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Commodity Price Volatility?

Increasingly volatile commodity prices have been affecting many MACNY members for the last few years. Oil, Steel, Resin, Corrugated, and other commodities have increased in price for a number of reasons and manufacturers face margin pressure without the ability to raise prices. ISM recently published an interesting Critical Issues research report describing how some companies are responding to commodity prices called “Managing Commodity Spend in Turbulent Times”. Perhaps volatile isn’t even a fair word; perhaps the description should just be “high” commodity prices. The volatility comes from the uncertainty of the coming months and the potential for wild swings in prices in that period.

Most commodity pricing is outside the direct control of businesses. So the question becomes how to address the risk from this volatility. The article describes several methods used by companies to manage this volatility. The ones that struck me as most generally useful were to consider using financial instruments to hedge against price fluctuations, using contractual arrangements to share volatility risk, and developing market intelligence and understanding how it impacts your costs.

Companies can purchase financial instruments that can reduce the risk of price volatility. You can use futures, calls, puts, and collars to hedge against price volatility. I had not heard of collars, a kind of hedging tool that is a combined put and call that protects the purchaser from upward volatility but also allows for some downward pricing benefit. Some commodities can be directly hedged like natural gas because there is a futures market for it. But other commodities can be indirectly hedged by buying commodities that track the pricing of the commodity that is being sought. For example, one can hedge diesel fuel pricing with options on crude oil or heating oil. Unfortunately steel doesn’t have these kind of hedging opportunities as it has fragmented grades and specifications and there isn’t a futures market for it.

I have heard many of our members describe the use of contract escalators to help mitigate against commodity price increases, so I suspect that this is increasingly common. The article also mentioned negotiating formula pricing that uses an escalator for that portion of the supplier’s product that is exposed to the underlying commodity price. Another option noted was to base pricing on a commodity index to help assure fair pricing over a long term.

Another strategy was to systematically review design specifications. The idea is to look at the total costs and consider altering the design requirements with engineering and production to reduce the exposure to volatile commodities. To me this seems even more challenging than hedging strategies.

I also found the discussion of investing in market intelligence to be helpful. Market intelligence includes everything in the area of which commodity markets impact costs and how they impact costs. It includes macroeconomic factors that influence price, like currency exchange rates and demand in international markets. The idea is to add the ability to gather strategic market information and use it to reduce the uncertainly about supply pricing. You can then use this information to make strategic decisions on long and short term buying contracts and to make spot purchases to avoid over committing at certain price levels. So you need to invest in communicating market intelligence to decision makers for use in strategic sourcing decisions and invest in teaching your buyers to develop this information for their areas of specialty.

For more information, please see the article at the Institute for Supply Management at http://www.ism.ws

July 2005

John Lawyer
Director of Purchasing and Technology Solutions
Manufacturers Association of Central New York
jlawyer@macny.org
315.474.4201 ext.17