Commodity price risk management has long been a major concern for firms buying or selling commodities.
So far, these firms have relied on the gut feeling of industry experts to make such decisions. That brings in a lot of uncertainty for the business because commodity price variations are the second most significant driver of earnings uncertainty at publicly traded companies1.
As per Oliver Wyman, the commodity spend represents up to a whopping 70% of the revenue for major industries.
Automotive (40 - 50%)
Aviation (30 - 40%)
Utilities (60 to 70%)
Food companies (20%)
FMCG - Non-food (20 to 30%)
McKinsey estimates an annualized volatility of up to 20%, with annual price swings of up to 70% of that year’s average price indicating an extreme uncertainty of earnings in the above industries.
Over the last two decades, several commodities have witnessed rising volatility that has impacted across many basic materials, from fuels to foodstuffs. The underlying drivers of commodity-price instability are a complex cocktail of demand fluctuations, supply disruptions, and financial moves by market players.
McKinsey estimates, these embedded costs account for up to 30% of external spending in highly integrated supply chains, such as automotive2. And for firms involved in manufacturing, the volatility creates a headache.
Covid-19 disrupted global supplier operations and supply chains significantly. Additionally, different industries face a varying impact on their demand and pricing. The pandemic has further fuelled the volatility of prices and left businesses exposed to risk. Specifically, one of the commodities in focus during the pandemic has been steel, whose price has risen more than 200% between March 2020 and May 2021. Copper, another critical commodity for high-tech products, doubled over the same period.
Firms should be aware of the following four significant risks that are associated with high commodity price vocality:
1.Mishandled Hedging: Traditional yearly hedge programs are too risky. Recent reports have surfaced that detail instances in which companies have incurred significant losses from mishandled hedging. McKinsey states that these losses sometimes amount between 5 to 25 % before EBITDA4.
2.Hidden Costs in Value Chain: With increased outsourcing, the costs are hidden in the upstream tiers of the supply chain in most industries. E.g., Up to 80% of the value chain is outside the OEM in the automotive industry. An estimated 60% of that comes from suppliers from the second tier and beyond. As the supplier agreements don’t explicitly recognise the contribution of basic material costs, they don’t share the benefits when prices fall. But the suppliers pass on the increased base material prices when they have to4.
3.Missing right time to buy signal: Most firms miss buying at the right time to save costs, leaving a lot of money on the table that could save up to 25% margins in certain purchases.
4.Inaccurate Annual Planning: The company's annual planning reflects the highest risk from price volatility. The inability to do accurate planning leads to wrong decisions and bad investments and may hurt the financials of the firm badly.
Our next blog will explore how companies can leverage the latest AI technologies to leverage insights from thousands of variables to improve their commodity purchasing decisions and protect themselves from margin fluctuations.
1According to a survey of nearly 500 senior financial professionals conducted recently by the Association for Financial Professionals (AFP) with Oliver Wyman’s Global Risk Center.
2Figures are based on analysis of data from the IMF Commodity Data Portal, International Monetary Fund, last updated August 13, 2019, data.imf.org.