures or options is a complex process, it is important to work with the finance department in designing and implementing a hedging strategy in order to attain the greatest outcomes for managing price volatility. Additional information associated with hedging strategies is discussed in Chapter 9—Further Insights on Financial Hedging Instruments.

Cross-Hedging

Cross-hedging is used to offset price risk with a commodity having similar price movements in situations in which no commodity exchange exists or the market liquidity for a commodity’s financial derivatives is low. However, the use of cross-hedging has specific legal requirements that must be met in order to implement it as a risk management tool, thereby limiting the extent to which it is deployed. In our research we have observed only a few organizations experienced in cross-hedging.

One of the limitations with hedging using futures contracts is some commodities are not traded in futures markets. Thus, it is not possible to directly hedge these commodities. In these situations, you need to identify a commodity traded in futures whose price movements are strongly related to the movements of the actual physical commodity the company purchases. For example, prior to 2007, diesel fuel was not traded on the futures market.⁸ When the price of diesel began to increase in 2001, Hershey’s looked for a substitute commodity it could use for hedging. Managers found the price movements of diesel fuel were highly correlated with those of heating oil, which was traded on the New York Mercantile Exchange (NYMEX), and thus heat oil was a good candidate for cross-hedging.⁹

The first step with cross-hedging is to identify commodities whose price movements may be similar to the commodity of interest. Use correlation and regression (described in Chapter 4) to understand the strength of the relationship between historical prices of the two commodities, ideally over at least a 10-year period. If a high correlation is found, then do a fundamental analysis of both commodities (also described in Chapter 4) to estimate the probability the historical relationship is likely to continue in the future. If so, use the commodity for cross-hedging.

Another consideration is how many futures contracts to buy for hedging. Even if you find the prices of two commodities are highly correlated, it is highly unlikely the two commodities will be exactly the same price. Hershey’s found diesel fuel was about twice as expensive as heating oil.¹⁰ Thus, the company purchased heating oil futures in the value covering the total spend in diesel fuel.

Improving Product/Production Designs and Systems

In the long-term, organizations can reduce their exposure to price risk by reducing or eliminating their need for the commodity by improving product designs and production and supply chain systems. For example, many organizations have installed new lighting fixtures that use energy-efficient light bulbs and sensors that turn off lights when they are not in use to reduce electricity consumption. Redesign of products, processes, and packaging can significantly reduce the demand for a commodity, lowering spend and reducing exposure to price risk. In 2007, Arrowhead redesigned its water bottle, so they use 30 percent less plastic yet are functional and have a high level of consumer acceptance.¹¹ Reducing demand for commodities also is consistent with environmental sustainability initiatives.

Continuous improvement is used by some companies to reduce the quantity of the commodity used in the product or the amount of scrap generated in the production process. Commodity price increases for direct purchases, as well as the content in supplier components, can motivate companies to reduce their consumption. For example, several companies we have studied redesigned products to use a lower grade of steel or reduce the thickness of a part to reduce the amount of aluminum used. Continuous improvement appears to be a less frequently utilized tool for commodity price risk management. However, this may also be a by-product of companies’ pursuits of lean initiatives.

Product and process innovation requires collaboration, both internally with various functions, and externally, with supply chain partners. The redesign of products and processes to reduce commodity demand may require a large investment in research and development, marketing research, and capital equipment. However, if successful, reducing demand for the commodity will subsequently reduce the organization’s exposure to price risk.

Developing a Substitution Strategy

Substituting commodities concerns the ability of the purchasing firm and suppliers to use different materials in the product based on the price movements of the commodity itself. The strategy for commodity substitution is appropriate for both direct commodity and value chain purchases, with its application for direct commodity purchases discussed here. Ideally, the different commodities should be preapproved so they can be easily switched. For example, some coffee producers routinely switch between Arabica and Robusta coffee beans based on price. However, easily switching from one commodity to another is often not technically feasible or economically viable. When sourcing tires for its products, one of the firms we have studied allows its tire suppliers to change the percentage mix of styrene butadiene rubber and natural rubber quantities within strict bounds, based in part on the prices of these commodities. The actual tire formulation is left to the suppliers’ discretion as long as they stay within the agreed-upon specifications. Examples in the food production industry include flexibility in the ratios of butter and milk powder used, and switching between sugar and other types of sweeteners.

In most cases, we found switching from one commodity to another requires engineering design and extensive testing to confirm the product with the new material meets performance requirements. It is absolutely essential that prior approval is obtained from customers, including the final consumer, in these types of decisions—and no detrimental technical effects result from the substitution. In addition, new equipment and tooling are often needed. For example, a firm we worked with encourages its customers to switch their products to a resin having a more stable price. However, this switch is not a painless one; for one thing, there are some technical advantages to the current resin relative to the alternative resins. If the resin is switched on an existing product, new molds are needed. Further, prior to switching, customers have to conduct tests to confirm the products perform to their specifications. Because of these challenges, customers are reluctant to move forward.

Thus, switching commodities is a longer term approach that is evaluated and considered during product development. For example, the substitution of materials (e.g., aluminum, light-weight materials, rare earth elements) takes place based on long-term forecasts for some firms in the automotive industry where their supply management teams can still influence the final product/bill of material. Such substitution is a key commodity price risk management activity during the development phase of a car line. Another firm we have studied redesigns its parts to replace metal with plastic, but with the primary purpose is to meet customer-mandated weight reduction goals. However, switching to different materials can also reduce price volatility.

In some cases, substitute materials have not been approved by the organization. In this situation, you must provide strong supporting evidence of the viability of substitution, by comparing the historical price patterns of potential substitutes to those of the approved commodity. For substitution to be effective, the historical prices of the approved and substitute commodities must intersect and preferably be strongly negatively correlated, so when one commodity’s price is lower, the other is higher. However, a negative correlation is not necessary, since prices of two commodities can still intersect.

The ability and expertise to substitute materials in product or production process design almost always requires the internal input, buy-in, support, cooperation, and integration from multiple business functions, as well as supply chain partners. Typically, product design, marketing, operations, purchasing, and logistics are involved in developing and implementing a successful substitution strategy for managing commodity price risk.

Design engineers—both internally, within the firm, and externally, if designs are solicited and purchased from other firms—serve a critical role for developing the capability to change material inputs in a product’s design. Marketing and sales are also key business functions to include in determining the viability of employing a substitution strategy for managing commodity price risk. The marketing function should understand and incorporate the “voice of the customer” in determining the appropriateness of various materials in the bill of materials.

For manufacturing, questions include these: How does the substitute material affect production through input and capacity utilization? Does the current production equipment allow for the use of substitute materials? What are the effects on production process quality and yield? Is there an increase or decrease in labor time or other costs, such as processing costs?

The supply management function often has the primary oversight for understanding suppliers and the industries those suppliers compete, and it should definitely have a “seat at the table” when considering substitute materials. For example, design engineers may be able to identify a substitute material that can be incorporated as an option in the bill of materials for a product. However, they may or may not have the requisite knowledge of the market dynamics of potential material substitutes. Are there potential threats of supply disruptions? Are the materials available only from a limited number of suppliers or regions of the world? How do the prices move in relation to other candidate materials? Are these materials already purchased for different applications, and if so, what are the potential effects of volume increases (or decreases) on the overall total costs of purchases from suppliers?

In conjunction with supply management, logistics should also be solicited for input on substitution decisions. Are there any import restrictions or tariffs with regard to the candidate substitute material? Do current or potential carriers have the capability of switching routes in a costeffective manner? Should alternative transportation modes be considered, and how does this influence the flow of material and inventory levels?

An analysis of external forces and supply chain dynamics and relationships is just as important as the internal influences of other business functions in determining the appropriateness and viability of executing a substitution strategy. These include considering the effects of suppliers at multiple tiers in the upstream (supplier-facing) supply chain, customer acceptance, competitor reactions, governmental policies, and even the effect on the natural environment.

Summary

This chapter provides a discussion of approaches and techniques you can implement for managing price risk associated with direct commodity purchases. There is “no one size fits all” approach for managing price fluctuations of direct commodity purchases. Firm size, supply management expertise, customer requirements, and a myriad of other factors influence the ability and availability of approaches for mitigating this risk. The approaches described in this chapter are provided in order of complexity or difficulty in implementation. The more complex processes are generally, the more expensive they are to conduct. Hence, why, it is imperative to determine, as outlined in Chapter 2, whether it is cost-effective for managing commodity price volatility, and which approaches provide the best value for firms to implement, given an uncertain future price.

Firms are exposed to commodity price volatility and its risk not just from their direct commodity purchases, but are also frequently vulnerable to risk associated with supplier exposure to price fluctuations in their direct purchases of commodities (second-tier supply sources from the firm’s perspective). Approaches and tools for managing this form of price risk are discussed in the next chapter.