A right old fix

Com­mod­i­ty price infla­tion can be a sig­nif­i­cant headache for busi­ness­es, pre­sent­ing them with two unap­peal­ing options — accept low­er prof­its or pass high­er input costs on to cus­tomers. Nei­ther is this issue lim­it­ed to man­u­fac­tur­ers; any com­pa­ny that uses elec­tric­i­ty, trans­porta­tion or even paper is exposed to some degree of com­mod­i­ty price risk.

While infla­tion is a con­cern, com­mod­i­ty prices can go down as well as up. Ross Stra­chan, com­modi­ties econ­o­mist at Cap­i­tal Eco­nom­ics, points out that, fol­low­ing a peri­od of rapid infla­tion from 2009 to 2011, the prices of many com­modi­ties have been falling for the past six months. While prices have recov­ered to an extent more recent­ly, he believes that over­all prices will drop over the course of 2012.

“We have a strong view on this and it dif­fers quite sig­nif­i­cant­ly from the mar­ket con­sen­sus,” he says. “For exam­ple, while the price of Brent crude cur­rent­ly stands at $115 per bar­rel, we expect the price to go down to around $85 per bar­rel by the end of the year.”

While falling prices sound like good news for com­pa­nies pur­chas­ing these com­modi­ties, those who have pre­vi­ous­ly fixed deals with sup­pli­ers may find they are locked in to prices above the cur­rent mar­ket val­ue.

The key is to under­stand what por­tion of the cost is made up of which com­modi­ties

On the one hand, the ratio­nale for hedg­ing is usu­al­ly to gain bud­getary cer­tain­ty, rather than ben­e­fit­ing from mar­ket move­ments. On the oth­er, as Mr Stra­chan observes, “the risk is that you will be vul­ner­a­ble to com­peti­tors under­cut­ting you if they are get­ting a cheap­er raw mate­r­i­al price”.

For com­pa­nies look­ing to man­age com­mod­i­ty price risk, the biggest issue is there­fore volatil­i­ty, rather than sim­ply infla­tion. So, how can com­pa­nies pro­tect them­selves from com­mod­i­ty price volatil­i­ty? There are numer­ous strate­gies to choose from. For starters, the pur­chas­ing com­pa­ny may have some influ­ence when it comes to set­ting the price of goods. “The key is to under­stand what por­tion of the cost is made up of which com­modi­ties,” says Robert Tevel­son, senior part­ner at The Boston Con­sult­ing Group. “Once trans­paren­cy is secured, a buy­er can nego­ti­ate with a bet­ter fact base.”

Agree­ing fixed prices with sup­pli­ers is a straight­for­ward method of gain­ing cer­tain­ty, although the sup­pli­er will charge a pre­mi­um for shoul­der­ing the com­mod­i­ty price risk. In oth­er cas­es, the pur­chas­ing com­pa­ny may wish to hedge com­mod­i­ty price risk on the finan­cial mar­kets by buy­ing for­ward con­tracts which lock in a set price at a future date.

But cer­tain­ty comes at a price. “For the past 18 months, aside from sea­son­al peaks around win­ter, the UK whole­sale pow­er mar­ket pric­ing (day-ahead pric­ing) has been on a flat or falling pro­file,” says Amar Tre­on, direc­tor of pro­cure­ment for Vir­gin Media. “In con­trast, avail­able for­ward prices have attract­ed par­tic­u­lar­ly large pre­mi­ums over the same peri­od.”

While not all com­modi­ties can be hedged with finan­cial instru­ments, oth­er arrange­ments may be pos­si­ble, such as set­ting up a proxy hedge with a cor­re­lat­ed com­mod­i­ty. For an even high­er pre­mi­um, com­pa­nies can pur­chase options, which give them the right – but not the oblig­a­tion – to pur­chase the com­mod­i­ty at the spec­i­fied price on a par­tic­u­lar date.

Hedg­ing needn’t be all or noth­ing as com­pa­nies may adopt a strat­e­gy which allows them to ben­e­fit to a lim­it­ed extent from mar­ket move­ments in their favour. Nigel Hold­en, head of ener­gy and envi­ron­ment for the Co-oper­a­tive Group, is respon­si­ble for buy­ing ener­gy for the group as well as for its exter­nal cus­tomers. He says that com­mod­i­ty price infla­tion is a major cost for the group and “needs to be man­aged flex­i­bly giv­en the nature of the mar­ket”.

Where ener­gy is con­cerned, the company’s risk man­age­ment pol­i­cy stip­u­lates that 50 per cent of the group’s pow­er is pur­chased over an 18-month peri­od pri­or to the begin­ning of the finan­cial year, while the remain­ing 50 per cent is bought short, usu­al­ly a month ahead, but some­times as lit­tle as a week or a day in advance.

The spec­trum of tech­niques avail­able to com­pa­nies look­ing to man­age this area is attract­ing more atten­tion as they adjust to high­er volatil­i­ty lev­els. “Where­as his­tor­i­cal­ly com­pa­nies have tend­ed sim­ply to lock in prices and leave them there, more are now becom­ing inter­est­ed in man­ag­ing com­mod­i­ty price risk,” says David Green­berg, senior man­ag­er at Accen­ture. In light of ongo­ing mar­ket volatil­i­ty, this trend is like­ly to con­tin­ue.

Commodity price inflation can be a significant headache for businesses, presenting them with two unappealing options - accept lower profits or pass higher input costs on to customers. Neither is this issue limited to manufacturers; any company that uses electricity, transportation or even paper is exposed to some degree of commodity price risk.