Hot Commodities

Why volatile commodity prices should be on the CEO's radar screen.

Japan’s nuclear crisis and political unrest in the Middle East have triggered price spikes and supply disruptions in everything from oil to wheat to gold. It might be tempting to view these recent price swings as a temporary phenomenon. They’re not. They are the new normal.

Changes in both supply and demand dynamics are likely to create a long period of sustained commodity price volatility, with significant downstream implications for many businesses. The recent Global Risks 2011 report published by the World Economic Forum with partners including Oliver Wyman revealed that 580 experts, business leaders and policy makers believe it is likely the world will experience extremely volatile energy prices, commodity prices and consumer prices in the next ten years.

There are a number of structural reasons for the sustained increase in commodity price volatility. Global demand for commodities such as food and energy will grow at a double-digit rate over the next decade due to population growth and increases in per capita usage driven by economic development. This rising demand will likely fuel investment in commodity extraction, encouraging players in these businesses to consider increasingly risky projects that will be more prone to disruption.

Supply disruptions will also be more frequent due to changing climate patterns and the increasing number and magnitude of extreme weather events that they will cause. Floods, droughts, hurricanes and many other types of extreme weather events are all projected to increase in the next decade. Shortages in some regions will likely be further exacerbated by a rising number of governments taking unilateral actions to cope with their scarcity of resources. In the last twelve months alone, Russia, Pakistan, India and Vietnam have all restricted exports of agricultural commodities ranging from grain to cotton to rice.

Further price swings might also be created by political choices related to the trade-offs inherent in addressing interconnected resource shortages. For example, the International Energy Agency predicts the globe will need 3.2 million barrels per day of biofuels to meet policy incentives related to reducing vehicle emissions. However, producing those fuels could amplify food shortages and put further pressure on water shortages as well. The range of geopolitical and environmental uncertainties surrounding commodity supply will also likely fuel financial speculation in commodities—amplifying price volatilities even further.

Commodity price volatility, and its management, have always been critical issues in some businesses. For example, they have been on the agenda of airline CEOs since jet fuel prices (and their hedging) have been a strategic issue for some time. Similarly, CEOs of energy, chemical, pharmaceutical and food companies have had to grapple with commodity price volatility over the past several years. Now, however, no matter whether a company competes in the technology sector, and therefore depends on rare earth minerals, or automotive and cell phone sectors, and relies on semiconductors, commodity price volatility impacts the profitability of firms across the board.

Nevertheless, many businesses treat commodity price volatility as a tactical management issue to work through periodically. Going forward, this issue should move up the agenda of many companies since the degree of impact of commodity price swings on the volatility of overall earnings will rise and be more than a temporal effect.

The stakes are rising. Consider: On April 7, US oil contracts exceeded $110 per barrel for the first time in two and a half years. If oil prices remain at that level, we estimate that companies and consumers will need to figure out a way to pay $1 trillion more for oil this year than they did in 2010. But that estimate just scratches the surface of the costs that companies and consumers will need to bear since there have been recent increases in the prices of many other commodities as well.

As a result, businesses ranging from manufacturers to retailers to bakers are all struggling to manage the volatility that raw material prices are introducing into their earnings. Some are discovering that the cost of their electricity supply, for example, is becoming a core driver of their earnings. Others are being forced to renegotiate contracts with their suppliers—if they don’t accept higher prices, their suppliers are at risk of going bankrupt as they are paying much higher prices for raw materials.

CEOs need to determine the degree to which taking commodity price risk fits with their risk appetite and shareholder expectations. It might be that their investors expect the company to have this risk, and fully expect to see the resulting increase in earnings volatility that stems from increasing commodity price swings. However, it might also be that the bet investors are making on the company lies in other factors, such as superior operational management or customer distribution. In these businesses, CEOs will likely want to mitigate the effect of commodity price swings on earnings.

These companies need either to invest in the risk management capabilities necessary to manage through a long-term pattern of heightened commodity price volatility or to redefine their business models (for example, through supplier contract structures) so they are not directly exposed to the risk. Separately, all companies should consider investing in methods and technologies that ensure more effective and efficient usage of resources and commodities to reduce their overall exposure to volatile prices.

We are entering a new age of commodity price volatility, likely to extend for ten years or more. The impact on the earnings volatility of many companies is likely to be substantial and sustained—resulting in a meaningful effect on shareholder returns. These companies need to consider whether they change their business model or management approach or both to align their commodity risk exposure to their risk appetite. CEOs should have this issue on their radar screen and take the lead in arriving at an answer.

Hot Commodities