Why Commodity-Buying Organizations Need Their Own Hedging Strategies

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Though we don’t take on too many consulting projects these days, we received a call from a client late last week that got us thinking about what we call the “commodity volatility conundrum. That conundrum goes something like this: “We (the buying organization) would like to have our supplier(s) hold pricing firm for a longer period of time, despite the fact that commodity volatility has caused mills and distributors to offset that risk with shorter quote validity terms.”

The commodity conundrum becomes further complicated when buying organizations refuse to commit specific volumes. But why would a smart sourcing organization just turn to its supplier(s) to hold prices fixed for longer time periods? Perhaps the buying organization feels that that represents the easiest thing to do: put the risk onto the supplier and have him or her “deal” with it. Or maybe the buying organization pays on a timely basis, buys in good consistent volumes and expects the supplier to “serve the customer. No matter what rationale a buying organization uses to justify the request to the supply base, we’d argue the buying organization ends up the loser — he/she may just not know why.

Why a Commodity Management Strategy Is a Good Idea

We can think of three good reasons why a buying organization ought to create a commodity management strategy as opposed to relying solely on its supply base to bear the brunt of the burden. The first and most obvious reason involves cost.

Think back to those Carmax commercials, this one in particular speaking of car dealers: “They’ll squeeze you on the front end or squeeze you on the back end. How true! Consider this: when you ask your supply base to quote you a longer “fixed price period, how do you expect the supplier to do this? We see two options.

The first involves committing specified volume (via a contract) with the supplier so that the supplier can go out, lock in a forward buy with a producer and make sure the supplier’s allocation will fill the entire customer order. The second involves the buying organization not providing a contractual volume commitment (which would require the supplier to take on 100% of the risk) and “pad the price with its own arbitrary “hedge” cost. (Ed. note: the term “hedge” used here loosely.) We think it’s plain naive to think that by throwing the risk onto the supplier, the buying organization should receive “a good competitive price.”

The second reason buying organizations ought to consider a commodity management strategy rests upon the notion of supply chain transparency. Knowing how each entity within the supply chain prices its products and services only helps the buying organization better understand total cost of ownership (TCO).

For example, if a company opts to buy based on the lowest price per ton available in the market and the price represents a margin basically just above cost, the supplier might place stringent payment requirements onto the buying organization. The organization may need to pay for the entire order even if the last ton doesn’t ship for eight months! Somehow, we doubt that particular buying organization has considered its cost of capital, inventory carrying cost or impact to EBITDA for essentially pre-buying such a large volume.

But the third and perhaps most compelling rationale behind developing a commodity management strategy involves margin risk. By leaving the burden of extending quote validity periods or holding current pricing for longer periods of time to suppliers, the buying organization cedes control of its own ability to manage margins.

Instead, buying organizations may wish to consider developing hedging strategies — whether that includes forward buying, formal hedges (physical or financial) or specific volume commitments in exchange for fixed pricing to lock in margins. As we say, better to pay $5/ton over the lowest price to lock in margins than get caught holding a bag of $50/ton material over the lowest price.

–Lisa Reisman

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