Commodity price swings are the second-largest driver of earnings uncertainty at publicly-traded companies, following macroeconomic factors. Nearly one quarter (23 percent) of senior financial professionals consider commodities to be the primary driver of their earnings variability, according to a survey conducted by the Association for Financial Professionals (AFP) with Oliver Wyman’s Global Risk Center. Take consumer product companies. Their margins are squeezed as the prices of commodities ranging from aluminum to milk rise faster than their revenues. Raw materials are their biggest expense, accounting for about half of their costs. Yet most consumer product players try to stabilize their profits – unsuccessfully – by cutting production costs, reformulating products, and investing in their brand.
There is a better approach. Savvy managers are reducing their earnings’ volatility caused by commodities by about 10 percent by shifting their procurement mind-set from securing supplies toward price risk management. They are developing a significant advantage over their competitors by taking three steps:
Step 1: Create transparency. Consumer product companies have recently experienced some rude surprises – announcing quarterly losses due to price spikes in the raw materials used in their products. Procurement teams need to develop a comprehensive understanding for the underlying cost and price drivers of the full breadth of commodities sourced globally. This includes their indirect exposure to commodities such as the grain eaten by the chickens that provide the eggs for their goods. Procurement teams should also look at historical volatilities in combination with a forward-looking risk exposure model.
Step 2: Optimize risk-return. Procurement teams need to think more like traders. By this, we mean they should consider trade-offs involved in buying decisions and evaluate if risks tied to more uncertain commodity prices are worth the received discount. In increasingly volatile markets, it might make sense for a company to pay more for a commodity if there is price certainty. It’s also important for companies to be able to pounce when commodity prices suddenly surge or plunge not just in one business – but across an entire business portfolio.
Step 3: Share risk. Companies can improve their capability to share the rising risks they face from unpredictable commodity prices by developing contracts that assign these risks more equitably between buyer and supplier. One way to encourage this is to follow the example of New Zealand-based food service company Fonterra: It has started to auction a significant portion of its dairy production for future delivery. The price transparency resulting from these auctions has created more price certainty not only for Fonterra’s contracts, but also for the dairy industry as a whole.
It’s tempting to think volatile commodity prices are temporary. They’re not. They are the new normal. Procurement managers must clear their heads and adapt to this new environment. They must become expert commodity price risk managers.
Roland Rechtsteiner is a Zurich-based partner at Oliver Wyman and head of the Global Risk & Trading practice. Ernst Frankl is a Frankfurt-based associate partner in Oliver Wyman’s Global Risk & Trading practice.