Tanking commodity prices: manage now or pay later

By Mark O Toole | 7 August 2015

Another day, another fall in commodity prices – an all too familiar story. But this freefall is perhaps the only predictable thing in a market where a myriad of factors appear to be playing a role in the decline. Already this month we’ve seen record low Chinese manufacturing PMI data dragging the commodities market down with it. On top of this, there has been another bear run on the price of crude oil as it sank to below $50 per barrel.

While this may not be great news for investors, the continuing fall in costs is, at least, providing some relief to manufacturers and other companies with large commodity exposures. With input prices falling, profitability and margin should increase since companies typically lag when it comes to reducing consumer prices. But – as the saying almost goes – what goes down must come up.

Reaping additional profits now is all well and good, but having the right systems in place to plan ahead to hedge against larger price increases in the future is a must. When China begins a new growth cycle and when (or should that be if) the European Union (EU) brings some stability to the sovereign debt situation, prices on raw materials will again be on the upswing. There is no way to time the recovery of the Chinese growth market or the dawning of a more stable European debt situation, but the impetus is on corporate players to act. 

Increased price volatility has significantly increased the extent to which corporates can be caught out by price swings through poor commodity risk management. On the flipside, businesses that manage their commodity risk in a more centralised and sophisticated manner have an increased chance of gaining an edge over rivals that don’t.

An important first step is to rethink buying habits: instead of the traditionally short-term approach, firms should look to lock in low prices through longer-term contracts. This is especially pertinent for food and beverage companies, where prices can fluctuate simply on the yield of the next crop, and they face seeing the opportunity evaporate for potentially years to come.

Forward-thinking CFOs are ensuring their businesses take the opportunities presented by breaking down the barriers between treasury and procurement, integrating the two in such a way that the financial officer is able to have a single, sophisticated, and timely view of risk (commodity and currency) across the enterprise. This involves the use of technology (fully integrated into existing systems, commonly ERP platforms) that allows the two to ‘talk to each other’. Properly implemented, this allows businesses to make far smarter procurement decisions, far more quickly, in response to market fluctuations. It also opens the door to the use of sophisticated analysis and financial commodity hedging, should this be appropriate for the business. Furthermore, for a business previously reliant on spreadsheets, it pays dividends in terms of man-hours and reduced operational risk and lower error rates. All of which translates directly into an improved bottom line.

Businesses active in the commodity markets – the BPs, merchant traders and utilities of this world – evolved in this direction some time ago. Now, given the increased pressures of competition and volatility – as well as the opportunities presented by current prices – it is high time for corporates to follow suit.
 

By Mark O'Toole, Vice President Commodities & Treasury Solutions, OpenLink

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