Commodity Prices: The Wild Ride Ahead
February 05, 2013 - Article
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By Scott Stewart, Contributing editor

These are unsettled times for food companies. It used to be they didn’t have to worry much about ingredient costs, because those in highest demand, such as corn, were fairly plentiful and their prices predictable. It’s a very different story today. 

Commodity prices have been volatile for more than a decade, creating new levels of inflation that have dramatically impacted budgeting and profit margins for food companies. No longer do we have the luxury of looking at commodity prices as a supply/demand exercise. Repercussions from factors that move commodity markets have forced food companies to change how they do business by either raising prices to what the market will bear or changing formulations. Food designers are caught in the middle, struggling to access competitively priced commodities that still meet their needs.

Without a doubt, achieving profitability is more challenging than ever before.

Volatility: The new normal

We’ve seen grain and dairy markets fluctuate wildly. Dairy prices declined 43% on average during downturns over the past 15 years. Corn and wheat prices rallied more than $3 a bushel last summer due to pervasive drought conditions across the country.  Increasingly, businesses operate in a global marketplace. Factors such as currency fluctuations, bad weather, commodity demands from emerging markets and economic trends may all influence prices at any given time.

If we were to see high crop yields this year, commodity prices could dive, much like they did in 2008, when grain prices peaked just before the recession began. Corn was as high as $8 a bushel in June of 2008, yet by that December, the price had fallen to $2.90. With a snap of the fingers, the market was decimated, losing 65% of its value.

Had Congress not acted this month to avoid sending the country over the fiscal cliff, by spring we would have had the potential for another volatile move in price much like we saw back in 2008. As it is, uncertainty over government policy regarding remaining fiscal cliff issues will be a contributing factor to the volatile nature of commodity and equity markets until a true resolution is found. 

Global impacts

For a long time, domestic supply dominated U.S. pricing. However, global competition for the same ingredients exploded in recent years, and the demand has driven up prices.  

When commodity prices become globalized, there is an inherent spike in price volatility. We saw it in the crude oil market and are now seeing it in the food/agriculture markets. In the next five years or so, we also expect to see price volatility in the natural gas market as it globalizes.

China and emerging markets have also had a profound impact during the last decade, essentially creating a global price for many commodities. What happens in other countries can lead to a spike in commodity prices on the American futures exchange even if the crop at home is fine and domestic demand isn’t creating a shortfall.

Instability ahead

Whether caused by the next fiscal cliff or another dramatic weather event, volatile conditions in today’s world will continue and even increase in the future. In terms of commodity prices, we are looking at the likelihood of higher highs and lower lows.

By examining some possible scenarios for the year ahead, it’s easy to envision corn prices dropping as low as $4 or spiking as high as $12 a bushel or more.

Price volatility creates uncertainty and diminishes business confidence. Uncertainty alone can significantly harm a business’s ability to plan. The fiscal cliff, for example, had companies and consumers alike watching milk prices.  A little known loophole in the Farm Bill could have allowed the milk pricing formula to be rolled back to one used decades earlier. Depending on how the calculations were done, it would have essentially doubled the price of milk.  

In the long run, I doubt the fiscal cliff truly matters to commodity markets. At Stewart-Peterson we believe the greater impact will come from events we never see coming, such as Europe pulling out of recession and becoming a stronger buyer of commodities, or further deterioration in China’s economy driving fewer purchases.  Or, maybe the biggest wild card of all, more devastating weather events. 

Unfortunately, there’s no way to consistently predict commodity pricing over time. Even the experts can be wrong about price direction. Betting that the market will only go in one direction or the other is highly risky.

So how do those with purchasing responsibility get smarter about dealing with something that, by its very nature, is unpredictable? They will have to manage price risk, and do it consistently.

Preparing for the wild ride

Price risk management means putting the available tools, from strategic cash purchases to hedging, to work. Hedging involves a range of tactics from simple futures and options contracts to complex, layered strategies.

Price risk management can help businesses whose margins are subject to material variability caused by price volatility. Many of the world’s leading businesses that are effectively managing price risk are also lowering commodity purchase costs, protecting margins from price volatility, improving predictability of commodity purchase costs…and gaining a competitive edge.

Southwest Airlines is a shining example outside of the food industry. By committing to fuel hedging, the airline saved $3.5 billion between 1998 and 2008. Within the food industry, companies such as General Mills and Nestlé are using hedge tactics such as long-term contracts to protect the bottom line and boost profitability.

Since it’s almost impossible to know what the market will do, you have to envision the “what ifs" and plan for them in order to strategically manage price risk in your company. Follow a process that paints a picture of all possible commodity price scenarios. Develop purchasing strategies so that you know ahead of time what you are going to do if prices go up or down…either a little or a lot.

Positioned for success

The idea is to look at many possible outcomes and prepare for each as if it could actually happen. When you can pre-plan your responses to multiple price scenarios, you improve your ability to react to actual market situations and end up in a better position to manage costs. This is market scenario planning and is modeled after the scenario planning done by military strategists for centuries and business strategists over the last several decades.

With no end in sight for market volatility, having mechanisms in place to neutralize commodity price risk becomes a crucial to success in the food business. Raising prices is one approach that the market might be able to bear, to a certain point. Businesses that proactively manage price risk with creative and dynamic approaches will have a competitive advantage over those who allow the market to dictate their planning.

Scott Stewart, CEO of Stewart-Peterson, is a leading authority on marketing strategies and risk management. He founded Stewart-Peterson in 1985 to strategically manage price opportunities and risks for businesses whose margins are impacted by market volatility and commodity price fluctuations. Using  a process called Market Scenario Planningsm, Stewart-Peterson helps companies envision the many commodity price scenarios that could unfold in the market and then develops dynamic strategies to help capture opportunities and protect against risk. For further information, contact info@stewart-peterson.com.

 

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