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03/11/2011

Manufacturers Need to Deal With Soaring Commodity Prices

Robert J. Bowman, SupplyChainBrain | March 07, 2011

The warning signs are there for all to see. Just last week, the price of oil topped $100 a barrel for the first time in three years. And, despite an upbeat message from Federal Reserve chairman Ben Bernanke, the Dow Jones Industrial Average dropped 58 points at the end of February, with investors clearly worried about the impact of higher commodity prices. Even without fuel and food, the recent release of the Consumer Price Index saw some of the largest increases in recent history.

You don’t have to look far to discover the causes. In addition to bad weather all over the globe, the remarkable series of popular uprisings across Northern Africa and the Middle East is threatening to topple any number of autocrats and aging dictators. And while that’s good news for lovers of democracy, the situation creates massive uncertainties about the future price and supply of oil and other key commodities.

But perhaps “uncertainty” is the wrong word. Because one thing is certain: fuel prices are going up. Don’t be shocked to see gasoline at $4 a gallon this summer, or crude oil passing the $100-a-barrel benchmark without slowing down.

In fact, oil is just one of many commodities that global businesses need to be worrying about right now. (Copper and cotton are also seeing big price increases.) The key to a successful supply chain used to lie in cheap manufacturing. Now it’s all about how you cope with volatility in commodity markets.

Manufacturers are responding by beefing up stocks of commodities and raw materials, locking into current prices. That strategy, according to the Institute for Supply Management, has been driving up inventories for some time now. (February broke a seven-month streak of rising inventory levels, ISM reports. Companies are borrowing for that purpose – yes, banks are finally beginning to lend again – and the resulting infusion of fresh funds into the U.S. economy threatens to fuel inflation. Which, of course, gives consumer-goods producers yet another reason to jack up prices at the shelf.

At times like these – just prior to what appears to be a big leap in commodity prices – smart companies like to engage in hedging strategies. Southwest Airlines is well-known for its forward-buying of jet fuel in the early 2000s, a strategy that served it well when oil prices soared, then backfired when they declined. Paul Martyn, vice president of marketing with supplier-management expert BravoSolution, says this is a good moment to be thinking about such a move again.

“It’s an interesting time to be hedging against long-term inflation, and at the same time keeping enough supply flexible in commitment to take advantage of ripe opportunities,” says Martyn. The question, of course, always remains: are we at the peak of this particular pricing trend in critical materials, or is there room for further increases? When it comes to oil, I haven’t heard anyone who believes the price is about to level off, much less drop.

Companies have paid the price of being too cautious in their inventory strategies before. Global demand for coffee fell off sharply in 2008 and 2009, Martyn notes, and suppliers reacted by cutting production. Then bad weather in Asia and Latin America caused a serious shortfall in supply, causing coffee prices to skyrocket. “An aggressive company could have gone in there and taken advantage by building up inventory,” Martyn says. “It would have been a dominant strategy.”

Which way to go now? Martyn says purchasing managers need to align themselves with finance and operations in order to assess the situation properly. Currency valuation is another possible area where hedging might be called for.

Whatever you decide, don’t do it purely for the sake of speculation. The goal of hedging should be to take risk off the table, not increase it, says Jason Busch, managing director of Azul Partners. It’s one thing for Apple Inc. to buy up most of the world’s supply of flash memory or LCD touchscreens for its iPhones and iPads. That’s to ensure that the company has enough capacity to meet demand, while squelching similar efforts by its competition. Or maybe a high-tech manufacturer has a chance to pick up extra supplies of a rare earth metal like tantalum, which is in perpetual short supply. But if all you’re doing is playing the commodities market, “that’s bad,” Busch says. “Speculation is a game for traders, trading companies and investors.”

Hedging also entails some accounting issues. Busch says the purchaser needs to mark an asset at its current value on a quarterly basis, which is fine if the locked-in price remains below market levels. But if the company’s long-term cost begins to exceed the market rate, then the implications on its balance sheet can be severe.

In any case, there’s more than one way to engage in the hedging of commodities. “The most important thing is creating transparency,” says Busch. “It’s critical to understand not only what you’re buying, but what your suppliers are buying as well.”

The answer might be as basic as solidifying long-term relationships with suppliers. Those who make the effort find themselves with access to key materials when stocks are low, says Martyn.

Right now, with commodity prices and consumer demand on the rise once more, the biggest risk for manufacturers is doing nothing. “History has shown that those that walk confidently and firmly are the ones that take advantage of these upswings and can launch their companies into a decade of success,” Martyn says. “Those that sit on the sidelines as prices increase whittle away their advantage.”

Comments

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The prices increase every day. I think that in the feature would be a lot of poor people.

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