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Take Commodity Prices Out Of Supplier Negotiations.

RiskRaw materialsMarket Volatility
commodity volatility.jpg

In this guest post, Procurement Leaders invites O2 Finance's Oliver Kaczmarek to offer some alternative views on how procurement teams should adapt to commodity price volatility.

How many times have you heard your category buyers or even companies in their annual reports using one of the below excuses when it comes to justifying a disappointing performance (i.e. higher input costs than expected):

  • Energy costs went through the roof leading to a negative impact on transport costs
  • Weather conditions were unfavorable leading to higher soft commodities input cost
  • Price of metals used in packaging and/or finished goods sky rocketed due to the activity of hedge funds. These prices have lost any correlation with market fundamentals...

If you believe that you are not exposed or not significantly exposed to commodity price risks because you do not buy commodities but semi-finished products for the purpose of manufacturing your end products, you might be significantly overlooking your real economic exposure to commodity prices.

 

Focusing on the exposure within your own cost structure is one thing but analyzing the cost structure of your suppliers is another one. Hence, experience shows that direct and explicit exposures (i.e. contractually visible exposure) represents, in certain cases, only one third of the total exposure. This is striking for the exposure to energy prices. Direct energy consumption often counts for a small portion of the total energy price exposure when one considers that almost all spend categories include an indirect energy component in their pricing (e.g. conversion, transport, bunker surcharges,…).

It certainly takes time and efforts to break down the cost structure of your suppliers, to analyze and challenge their sourcing strategy and to discover hidden exposures but this is a must if you want to understand the real drivers of your procurement performance.


Now that you understand direct, indirect, explicit and implicit commodity risks embedded in your procurement contracts, it is time to decide on a case by case basis which one you want to start managing on your own. To make that call you must consider a number of factors among which one can name:

  • The ability of the supplier to manage commodity risks effectively and the alignment of its risk management policy and market expectations with yours;
  • Historical and expected price stability of goods purchased with that supplier,
  • Your market share for that supplier
  • Possibility for the supplier to provide a flexible physical arrangement meeting your business requirements,…

There is no one-size-fits-all business case for commodity price risk unbundling but as a rule of thumb, the lower the transparency of the supplier on these risks and its management thereof, the higher the probability that the unbundling of these risks might constitute a saving opportunity for you.

For example if the aggregated direct and indirect energy exposure across your categories is sizeable for you, then you probably do not want to hand-over the management thereof to a set of suppliers on which you have no grip and which will handle it without any transparency…


The nature of direct and indirect commodity components in the spend calls for a different approach in the management of these risks. Possibilities for managing these risks are numerous, ranging from fixed price physical contracts to floating price framework agreements complemented by a portfolio of financial derivatives.

The key here is for companies to leverage on the complementary expertise of their procurement teams (in continuous contact with physical suppliers) and their treasury / risk management department (actively following financial markets and in regular contact with banks). Although this might require some preliminary alignment of targets and objectives between these teams, this is the ideal way to extract the most added value out of commodity risk management and to deliver transparent, predictable and optimized input costs to the business.


Oliver Kaczmarek is founder of O2 Finance, which consulting services in the area of Treasury, Financial and Commodity Risk Management.

This contributed article has been written by a guest writer at the invitation of Procurement Leaders. Procurement Leaders received no payment directly connected with the publishing of this content.

 

Oliver Kaczmarek
Posted by Oliver Kaczmarek

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