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A right old fix

Commodity price inflation can be a significant headache for businesses, presenting them with two unappealing options - accept lower profits or pass higher input costs on to customers. Neither is this issue limited to manufacturers; any company that uses electricity, transportation or even paper is exposed to some degree of commodity price risk.

While inflation is a concern, commodity prices can go down as well as up. Ross Strachan, commodities economist at Capital Economics, points out that, following a period of rapid inflation from 2009 to 2011, the prices of many commodities have been falling for the past six months. While prices have recovered to an extent more recently, he believes that overall prices will drop over the course of 2012.

“We have a strong view on this and it differs quite significantly from the market consensus,” he says. “For example, while the price of Brent crude currently stands at $115 per barrel, we expect the price to go down to around $85 per barrel by the end of the year.”

While falling prices sound like good news for companies purchasing these commodities, those who have previously fixed deals with suppliers may find they are locked in to prices above the current market value.

The key is to understand what portion of the cost is made up of which commodities

On the one hand, the rationale for hedging is usually to gain budgetary certainty, rather than benefiting from market movements. On the other, as Mr Strachan observes, “the risk is that you will be vulnerable to competitors undercutting you if they are getting a cheaper raw material price”.

For companies looking to manage commodity price risk, the biggest issue is therefore volatility, rather than simply inflation. So, how can companies protect themselves from commodity price volatility? There are numerous strategies to choose from. For starters, the purchasing company may have some influence when it comes to setting the price of goods. “The key is to understand what portion of the cost is made up of which commodities,” says Robert Tevelson, senior partner at The Boston Consulting Group. “Once transparency is secured, a buyer can negotiate with a better fact base.”

Agreeing fixed prices with suppliers is a straightforward method of gaining certainty, although the supplier will charge a premium for shouldering the commodity price risk. In other cases, the purchasing company may wish to hedge commodity price risk on the financial markets by buying forward contracts which lock in a set price at a future date.

But certainty comes at a price. “For the past 18 months, aside from seasonal peaks around winter, the UK wholesale power market pricing (day-ahead pricing) has been on a flat or falling profile,” says Amar Treon, director of procurement for Virgin Media. “In contrast, available forward prices have attracted particularly large premiums over the same period.”

While not all commodities can be hedged with financial instruments, other arrangements may be possible, such as setting up a proxy hedge with a correlated commodity. For an even higher premium, companies can purchase options, which give them the right – but not the obligation – to purchase the commodity at the specified price on a particular date.

Hedging needn’t be all or nothing as companies may adopt a strategy which allows them to benefit to a limited extent from market movements in their favour. Nigel Holden, head of energy and environment for the Co-operative Group, is responsible for buying energy for the group as well as for its external customers. He says that commodity price inflation is a major cost for the group and “needs to be managed flexibly given the nature of the market”.

Where energy is concerned, the company’s risk management policy stipulates that 50 per cent of the group’s power is purchased over an 18-month period prior to the beginning of the financial year, while the remaining 50 per cent is bought short, usually a month ahead, but sometimes as little as a week or a day in advance.

The spectrum of techniques available to companies looking to manage this area is attracting more attention as they adjust to higher volatility levels. “Whereas historically companies have tended simply to lock in prices and leave them there, more are now becoming interested in managing commodity price risk,” says David Greenberg, senior manager at Accenture. In light of ongoing market volatility, this trend is likely to continue.