© george a. zsidisin, ph.d., 2005 managing commodity price and supply risk george a. zsidisin,...
TRANSCRIPT
© George A. Zsidisin, Ph.D., 2005
Managing Commodity Price and Supply Risk
George A. Zsidisin, Ph.D., C.P.M.Assistant Professor
Michigan State [email protected]
Agenda
•What is supply risk?
•Managing price volatility
•Supply continuity planning
•Summary
Definition of Supply Risk
“The potential occurrence of an incident or failure to
seize opportunities with inbound supply in which its
outcomes result in a financial loss for the firm.”
Supply Risk Sources
• Suppliers
• Market/Industry
• Amplified by Item and Platform Characteristics
Risk Sources from Suppliers
• Capacity constraints
• Cost reduction capabilities
• Cycle time
• Disasters
• Environmental performance
• Financial health
• Transportation systems
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
Risk Sources from Markets
• Global sourcing
• Market capacity constraints
• Number of qualified suppliers
• Geopolitical climate
• Market price increases
Model of Supply Risk Effects
Market/ Industry
Suppliers
Geopolitical Environment
Customers
PurchasePrice Increases
SupplyInterruptions
RevenueReduction
ProductLiability
PROFITPROFITEROSIONEROSION
Managing Supply Risk
• Commodity price volatility
• Supply continuity planning
Commodity Prices are Volatile
•Oil price volatility
•Steel (>100% price increase from 12-04 to today)
•Import tariff removal•Industry consolidation•Production capacity reduction•Increase use in China
•Food products
•Florida hurricanes September 2004•Tomato prices skyrocketed
Understanding Commodity Relationships – Company Example
Natural Gas Crude Oil
Ammonia
HDPE LLDPE PP
EthylenePropylene
EthanePropaneButane Naptha Distillate
Electricity
Urea
Bottles Bags Durables
Diesel
AmmoniumSulfate
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
Influencing Factors
•Substitutability
•Pass/Share Risk BurdenCustomerSupplier
•Inventory Carrying Cost
•Scale of Purchase
•Direct Futures/Options Exist
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?
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 Smart•Executive Planet
Geography Specific:•Asia•Europe•Middle East•South America
Framework for Commodity Risk Management
Use Substitute
Dollar Size ofPurchase
Yes
Yes
No
High
High
Low
Contractual ClauseOr Pass On
Price IncreaseImminent
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)
Framework for Commodity Risk Management
Live With It
Acquire SurrogateFutures/Options
Acquire Futures/OptionsDirect Market
Exists
Yes
Yes
No
No
Substitute MarketExists
(Slide continued)
Commodity Hedging Example
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 $5.7M
The Problem
Sensitivity Analysis
Diesel Pump Price($ / gal)
$1.10 $1.50 $2.00
Surcharge $0 $2.3 million $4.9 million(Sep - Dec 01)
Surcharge $0 $6.2 million $13.2 million(Annualized)
National Average Diesel 1994-2001Long Term Trends
NATIONAL AVERAGE PRICE OF DIESEL FUEL
$0.800
$0.900
$1.000
$1.100
$1.200
$1.300
$1.400
$1.500
$1.600
$1.700
3/2
1/9
4
6/6
/94
8/2
2/9
4
11/7
/94
1/2
3/9
5
4/1
0/9
5
6/2
6/9
5
9/1
1/9
5
11/2
7/9
5
2/1
2/9
6
4/2
9/9
6
7/1
5/9
6
9/3
0/9
6
12/1
6/9
6
3/3
/97
5/1
9/9
7
8/4
/97
10/2
0/9
7
1/5
/98
3/2
3/9
8
6/8
/98
8/2
4/9
8
11/9
/98
1/2
5/9
9
4/1
2/9
9
6/2
8/9
9
9/1
3/9
9
11/2
9/9
9
2/1
4/0
0
5/1
/00
7/1
7/0
0
10/2
/00
12/1
8/0
0
3/5
/01
5/2
1/0
1
US No 2 Diesel Retail Sales by All Sellers ($/gal)
Now What?
• Company Consumes and Hedges/Trades Natural Gas Futures
• Company Does not Consume Diesel Fuel, nor is it Traded.
• Company Does not Consume Heating Oil, but it is Traded.
• Strong Correlation between Heating Oil Futures and Diesel Pump Prices
Heating Oil and Diesel Correlation
HEATING OIL to DIESEL5+ YEARS of DATA
y = 0.9921x + 0.6459
R2 = 0.9425
$0.800
$0.900
$1.000
$1.100
$1.200
$1.300
$1.400
$1.500
$1.600
$1.700
$1.800
$- $0.20 $0.40 $0.60 $0.80 $1.00 $1.20
Diesel Pump ($/gal) Linear (Diesel Pump ($/gal))
One Potential Solution
• For surcharges – the company does consume diesel fuel (27 Million Gallons Annually) and therefore should participate in futures trading of heating oil.
Correlation between Heating Oil Futures and Diesel Pump Prices
• R2 correlation coefficient = 0.944 (very good)
• 42,000 gals = 1 Heating Oil Futures Contract
• Would need 660 Heating Oil contracts to cover surcharges
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
Fuel Hedging
• New and Innovative Component of our Fuel Strategy in Cooperation w/Commodities.
• Balance market exposures to diesel price fluctuations thru participation in heating oil futures.
• “Locked-In” pricing on 27,500,000 gallons of fuel.
• Paid Fuel in 2002 @ $1.24 !!!!!!!
• Market Returned Incremental $1.7M in 2002 !!
Supply Continuity Planning
Definition of Business Continuity Planning
• “The business management practices that provide the focus and 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 strategic objectives” (Shaw and Harrald, 2004; p. 3)
• Supply Continuity planning (SCP) is an important facet of business continuity planning
Enhanced SCP/SC Framework
AwarenessAwareness PreventionPrevention RemediationRemediation KnowledgeManagementKnowledge
Management
Internal External
Identification Assessment Treatment Monitoring
Plan – how to minimize:• Impact• Duration• Resources
Execution
Track results Things gone
right Things gone
wrong Future action
list
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
Elements of SCP
Prevention• Goal
• Reduce likelihood and/or impact of supply chain disruptions.
• Key Processes:• Risk identification• Risk assessment• Risk treatment• Risk monitoring
Elements of SCP
Remediation• Goal:
• Identify “a priori” procedures for managing the four stages of a disruption– Interruption, response, recovery, restoration of
operations• Minimize adverse impact on:
– Time– Cost
• Determine most effective allocation of resources
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 reflect lessons learned.
• A SCP “post mortem”• Formalized activity
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 planning are two ways that organizations can manage supply risk
QUESTIONS?