© George A. Zsidisin, Ph.D., 2005

Managing Commodity Price and Supply Risk

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

Michigan State Universityzsidisin@msu.edu

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?