It's obvious that shifts in policy, availability, and priority of commodities can directly impact related industries – no one is surprised that aluminum imports will impact (for better or worse) the automotive industry – but for those companies and industries that aren’t directly involved in the commodities markets, there can be significant impact as well.
Whether you buy from a U.S. supplier or a supplier overseas, you are likely dealing with the impact of imported commodities through your supply chain. Service industries or those building more complex manufactured goods are typically dealing with a complex web of suppliers and suppliers’ suppliers who may or may not be sourcing their products through imported commodities.
The result for you as the customer is that your production costs can fluctuate based on commodity prices. A single commodity can affect the bottom line in any number of ways. For example, the price of oil affects the price of rubber, of transporting goods by long-haul truck and even the price of plastic.
And because most products in the marketplace originate with one or more commodities of some sort, commodities also tend to have an impact on the economy as a whole, spreading its influence beyond the immediate buy-sell relationship.
Understanding how all of these elements impact pricing can help you better plan for fluctuations and volatility, and help protect your bottom line.
Commodities and Inflation
Oil and agricultural commodities (including imports, which help set the market rate) are the predominant determinants of the inflation rate, and typically touch every industry to some degree. The inflation rate influences where the Fed sets interest rates, which are used to promote an equilibrium between credit-financed growth and consumption-based growth. If prices for these commodities go up, inflation increases and interest rates may follow suit in order to maintain equilibrium – ultimately making it more expensive to borrow money and leaving fewer consumer purchasing dollars.
Currently borrowing is relatively cheap, but the pattern of inflation growth suggests this may not last forever, as the Consumer Price Index (CPI) has risen by 2.7% over the last 12 months, according to the Bureau of Labor Statistics.
To help mitigate commodity risk in a rising rates situation, you can consider negotiating fixed-price contracts with your suppliers to stem the erosive effect of inflation on returns, or purchase in bulk to take advantage of current pricing.
"The majority supplier contracts do not extend longer than 6 or 12 months," says Robert Tull, Managing Director and Global Head of Financial Risk Solutions at Fifth Third. "Instead, consider a fixed price swap or a commodity cap of the underlying commodity. This approach allows you to take advantage of the price longer term – potentially up to 36 months. By hedging this way, your variable cost input mimics more of a fixed cost, bringing more predictability for cash flow and underlying expenses."
The fluctuations in foreign exchange rates can mean that imported commodities (among other things) suddenly become significantly more expensive or less expensive than domestic offerings.
For example, with the U.S.’s current trade policy, the dollar is fairly strong versus other currencies. For U.S. companies, this means exporting becomes more difficult if other products compete at a lower price; and importing becomes expensive. Another complicating factor is that some countries like Malaysia and China have currency controls to limit how much of their currency is in circulation, making it difficult to foresee a change in direction of the exchange rate.
"In times of a strengthening dollar, companies that import tend to be able to reduce their overall cost of goods sold," Tull said. "But movements in the dollar can be abrupt. So importers should consider layering on hedges, both short term and long term, that meet or exceed their forecasted budget costs. This will assist in potentially meeting certain budget levels and assist in managing their COGS."
The significant ongoing currency risk means that it makes sense to consult your banking partners who are familiar with your industry, evaluating foreign and domestic accounts and, assessing the impact of currency movements on your business
"A strengthening dollar may present challenges to a company’s product being sold in the foreign market. Being able to bill in the local currency takes the currency risk off the foreign distributor. This allows the distributor to focus on selling the product, not managing currency risk," Tull said.
In turn, your financial partner can assist in creating a price list and hedging program that will help you manage the currency risk and potentially minimize volatility of your profit margins. "This can be done on both a short and long-term basis – up to five years – helping to manage the predictability of cash flows."
Foreign Policy Risk
International relations remain a significant risk to manage, with many U.S. trade agreements in the throes of negotiation. Tariffs in particular have become the main consideration, as some industries could benefit heavily from tariffs while others could see costs skyrocket.
The impact is two-fold – you could see prices for domestic suppliers go up as a result of less competition, but you could also be locked in to paying the higher costs for imported goods if domestic purchasing isn’t an option for you.
For example, Harley Davidson, a U.S.-based company, has moved part of its operations to Europe because the European Union’s recent tariffs have increased the average cost of exporting a motorcycle there by $2,200.
Companies who rely on Vitamin C, on the other hand, won’t necessarily have that same option. China is estimated to produce 95% of the global supply of Vitamin C, making switching operations to another supplier nearly impossible. If your product requires Vitamin C, it’s likely you’ll need to purchase that product from China, tariffs or not.
There are a few options for hedging against foreign policy risks such as tariffs. You can employ commodity futures to manage the price fluctuations, or you can negotiate long-term fixed-price contracts for goods that are prone to political volatility.
"The best approach to managing this risk is to first understand the underlying risks -- bringing in outside experts to help identify those areas of your business that can be impacted, and steps to take for the short-to-medium term," Tull said.
How to Navigate the Landscape
Knowing how commodities can affect your bottom line is just the beginning – the next step is developing a game plan based on how your business can take advantage of opportunities, mitigate risk and navigate shifting ground.
The key is to work with business and banking partners who know your industry and your company intimately – leverage these partners and use their expertise to build a game plan that’s tailored for success.