Commodity Risk in Portfolio Companies: A Portfolio Company Is an Entity in Which a Venture Capital Firm, Buyout Firm, Holding Company, or Other Investment Fund Invests. Managements of Portfolio Companies Need to Steer a Course That Maximizes Both Liquidity and Profitability in an Environment of Upward-Trending Commodity Prices
Johnson, David, The RMA Journal
ECONOMIC RECOVERY, SUCH as it is, has arrived, but it is a tepid, uninspiring one for many. GDP growth is low but positive. Corporate profits are up mainly on the strength of cost-cutting prowess and foreign sales. Companies are beginning to invest, but cautiously. The good news is only moderately good.
Overshadowing positive macroeconomic factors is a massive change in the price trends of major commodities. Rising standards of living in the developing world are pulling billions of formerly impoverished individuals into a burgeoning global middle class. However, this extraordinary feel-good story for humanity is translating into a nightmare scenario for capital providers, CFOs, and purchasing managers as commodity prices soar. It's an issue that is increasingly on the minds of thoughtful lenders everywhere, and rightly so.
While many commentators have blamed commodity price increases on frenzied speculation, the underlying global supply/demand imbalances offer economic rationale to the upward price trend. In fact, if we divide price data from the IMF's All Commodities Index from 1992 to 2010 into two periods of 114 months each, a noteworthy trend emerges (see figure). At the end of the first period, starting in January 1992 and ending in June 2001, prices had increased 18.3%. However, by the end of the second period, July 2001 through December 2010, prices had soared 194.4%.
Price trends of this magnitude and duration, affecting a broad commodity index of global scale (Table 1), are highly unlikely to be attributable to speculators. Instead, they are more likely to signal fundamental market shifts. Ironically, high growth and the attendant consumption demands of emerging economies are driving cost increases that could become increasingly dangerous to slow-growing developed economies.
The Case for a Longer-term Shift in Commodity Price Trends
In the face of new demand, additional sources of supply can and will be brought online, but with a time lag. The global economy seems to be caught in the midst of just such a lag, with demand for many commodities significantly outstripping supply while new sources are in development.
Indeed, increased supply may prove insufficient to pull down prices to levels of the past. Anecdotal evidence from around the globe is pointing savvy market watchers to the conclusion that many of the low-cost sources of commodities have already been accessed, and we may have entered an age in which adding supply will be more technically demanding, politically treacherous, and time intensive. That additional supply may also prove more costly to access.
Interestingly, recent steps by major multinationals indicate that they do not view these price trends as temporary. ArcelorMittal, the world's largest steel company, has in recent months been involved in a contentious battle for mining company Baffinland in order to secure a supply of iron ore, a key input in steelmaking. Notably, ArcelorMittal has announced its intention to invest $4 billion to increase Baffinland's annual iron ore production to 100 million metric tons, nearly twice the current level of 60 million. Meanwhile, another multinational, Starbucks, reported that its expansion plans in China would include farmland, presumably as a hedge against volatile coffee prices.
These are only two examples, but they involve large companies with best-in-class financial planning capability It stands to reason that if these multinationals see a return to vertical integration as a positive net-present-value endeavor, there is a strong case to be made for it.
Impact on Portfolio Companies: Operational
An economic environment of high and rising input costs should be of particular concern to middle-market lenders. Companies operating in the middle market often lack the pricing power to pass along cost increases. …