Magazine article Risk Management

The Volatility of Raw Materials Market

Magazine article Risk Management

The Volatility of Raw Materials Market

Article excerpt

[ILLUSTRATION OMITTED]

Over the past few years, highly unstable prices in commodities markets have put financial pressure on many producers. Between 2003 and 2008, prices for many of the raw materials used for making industrial products (such as crude oil, steel and aluminum) and consumer packaged goods (such as paper, wheat and milk) rose at double-digit rates only to fall dramatically in the following year. Some sectors have recovered while others remain depressed, but the consensus is that more volatility and uncertainty can be expected going forward.

Many manufacturers lack the flexibility to quickly respond to market volatility. Traditional approaches often leave decisions in the hands of a single function at each step in the value chain: product development and R&D determine the required feedstocks and materials specifications to use for the given product; procurement determines supply availability, negotiates with suppliers and bears the most responsibility for acquiring materials; manufacturing determines the production process and requirements; finance provides hedging strategies; and the marketing and sales provide demand signals and sets the price for the finished product.

The failure to integrate these functions can lead to costly misalignment of efforts. A lack of coordination between supplier and customer sales contracts is a common example. If purchasing renegotiates a higher price for a particular raw material to ensure availability when prices are rising, but sales has already locked the company into non-negotiable customer contracts for the same time period, the higher prices cannot be passed on to customers. In effect, the company assumes the full cost of mitigating the supply risk, rather than being able to share some of that cost--and risk with the customer.

In one case, an aluminum products manufacturer set price ceilings for customers without capping supplier contracts, and as a result, was unable to pass along raw materials price increases. When these prices rose to unprecedented levels, the company's financials collapsed, market capitalization dropped by approximately 35%, and the company lost $1.1 billion over four years.

Moreover, companies without departmental cooperation struggle to develop production methods that can respond to cost fluctuations. Deploying a new technology in the production process, for example, can allow a manufacturer to substitute alternative feedstocks as prices seesaw, freeing it from relying on a single feedstock or sole supplier. But at many companies, sales, purchasing, product development and manufacturing do not work together enough to exploit these opportunities.

Another pitfall is over-relying on hedging as the primary way to manage raw materials price volatility. Typically the exclusive domain of finance, hedging is often carried out with limited visibility into the terms of sales contracts being negotiated by marketing, sales or procurement. Companies that make the wrong bets can pay a heavy price, becoming locked into contracts while prices fall. When natural gas prices fell from a short-term high, for instance, one specialty chemicals company hedged using six-month forward contracts. As gas prices continued to drop, the company's cost disadvantage doubled.

As with any good risk management strategy, companies looking to mitigate raw materials price volatility must look up and down the value chain. Consider all the risks--from supply-chain concerns of transporting cheap raw materials from distant locations and storing large inventories to the capital-expenditure perils of refitting plants and altering production processes for different feedstocks.

After these risks are assessed, companies can then choose from among four categories of risk transfer and mitigation techniques:

1. Upstream Risk Transfer to Suppliers

Companies can employ sourcing and contracting techniques to limit suppliers' ability to pass on additional costs. …

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