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George A. Zsidisin, Ph.D., 2005

Managing Commodity Price andSupply Risk

George A. Zsidisin, Ph.D., C.P.M.Assistant Professor

Michigan State [email protected]
mailto:[email protected]:[email protected]


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Agenda

What is supply risk?

Managing price volatility

Supply continuity planning

Summary


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Definition of Supply Risk

The potential occurrence of an incident or failure to

seize opportunities with inbound supply in which itsoutcomes result in a financial loss for the firm.


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Supply Risk Sources

Suppliers

Market/Industry

Amplified by Item and Platform Characteristics


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Risk Sources from Suppliers

Capacity constraints

Cost reduction capabilities

Cycle time

Disasters

Environmental performance

Financial health

Transportation systems


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Risk Sources from Suppliers

Information system incompatibility

Inventory management

Legal liabilities

Management vision and stability

Product and process innovation

Quality problems Shipment quantity inaccuracies

Volume and product mix requirements


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Risk Sources from Markets

Global sourcing

Market capacity constraints

Number of qualified suppliers

Geopolitical climate

Market price increases


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Model of Supply Risk Effects

Market/Industry

Suppliers

GeopoliticalEnvironment

Customers

PurchasePrice Increases

SupplyInterruptions

RevenueReduction

ProductLiability

PROFITEROSION


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Managing Supply Risk

Commodity price volatility

Supply continuity planning


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Commodity Prices are Volatile

Oil price volatility

Steel (>100% price increase from 12-04 to today)

Import tariff removalIndustry consolidationProduction capacity reductionIncrease use in China

Food products

Florida hurricanes September 2004Tomato prices skyrocketed


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Understanding Commodity Relationships Company Example

Natural Gas Crude Oil

Ammonia

HDPE LLDPE PP

EthylenePropylene

EthanePropaneButane Naptha Distillate

Electricity

Urea

Bottles Bags Durables

DieselAmmonium

Sulfate


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Approaches to Manage Price Volatility

1. Hedging Formal market instruments Indirect hedging

2. Avoiding Market intelligence Substitutes

3. Reducing Process improvements Forward buys

4. Sharing Contracts Pass through pricing


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Influencing Factors

Substitutability

Pass/Share Risk Burden

CustomerSupplier

Inventory Carrying Cost

Scale of Purchase

Direct Futures/Options Exist


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Managing Price Volatility

Starts with Setting Risk Objects , Relationships , and Market Intelligence

Setting Risk Objectives : Do current commodity market prices represent a value ? What are the underlying commodity market fundamental

trends? Is there product price flexibility? Can the business withstand potential margin erosion? How will competitors react to changing commodity

prices? Is the changing price a blip or long-term trend?


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Gathering Market Intelligence Web Sites

Global Business Reference: Supplier Directories Embassies and Consulates HBS

Industry Links: NAICS/SIC/UNSPSC SemaTech Raw Material Indexes

Economic Indicators: Economist, WTO, World

Bank

CIA Fact Book, OANDA

Company Financial Research:SEC Filings (Edgar online)Fortune 500

Useful Links:Globe SmartExecutive Planet

Geography Specific:AsiaEuropeMiddle EastSouth America


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Framework for Commodity Risk Management

Use Substitute

Dollar Size ofPurchase

Yes

Yes

No

High

HighLow

Contractual ClauseOr Pass On

Price Increase

Imminent

Economical toBuy Ahead

Do Nothing

Forward Buy

Yes

No

No

SubstituteAvailable

Pass/Share withCustomer

Pass/Share withSupplier

InventoryCarrying Cost

Yes

Low

No

Yes

(Slide continued on next page)


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Commodity Hedging Example


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Background

Surcharge History

1998 / 1999- Low Fuel Costs

2000

Fuel costs began to escalate in February

Paid $5.4M

2001 YTD

Fuel costs remained high

Paid $2.8M YTD (Jan - Jul)

Plan is $6.3M, the 5+7 Outlook is $5.7M


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One Potential Solution

For surcharges the company does consume diesel fuel (27Million Gallons Annually) and therefore should participate infutures trading of heating oil.

Correlation between Heating Oil Futures and Diesel Pump Prices

R 2 correlation coefficient = 0.944 (very good)

42,000 gals = 1 Heating Oil Futures Contract

Would need 660 Heating Oil contracts to cover surcharges


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2002 Results

2002 Fuel Expense

$(500)

$(400)

$(300)

$(200)

$(100)

$-

$100$200

$300

$400

Futures Activity $198 181 (130) (93) (114) (107) (138) (198) (409) (380) (123) (373) $(1,686)

$ pd Truckers $100 100 120 160 140 240 205 150 205 340 314 314 $2,388

Net Expense $298 281 (10) 67 26 133 67 (48) (204) (40) 191 (59) $702

JAN FEB MAR APR MAY JUN JUL AUG SEPT OCT NOV DEC YTD


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Fuel Hedging

New and Innovative Component of our FuelStrategy in Cooperation w/Commodities.

Balance market exposures to diesel pricefluctuations thru participation in heating oilfutures.

Locked -In pricing on 27,500,000 gallons offuel.

Paid Fuel in 2002 @ $1.24 !!!!!!!

Market Returned Incremental $1.7M in 2002 !!


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Supply Continuity Planning


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Definition of Business Continuity Planning

The business management practices that provide the focusand guidance for the decisions and actions necessary for a

business to prevent, mitigate, prepare for, respond to,resume, recover, restore, and transition from a disruptive(crisis) event in a manner consistent with its strategicobjectives (Shaw and Harrald, 2004; p. 3)

Supply Continuity planning (SCP) is an important facet of business continuity planning


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Enhanced SCP/SC Framework

Awareness Prevention Remediation KnowledgeManagement

InternalExternal

Identification AssessmentTreatmentMonitoring

Plan how tominimize:

Impact Duration Resources

Execution

Track resultsThings gonerightThings gonewrongFuture actionlist


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Elements of SCP

Awareness

Recognition of exposure to risk within the supply chain Awareness of

Probability Impact Recognition of effects of risk on:

Physical assets Information

Awareness: Internal External


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Elements of SCP

Remediation Goal:

Identify a priori procedures for managing thefour stages of a disruption Interruption, response, recovery, restoration of

operations Minimize adverse impact on:

Time Cost

Determine most effective allocation of resources


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Elements of SCP

Knowledge Management Goal

Learn from experience Things gone wrong Things gone right Results of remediation efforts

Modify current procedures and systems to reflectlessons learned.

A SCP post mortem Formalized activity


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Summary for Managing Supply Risk

Supply risk differs by its sources and dimensions

Awareness and knowledge are the first steps

Commodity price management and supply continuity planningare two ways that organizations can manage supply risk

QUESTIONS?

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