The first article of a 5-part series on How to Embed Forecasting Capability into Aluminum Sourcing Practices.
This initial step requires the aluminum buyer to fairly and accurately assess the company’s degree of exposure to aluminum price risk as well as determine the risk tolerance of the organization before implementing any forecasting capability.
Estimating the Degree of Aluminum Risk Exposure
A company has several checklist items to examine to ascertain price risk:
- How many dollars does the company spend on both aluminum semi-finished materials and/or parts that contain aluminum?
- How does the end-to-end price equation work with key customers? For example, pass-through pricing reduces risk, but fixed pricing with customers does not. How readily can the company pass through price increases?
- What is the company’s policy regarding hedging? Is the company obligated to hedge under any circumstances?
- How does the company manage its purchase contracts? For example, does it buy on long-term contracts only? Does it buy on the spot market only?
The next important question to ask involves the company’s sensitivity to aluminum price volatility.
If a company answered Question 2 above with a “we can pass through price increases,” that may mean lower price risk exposure, but not necessarily if the company has some sort of cap/collar pricing scheme in place with its customers. And obviously any company that can’t pass on price increases faces greater price risk.
Let’s examine a trusty two-by-two matrix to ascertain the company’s estimate of its overall exposure to aluminum price volatility and the degree of dependence on aluminum.
If both the level of dependence and price volatility remain low, it makes less sense to implement risk management tools, since the cost of actively managing price risk will be higher than the financial benefits. As dependence and price volatility increase, managing aluminum price risk can improve financial performance.
Aluminum Spend Analysis
Again, the company’s overall dependence on aluminum includes both its direct purchases as well as its part/sub-assembly and assembly purchases containing aluminum. A spend analysis would provide this information.
The results of a spend analysis help enable the decision to make use of risk management tools. For example, if a firm has revenues of $4 billion, but only has $50,000 of annual aluminum spend, even a 100% price increase won’t have a significant impact on profitability.
It goes without saying that low price volatility results in low price risk. But even single-digit monthly price changes can wreak havoc on both a company’s margins and its EBITDA or EPS if the aluminum spend appears significant.
The table below shows an analysis of the change in the high/low weekly price of aluminum as a percentage of average annual price:
This table suggests significant price fluctuations for aluminum. We’d argue the average annual price movement of 36.8% for the past 6 years, with a high of over 68% in 2008, suggests aluminum has a high degree of volatility. Therefore, as long as a company’s aluminum spend levels remain significant, it would make sense to proactively manage aluminum price volatility.
High Risk vs. Low Risk Tolerance
The level of risk a company may opt to take to manage its supply chains and aluminum spend depends on a range of factors, such as the company’s experiences, philosophy, maturity, industry, etc.
Risk-averse organizations prefer options that will have a more certain outcome, but may generate lower returns, to choices that have less certain outcomes yet higher expected value payouts. In the same manner, companies with a high-risk tolerance may demonstrate a greater willingness to accept risk exposure and potentially adverse impacts from a particular event(s).
The strategies that one might choose to address aluminum price volatility need alignment with those of the business unit and the firm.
Raul de Frutos Tinoco is MetalMiner’s lead forecasting analyst. Hear Raul and other experts speak at our upcoming commodity conference: