Managing Supply Risk Part Three - Hedging Strategies: Cross-Functional Teams
By Bill McBeath
on Nov 16, 2010
Global dynamics ensure that commodity prices will remain volatile, with huge price spikes, for decades to come. Good hedging strategies are increasingly critical. Cross-functional teams are a great way to accomplish smarter hedging.
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This is part three in our series on Managing Supply Risk, which includes:
Commodity Price Volatility – Learn to Live with It!
The meteoric growth of emerging economies, in particular China, has had a dramatic impact on the price of raw materials and energy. With infrastructure construction in China continuing at breakneck pace, the world’s supplies of steel, concrete, copper, and other commodities are diverted and prices have risen dramatically as a result. China will almost certainly continue its spectacular building spree for many years (probably decades) to come, and is being joined by India, South East Asia, and other fast growing regions.
Fuel prices are even more volatile, given the political instability in so many oil producing regions. In addition, most experts predict that the world’s total oil producing capacity will peak sometime between 2010 and 2030 and drop continually after that. Once that happens, demand will persistently outstrip supply and oil prices will continually rise. We will go through an unstable and difficult period of transition to other sources of fuels.
As much as commodity prices have risen in the past few years, they could rise to new unheard of heights. But not in a straight line; they will likely remain highly volatile for many years, if not decades, to come.
Price volatility does not apply just to raw materials. In many cases intermediate materials (e.g. titanium sponge or tantalum powder) or components (e.g. memory chips) can be constrained by the production capacity, which can be overwhelmed during periods of high demand. For these industries, it can take a year or two to bring significant new capacity online. When these shortages occur, prices skyrocket. All too often it seems that just as demand cools off, the suppliers have just managed to create significant new capacity which now far exceeds demand, and the prices drop like a rock.
The bottom line is that sourcing personnel will have to learn to deal with commodity price volatility for many decades. That is why good hedging strategies are becoming an increasingly important element in the sourcing professional’s arsenal of methods and skills.
Commodity Price Hedging Strategies
Hedging can be done by shifting the risk to the customer (via surcharges), to the supplier (via price guarantees), or the market (via hedging instruments). Feasibility, costs, and impact of each option must be weighed.
Hedging is like an insurance policy—too little can be a big gamble and too much an unnecessary expense. If you hedge nothing, you are speculating that prices are going to remain stable or decline. If you hedge everything, you are speculating that prices will go up a lot, and you are paying a lot for that insurance. Hedging too far out is also very costly, while hedging for too short a period doesn’t cover your risks adequately. The trick is in finding the smartest balance. You don’t want to bet the farm one way or another.
The goal of managing commodity price risk is not to achieve price certainty, but to reduce price volatility. Over a 10 year period, someone who is doing a good job hedging will probably win half the time and lose half the time. In the end, if they break even andsignificantly reduce volatility, they’ve achieved their goal. However, some managers don’t understand this about hedges and have trouble supporting those expenses during periods when the hedges are not “paying off.” (That is a little like complaining about the expense of buying insurance because you haven’t had any fires or hurricanes to make those insurance costs worthwhile.)
Using a cross-functional team to create and manage hedging strategies, leverages complementary knowledge and skills that can be much more effective. Any one individual may not be aware of crucial facts or impacts that make all the difference.
Hedges cannot hold off rising prices forever. At some point the hedge runs out and if market prices have risen and prices stay up, the buyer has to deal with it. They still may want to renew a hedge, to protect against further price rises.
Cross-Functional Teams for Smarter Hedging
One of the firms that we interviewed uses cross-functional teams to create and manage their hedging strategies, leveraging a complementary mix of knowledge and skills. This seems to be a very smart approach. Their team consisted of people from the following functions:
How Cross-Functional Hedging Teams Might Have Saved the Day for Ford
Had Ford’s purchasing department leveraged the advanced knowledge and tools of their own treasury and R&D departments, it might have saved them at least part of their $1B write-off in 2002. As palladium prices rose from $100/ounce in the late 80s to $1,000/ounce in January 2000, Ford’s purchasing department bought up large stockpiles of palladium, mostly from Russian sources, on fears that supplies would dry up and worries that prices would continue to rise. However, the opposite happened. By 2001 prices plummeted to $330/ounce. Treasury participation might have helped them hedge against the risk. More importantly, cross-functional participation from Ford’s own researchers could have helped them see that new catalyst technology systems in the works would reduce the amounts of precious metals needed. The lesson: cross-functional teams can make smarter hedging decisions.
Sourcing/Commodity Manager—Understands dynamics of supply markets, such as pricing trends, sources of supply, capacity constraints, risks (political, geologic/weather, etc.), overall consumption, etc. Knowledgeable commodity managers have a good handle on the overall capacity and the current and projected levels of capacity utilization (i.e. degree of supply constraint) for the industry supplying the commodity.
Treasury—Expertise in financial and risk analysis, hedging instruments, accounting and regulatory requirements, tax and other consequences
Engineering—Knowledge of emerging technologies and new designs that may dramatically impact the quantities of particular materials and components needed in each product being manufactured. The need for some materials may be dramatically reduced or eliminated altogether, and at the same time new ones arise. (See side bar “How Cross-Functional Hedging Teams Might Have Saved the Day for Ford”)
Product Management—Knows the product mix/roadmap, and forecasted volumes, all of which impact the firm’s expected levels of consumption of commodities. Also should know the overall industry growth rate, which can be used to estimate industry-wide consumption of commodities.
Economist—Knowledge of the broader global conditions and long-term outlooks, which could impact both demand and supply.
In Part Four of this series, we will continue our discussion of approaches to hedging, including a look at financial instruments.
To view other articles from this issue of the brief, click here.