A critical step in risk management is taking stock of commodity exposure and understanding how your bottom line could be impacted.
Source: Bob Tull, Global Head of the Financial Risk Solutions Group.
At first glance energy metals and other commodities may appear to have little consequence for healthcare, retail or technology.
Dig a little deeper, however, and managing commodity risk can be a key differentiator of business performance – particularly as commodity markets grow increasingly complex.
Last year saw a significant recovery for a number of key commodities. And that shift is likely to continue throughout 2018 as the world’s major economies continue to grow or recover. Oil prices, for example, recently tipped past $60 a barrel for the first time in more than two and a half years. Key metals, such as copper, nickel and palladium, are all in positive territory as well.
Whatever the industry, a critical step in risk management is taking stock of commodity exposure and understanding how your bottom line is impacted – both directly and indirectly – by commodity fluctuations.
As with currency shifts, it’s important to understand your organization’s tolerance for commodity risk. While many companies may conclude their balance sheets can absorb price volatility, others will likely prefer to explore strategies for maintaining a more predictable path.
Unlike currency moves, commodity price swings can be much more volatile—sometimes increasing or decreasing by as much as 25 percent to 90 percent over relatively short periods of time: Between June 2014 and January 2015, for example, crude oil declined almost 60 percent, from $107 to $45 per barrel. Conversely, benchmark oil prices rallied more than 90 percent from $26 per barrel in February 2016 to more than $51 per barrel just four months later. And these swings were similar to the commodities uptick of 2013, which sent prices through the roof.
Coming to Terms with Surcharges
For many industries, the cost of rising commodity prices typically comes via surcharges – that is, additional fees charged by suppliers or transportation companies to minimize their own exposure.
These tolls only go one way: When commodity prices fall, suppliers don’t automatically pass along the savings. When prices increase, however, they can immediately tack on surcharges.
For low-margin industries, even small increases in transportation costs or materials can be devastating. Meanwhile, the rise of key commodities such as energy can represent a double whammy for some industries: At the same time the costs of producing or sourcing goods goes up, customers often adjust their spending to account for their own increased expenditures on transportation or energy. Further, many companies set their finished product prices in advance of when they will manufacture and deliver to their customers. If the prices of their raw material inputs, such as copper or aluminum, increase after they set pricing to their customers, it’s a hit on margins.
Taking Stock of Commodity Risk
The first step in building a commodities program is to analyze and quantify commodity exposure. This requires bringing together treasury professionals and procurement teams to create a unified strategy. Without such communication, companies run the risk of creating a hedging strategy that doesn’t line up with actual procurement plans.
Most companies can’t hedge against 100 percent of commodity risk 100 percent of the time. But it is possible to adopt a strategy that systematically manages commodity fluctuations on an ongoing basis. Financial risk management products are available that can enable a company to build a customized hedge program to mitigate commodities price risk.
Ensuring a Smoother Ride
A systematic hedging strategy is one way to minimize the risk of commodity price swings, but for most organizations managing commodities futures is not a core competency – and it requires working capital. Rather than attempt to hedge commodity prices on their own, many of our clients opt to lock in recurring commodity prices via a contract with Fifth Third.
In turn, we use our scale and expertise to hedge commodity exposure in order to ensure predictable prices for our clients.
If, for example, a transportation vendor stipulates a one cent increase in the fuel surcharge for every seven-cent increase in diesel prices, we can offer a client a fixed contract that would lock in the surcharge rate for up to three or four years, depending on the client’s credit profile. If energy prices don’t go up, the client may pay slightly more for energy prices than they would have without the contract, but for many of our clients the ability to plan and budget over a longer period is a greater priority.
Before embarking on any commodities strategy, it’s critical to first understand your organization’s total exposure as well as its ability to absorb ebbs, flows and shocks. Fifth Third’s dedicated commodities specialists work with our clients to holistically understand the commodities price risks inherent in their businesses. Once those risk levels are established, we customize a hedging program to minimize commodity price swings and protect margins.
Given the high degree of volatility in the commodities markets, exploring the risk management options available at Fifth Third Bank can be an important first step to managing the risks of direct and indirect commodities exposures.