Managing Commodity Price and Supply Risk
George A. Zsidisin, Ph.D., C.P.M.
Assistant Professor Michigan State University zsidisin@msu.edu
George A. Zsidisin, Ph.D., 2005
Agenda
What is supply risk? Managing price volatility Supply continuity planning Summary
Definition of Supply Risk
The potential occurrence of an incident or failure to seize opportunities with inbound supply in which its outcomes result in a financial loss for the firm.
Supply Risk Sources
Suppliers Market/Industry Amplified by Item and Platform Characteristics
Risk Sources from Suppliers
Capacity constraints Cost reduction capabilities Cycle time Disasters Environmental performance Financial health Transportation systems
Risk Sources from Suppliers
Information system incompatibility
Inventory management
Legal liabilities Management vision and stability Product and process innovation Quality problems Shipment quantity inaccuracies Volume and product mix requirements
Risk Sources from Markets
Global sourcing
Market capacity constraints Number of qualified suppliers
Geopolitical climate
Market price increases
Model of Supply Risk Effects
Purchase Price Increases
Market/ Industry
Suppliers
Supply Interruptions
Geopolitical Environment
Revenue Reduction
PROFIT EROSION
Customers
Product Liability
Managing Supply Risk
Commodity price volatility
Supply continuity planning
Commodity Prices are Volatile
Oil price volatility Steel (>100% price increase from 12-04 to today) Import tariff removal Industry consolidation Production capacity reduction Increase use in China
Food products
Florida hurricanes September 2004 Tomato prices skyrocketed
Understanding Commodity Relationships Company Example
Natural Gas
Ethane Propane Butane
Crude Oil
Naptha
Ethylene Propylene
Ammonia Electricity
Distillate Diesel
PP
Urea
Ammonium Sulfate
HDPE
LLDPE
Bottles
Bags
Durables
Approaches to Manage Price Volatility
1. Hedging Formal market instruments Indirect hedging 2. Avoiding Market intelligence Substitutes 3. Reducing Process improvements Forward buys 4. Sharing Contracts Pass through pricing
Influencing Factors
Substitutability
Pass/Share Risk Burden Customer Supplier Inventory Carrying Cost
Scale of Purchase
Direct Futures/Options Exist
Managing Price Volatility
Starts with Setting Risk Objects, Relationships, and Market Intelligence
Setting Risk Objectives: Do current commodity market prices represent a value? What are the underlying commodity market fundamental trends? Is there product price flexibility? Can the business withstand potential margin erosion? How will competitors react to changing commodity prices? Is the changing price a blip or long-term trend?
Gathering Market Intelligence Web Sites
Global Business Reference: Supplier Directories Embassies and Consulates HBS Industry Links: NAICS/SIC/UNSPSC SemaTech Raw Material Indexes Company Financial Research:
SEC Filings (Edgar online) Fortune 500
Useful Links:
Globe Smart Executive Planet
Geography Specific:
Asia Europe Middle East South America
Economic Indicators: Economist, WTO, World Bank CIA Fact Book, OANDA
Framework for Commodity Risk Management
Price Increase Imminent
Yes
Substitute Available
No
Yes
Use Substitute
Pass/Share with Customer
No
Yes
Contractual Clause Or Pass On
Pass/Share with Supplier
No
Yes
No
Inventory Carrying Cost
High
Low
Economical to Buy Ahead
Do Nothing
Dollar Size of Purchase
High
Low
Yes
Forward Buy
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Framework for Commodity Risk Management
(Slide continued)
Yes
Direct Market Exists
No Yes
Acquire Futures/Options
Substitute Market Exists
No
Acquire Surrogate Futures/Options
Live With It
Commodity Hedging Example
Background
Surcharge History
1998 / 1999- Low Fuel Costs
2000 Fuel costs began to escalate in February
Paid $5.4M
2001 YTD Fuel costs remained high Paid $2.8M YTD (Jan - Jul) Plan is $6.3M, the 5+7 Outlook is $5.7M
The Problem
Sensitivity Analysis
Diesel Pump Price ($ / gal)
$1.10 Surcharge
(Sep - Dec 01)
$1.50 $2.3 million $6.2 million
$2.00 $4.9 million $13.2 million
$0 $0
Surcharge
(Annualized)
National Average Diesel 1994-2001 Long Term Trends
N A T IO N A L A V E R A G E P R IC E O F D IE S E L F U E L
$ 1 .7 0 0
$ 1 .6 0 0
$ 1 .5 0 0
$ 1 .4 0 0
$ 1 .3 0 0
$ 1 .2 0 0
$ 1 .1 0 0
$ 1 .0 0 0
$ 0 .9 0 0
11/27/95
12/16/96
10/20/97
11/29/99
12/18/00
3/21/94
8/22/94
11/7/94
1/23/95
4/10/95
6/26/95
9/11/95
2/12/96
4/29/96
7/15/96
9/30/96
5/19/97
3/23/98
8/24/98
11/9/98
1/25/99
4/12/99
6/28/99
9/13/99
2/14/00
7/17/00
10/2/00
U S N o 2 D ie s e l R e t a il S a le s b y A ll S e lle rs ($ / g a l)
5/21/01
$ 0 .8 0 0
6/6/94
3/3/97
8/4/97
1/5/98
6/8/98
5/1/00
3/5/01
Now What?
Company Consumes and Hedges/Trades Natural Gas Futures
Company Does not Consume Diesel Fuel, nor is it Traded.
Company Does not Consume Heating Oil, but it is Traded.
Strong Correlation between Heating Oil Futures and Diesel Pump Prices
Heating Oil and Diesel Correlation
H E A T IN G O IL to D IE S E L 5+ YEARS of DAT A
$ 1 .8 0 0 y = 0 .9 9 2 1 x + 0 .6 4 5 9 R $ 1 .7 0 0
2
= 0 .9 4 2 5
$ 1 .6 0 0
$ 1 .5 0 0
$ 1 .4 0 0
$ 1 .3 0 0
$ 1 .2 0 0
$ 1 .1 0 0
$ 1 .0 0 0
$ 0 .9 0 0
$ 0 .8 0 0 $$ 0 .2 0 $ 0 .4 0 D ie s e l P u m p ($ / g a l) $ 0 .6 0 $ 0 .8 0 L in e a r (D ie s e l P u m p ($ / g a l)) $ 1 .0 0 $ 1 .2 0
One Potential Solution
For surcharges the company does consume diesel fuel (27 Million Gallons Annually) and therefore should participate in futures trading of heating oil. Correlation between Heating Oil Futures and Diesel Pump Prices R2 correlation coefficient = 0.944 (very good) 42,000 gals = 1 Heating Oil Futures Contract Would need 660 Heating Oil contracts to cover surcharges
2002 Results
2002 Fuel Expense
$400 $300 $200 $100 $$(100) $(200) $(300) $(400) $(500) Futures Activity $ pd Truckers Net Expense JAN $198 $100 $298 FEB 181 100 281 MAR (130) 120 (10) APR (93) 160 67 MAY (114) 140 26 JUN (107) 240 133 JUL (138) 205 67 AUG (198) 150 (48) SEPT (409) 205 (204) OCT (380) 340 (40) NOV (123) 314 191 DEC (373) 314 (59) YTD $(1,686) $2,388 $702
Fuel Hedging
New and Innovative Component of our Fuel Strategy in Cooperation w/Commodities. Balance market exposures to diesel price fluctuations thru participation in heating oil futures. Locked-In pricing on 27,500,000 gallons of fuel. Paid Fuel in 2002 @ $1.24 !!!!!!! Market Returned Incremental $1.7M in 2002 !!
Supply Continuity Planning
Definition of Business Continuity Planning
The business management practices that provide the focus and guidance for the decisions and actions necessary for a business to prevent, mitigate, prepare for, respond to, resume, recover, restore, and transition from a disruptive (crisis) event in a manner consistent with its strategic objectives (Shaw and Harrald, 2004; p. 3) Supply Continuity planning (SCP) is an important facet of business continuity planning
Enhanced SCP/SC Framework
Awareness
Internal External
Prevention
Identification Assessment Treatment Monitoring
Remediation
Plan how to minimize: Impact Duration Resources Execution
Knowledge Management
Track results Things gone right Things gone wrong Future action list
Elements of SCP
Awareness
Recognition of exposure to risk within the supply chain Awareness of Probability Impact Recognition of effects of risk on: Physical assets Information Awareness: Internal External
Elements of SCP
Prevention Goal Reduce likelihood and/or impact of supply chain disruptions. Key Processes: Risk identification Risk assessment Risk treatment Risk monitoring
Elements of SCP
Remediation Goal: Identify a priori procedures for managing the four stages of a disruption Interruption, response, recovery, restoration of operations Minimize adverse impact on: Time Cost Determine most effective allocation of resources
Elements of SCP
Knowledge Management Goal Learn from experience Things gone wrong Things gone right Results of remediation efforts Modify current procedures and systems to reflect lessons learned. A SCP post mortem Formalized activity
Summary for Managing Supply Risk
Supply risk differs by its sources and dimensions
Awareness and knowledge are the first steps
Commodity price management and supply continuity planning are two ways that organizations can manage supply risk
QUESTIONS?
