One of the benefits of living with this guy is the events I get invited to and hence the wonderful people I have the opportunity to meet. This week, I spent the day at Procurement Leaders Beyond Borders: The Expanding Role of the CPO conference right here in Chicago. I enjoy these events for so many reasons but primarily for the tidbits of insight I pick up from speakers and attendees. I’ve gone through my notes and thought I’d share with you the key insights I jotted down (in no particular order):
- I asked a panelist of CPO’s including folks from Deutsche Telekom, Starbucks, Harley Davidson and Microsoft what they thought were their top risks from a sourcing perspective. Here is what they said:
- Continuity of supply Starbucks
- The Ëœright’ management strategies for their commodities (e.g. more hedging) Starbucks
- Financial condition of their suppliers Deutsche Telekom
- Foreign corrupt practices and compliance risk specifically naming the Siemens and Daimler cases MicrosoftUS Steel also had a speaking slot and shared with the audience that the company sources 90% of its MRO, consumables (including rolls, LME metals, refractories etc), engineered components and plant services from regional suppliers while 10% comes from offshore suppliers. Many of the rolled products come from offshore sources such as Japan, Austria and the UK (a little known piece of information that tends not to get shared by the domestic steel mills too often)
- As an interesting aside, Harley-Davidson, for its direct materials purchases, sources 80% of its spend from 70 suppliers, most of which are domestic
- But by far the most fascinating topic of the day involved risk management, specifically hedging strategies. David McClain from Del Monte walked the audience through its company’s risk management strategies. According to McClain, “They [Del Monte] arbitrage risk premiums of what a supplier offers them and what they can buy in the form of a hedge, (provided one can correlate what they buy with something that can be hedged). Dave talked a lot about the forward curve and the futures markets and how the company strives to “extinguish risk wherever and whenever possible.
We recently wrote about a Corporate Executive Board study outlining the top risks of executives from large companies. Commodity volatility ranked number one. Next week, we’ll follow-up this post about an interesting little debate going on at SpendMatters. That debate involves answering the question of whether price-forecasting tools are practical for sourcing professionals or whether these tools and applications should be applied toward risk mitigation efforts. We’d argue both are required particularly as companies develop scenarios for risk mitigation efforts. We’ll cover that next week.
Over on PurchasingBizConnect, blogger Dave Hannon poses the question, “Commodity prices are up hedge or source? According to a recent Corporate Executive Board survey, Hannon explains commodity prices remain the number one risk for January 2010, “Fluctuations in commodity prices have disrupted companies’ forecasts and organizations are increasingly turning towards financial hedging strategies to manage this volatility.”Â The Corporate Executive Board report cites an array of strategies companies currently use to manage commodity volatility. These strategies include:
- Hedge through forward contracts, future contracts, options and alternate hedges
- Buy substitute inputs
- Trade finance solutions
- Identify new credit facilities
- Develop supplier partnerships
- Buy and hold more inventory
- Enter into fixed price contracts with suppliers
- Evaluate pricing and discounts to maintain margins
- Enter into long term agreements/contracts
Certainly our own anecdotal discussions with manufacturing organizations concur with many of the above-referenced strategies. In particular, in rising cost markets we see companies look to lock in prices sometimes as part of a formal hedging program, other times through the use of a forward buy. Throughout the fourth quarter of 2009, we consistently discussed the notion of “buying on the dips and/or taking some percentage of purchase volume “off the table. That last strategy might not guarantee “lowest price but it does create a hedge of sorts in that the company can manage sales margins, thereby reducing margin risk.
Here is a quick form to register and receive a free short white paper on how to use price indexes to manage commodity volatility we wrote back in 2008 during that rising commodity market. Ironically, it still contains some pointers useful in today’s up and down markets.
We hear rather a lot about how price movements in commodities are driven by fears of inflation and investment decisions from pension funds and investors keen to hedge against inflation. I have always wondered how accurate this assumption is but have lacked the time (or intellect) to challenge the concept. Pension funds and others seeking long term returns have been diverting an increasing share of their funds into commodities this decade in the belief that commodities are an effective hedge against inflation. According to an FT article, much of this thinking is based on a ground breaking paper written in 2004 by Gary Gorton of the Wharton School at the University of Pennsylvania and Geert Rouwenhorst of the Yale School of Management.
They created an equally weighted commodity index to study how it would have behaved relative to inflation between 1959 and 2004. Their conclusion was that commodity futures are “positively correlated with inflation, unexpected inflation and changes in expected inflation. They went further, saying commodity futures surpassed other mainstream asset classes in the degree of correlation, displaying a correlation of 0.45 with inflation over five-year periods, compared to correlations of -0.22 for bonds and -0.25 for equities. As a result, significant levels of investment have been made in commodities over the last five years and much of the rise in oil and metals prior to the crash of 2008 was blamed by some on just such inflows of money.
However more recent research by Watson Wyatt a consultancy looking at data from 1970 to date suggests that if one drills a bit deeper one can see the only time when commodities correlate well with inflation is in times of high inflation and that this is only relevant for about 25% of the time. Their conclusion is commodities are less dependent on general inflation than they are on good old supply and demand.
In defense, many would say the proportion of pension funds and other investors monies diverted into commodities is small, however much inflation is sighted as a reason for inflows the reality is investors don’t bet heavily on commodities for this reason. In this FT article, Barclays Capital is quoted as estimating that total commodity assets under management stood at just $224bn at the end of the third quarter, up by 37% this year, compared to trillions in other asset classes. What about Exchange Traded Funds or more accurately Exchange Traded Commodities or ETC’s, why do we hear a lot about their impact? Could pension funds be using ETC’s as their inflation hedge? Assets under management in exchange traded commodity products, totaled just $105.9bn worldwide at the end of the third quarter, according to data from Barclays Global Investors, compared with $933.5bn in general exchange traded funds. A survey on alternative assets under management by pension funds also shows commodities are insignificant. Just 0.4% of the $872bn held in alternative assets for pension funds by the 100 largest alternative investment managers is in commodities.
The conclusions one can draw from these points are several. For one, the latest research suggests commodities do not make a good hedge against inflation except in times of high inflation which comparatively speaking is rare. Another is that maybe investors have already cottoned onto this and in fact contrary to what we hear, pension funds and the like hold only a very small percentage of their investments in commodities as a result. Third, inflows into ETC’s and other forms of commodity investment are much more to do with a belief in the super cycle theories peddled by Goldman Sachs and the like than they are about hedging against inflation. Commodities continue to hold a level of interest because of belief they are an undervalued asset class which is, at least for a while, worth attention. The extension of this could be that if commodity prices stagnate in a period of more balanced supply and demand then investors funds will focus more on equities and other opportunities if that resulted in lower volatility for metals I suspect it is a result most of us would welcome.
Though Hamlet found himself in extremely dire circumstances, manufacturers throughout the world have faced a similar question, to raise prices or not? Certainly a few years ago, the answer to that question, in the automotive industry, was a resounding “no”. In other words, an OEM would never accept a price increase from his supplier, even if the supplier documented the cost increases from its suppliers. That began to change when steel surcharges really bit into supplier margins (and perhaps explains why so many automotive suppliers are no longer here today). We have personally seen many companies (both large and small) successfully implement price increases in rising commodity markets.
Reuters hosted a manufacturing summit in Chicago at the end of February. The summit featured the CEOs of many top manufacturing firms. They each spoke on various topics. We were most intrigued by the comments made about raw materials. In this audio file, Timken CEO Jim Griffith talks about how they finally did pass down cost increases to their automotive customers in the neighborhood of 10-20%. Griffith continued by saying that they live on both sides of the same coin, their company is profitable because of rising steel prices. But, they have not been getting adequate pricing for their products from automotive customers. If they don’t, “it’s the end of the road.” Read more
The LME’s first steel contract made its “soft launch” this past Monday ahead of full service being introduced in April of this year. The contract allows for steel billets in 65 ton lots to be traded 6 months forward for delivery to either the Marmara region in Turkey or Dubai, UAE for the Mediterranean contract or to Johor Malaysia or Inchon South Korea for the Asian contract.
As expected, volumes were low and probably orchestrated by some of the larger players to start the trading. The LME, however, was satisfied with the first day’s $1m turnover. It is hoped the contracts will pick up quicker than a plastics contract launched three years ago which failed to attract much interest, or for the Dubai Gold & Commodities Exchange (DGCX) steel contract launched late last year and now averaging 75 contracts or 750 tons a day. The DGCX contract is for reinforcing bar (rebar) used in the construction industry; consequently it is very applicable to the local Dubai market which is booming. The LME contract on the other hand is for steel billets, one step back up the food chain from rebar (billets are considered the starter material for making not just rebar but wire rod and merchant bars too). Consequently, the LME is hoping that consumers of a wide range of steel long products will take up the contract to hedge their forward supply risks.
Certainly there is much to aim for; a total 636 million tons of billet were produced in 2006, more than 10 times the total 61.3 million tons of non-ferrous metals such as gold and aluminum in the same year. The steel billet market was valued at $310 billion in 2006, about 35% more than the $230 billion value for all of the LME’s non-ferrous metals products. How much and how quickly the LME’s contract is taken up remains to be seen. There has been considerable skepticism from the larger producers. They see a futures contract as increasing the probability of volatility and running counter to their own efforts to bring stability to the market by consolidation and production management. The main interest in the contract has come from the banks and from small to medium size suppliers and manufacturers. The banks see it as a potential route to hedge risk on loans to the industry and (here comes the major producers concern) as a vehicle to tap into another lucrative volatile commodity market. Interestingly none of the western steel producers have applied for their billets to be approved as a deliverable brand. All the accepted brands are East European (principally Russian and Ukrainian), Turkish, or Greek with one Asian exception from Malaysia.
Of greater interest to US manufacturers is the eventual launch later this year of the much delayed Hot Rolled Steel Coil market by New York’s NYMEX exchange. This contract will allow consumers of steel sheet and plate to finally access a forward market. It will also allow buyers to arrange their physical purchase contracts accordingly, essentially locking in current pricing over a much longer term than producers are currently willing to offer. This is an issue for the steel goods market that we have seen time and again – the inability to create a national benchmark for steel pricing and to hedge the risk on the underlying metal component of semi finished and finished goods.
So it may have been a soft start but it’s likely to ring in some fundamental changes to the way steel is priced in the years ahead. We welcome the new contract and feel this will bring significant benefits especially if the LME’s lead encourages NYMEX to get their act together on the HR coil contract over the coming months.
Back in my Andersen days (yes, that Andersen), the firm had the motto “think straight, talk straight.” Not that we always did, but that certainly was the goal. My boss at Andersen, a wonderful guy named Jim Broering, had an even better motto: “Don’t make them yawn.” You laugh, but it had profound ramifications on what came out of people’s mouths or onto their powerpoint slides. Jim was the “so what” guy. What did the finding, the factoid, the news bit mean to the person receiving the information? That was the question he always pushed me to answer. And so I can’t help but feel that publishing New Year’s predictions, though perhaps helpful to some, may actually just be a yawn if there isn’t something more tangible for the reader.
So thinking of Jim’s words of wisdom, we thought we’d profer not predictions but our sense of different sourcing strategies companies have used in various markets (up, down, sideways etc). Of course there may be wildly different strategies for sourcing raw materials or semi-finished products (e.g. sheet, coil, plate, tube etc) vs. more finished products (fabricated parts, castings, forgings etc) which contain some of those metals we wrote about the other day. Read more