Commodity Risk Management

Commodity Risk Management: Connecting the Arab spring, Manchester United and JFK

Philip Joss Blog, Procurement

Spring 2011: Prince William was getting married to Catherine Middleton, the Arab spring was dominating geo-politics, Portugal was being bailed out by the EU and Manchester United were winning the English Premier League. This was also the peak of the last commodity cycle.

Unlike the financial collapse of 2008 (the previous commodity peak) it was not clear during 2011, or possibly even 2012, that the sector had passed its cyclical peak. However, with a few exceptions, the general trend in recent years has been for steadily falling raw material costs with the most significant single move being the slump in energy prices during 2014/2015.

For consumers of commodities, the past five years has largely been a period of relative calm characterised by lower year-on-year costs and downward revisions to budget forecasts. This has given breathing space and some relief after the extreme volatility of the 2006-2011 period.

However, after several years of generally benign conditions, when focus has largely shifted to other more pressing procurement issues, are times about to get more challenging for those charged with managing commodity costs?

It seems increasingly likely that for many commodities the price lows for the current cycle have passed and future price shocks seem heavily weighted to the upside. With crude oil up 50% since January, butter up a similar amount, soybean oil +10% and aluminium +9%, the energy, metals, vegetable oil and much of the soft commodity sectors have all seemingly left behind their lows of late 2014/early 2015.

Even if some markets remain weak and the sector is not (yet) ready to sustain an upsurge as seen in 2005-2008 and 2009-10 there are key warning indicators starting to flash. The recent trend of strong production growth across numerous markets appears to be changing as prices remain at (or below) the cost of production. Investments have been scaled back or cancelled whilst weather conditions have been unusually benign in key growing regions over the past 2-3 years. Meanwhile, the strong US dollar, a traditional accompaniment to lower commodity prices, has been weakened since mid-2014. Speculative interest in the sector is also returning. After four years of haemorrhaging cash, H1 2016 saw the biggest inflow of money to commodity hedge funds since 2009.

Taken together, these signals suggest a sector close to an inflexion point. Financial markets remain volatile places and any complacency amongst commodity consumers that may have slipped in over recent years is surely misplaced.

Despite some of the rises already noted, many commodity prices remain within the lower quartile for trading this century and represent long term value. Therefore, now must be considered a prime time to act to ensure that commodity risk management capabilities are optimised to ensure the full benefits have been realised from the recent declines and that structures and processes are in place to help offset and manage potential upward cost pressure in the months/years ahead. Not only will this deliver direct cost advantage but good decision making now can deliver medium/longer term competitive advantage.

To (mis)quote JFK ‘the time to repair the roof is when the sun is (still) shining’.

For more information on 4C’s approach to commodity risk management see here.