Managing Commodity Price and Supply Risk

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

Assistant Professor Michigan State University zsidisin@msu.edu

George A. Zsidisin, Ph.D., 2005

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

Purchase Price Increases

Market/ Industry

Suppliers

Supply Interruptions

Geopolitical Environment

Revenue Reduction

PROFIT EROSION

Customers

Product Liability

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
Ethane Propane Butane

Crude Oil
Naptha
Ethylene Propylene

Ammonia Electricity

Distillate Diesel
PP

Urea

Ammonium Sulfate

HDPE

LLDPE

Bottles

Bags

Durables

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

Useful Links:
Globe Smart Executive Planet

Geography Specific:
Asia Europe Middle East South America

Economic Indicators: Economist, WTO, World Bank CIA Fact Book, OANDA

Framework for Commodity Risk Management

Price Increase Imminent
Yes

Substitute Available
No

Yes

Use Substitute

Pass/Share with Customer

No

Yes

Contractual Clause Or Pass On

Pass/Share with Supplier

No

Yes

No

Inventory Carrying Cost

High

Low

Economical to Buy Ahead

Do Nothing

Dollar Size of Purchase

High

Low

Yes

Forward Buy

(Slide continued on next page)

Framework for Commodity Risk Management

(Slide continued)

Yes

Direct Market Exists

No Yes

Acquire Futures/Options

Substitute Market Exists

No

Acquire Surrogate Futures/Options

Live With It

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 Surcharge
(Sep - Dec 01)

$1.50 $2.3 million $6.2 million

$2.00 $4.9 million $13.2 million

$0 $0

Surcharge
(Annualized)

National Average Diesel 1994-2001 Long Term Trends

N A T IO N A L A V E R A G E P R IC E O F D IE S E L F U E L

$ 1 .7 0 0

$ 1 .6 0 0

$ 1 .5 0 0

$ 1 .4 0 0

$ 1 .3 0 0

$ 1 .2 0 0

$ 1 .1 0 0

$ 1 .0 0 0

$ 0 .9 0 0

11/27/95

12/16/96

10/20/97

11/29/99

12/18/00

3/21/94

8/22/94

11/7/94

1/23/95

4/10/95

6/26/95

9/11/95

2/12/96

4/29/96

7/15/96

9/30/96

5/19/97

3/23/98

8/24/98

11/9/98

1/25/99

4/12/99

6/28/99

9/13/99

2/14/00

7/17/00

10/2/00

U S N o 2 D ie s e l R e t a il S a le s b y A ll S e lle rs ($ / g a l)

5/21/01

$ 0 .8 0 0

6/6/94

3/3/97

8/4/97

1/5/98

6/8/98

5/1/00

3/5/01

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

H E A T IN G O IL to D IE S E L 5+ YEARS of DAT A
$ 1 .8 0 0 y = 0 .9 9 2 1 x + 0 .6 4 5 9 R $ 1 .7 0 0
2

= 0 .9 4 2 5

$ 1 .6 0 0

$ 1 .5 0 0

$ 1 .4 0 0

$ 1 .3 0 0

$ 1 .2 0 0

$ 1 .1 0 0

$ 1 .0 0 0

$ 0 .9 0 0

$ 0 .8 0 0 $$ 0 .2 0 $ 0 .4 0 D ie s e l P u m p ($ / g a l) $ 0 .6 0 $ 0 .8 0 L in e a r (D ie s e l P u m p ($ / g a l)) $ 1 .0 0 $ 1 .2 0

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

$400 $300 $200 $100 $$(100) $(200) $(300) $(400) $(500) Futures Activity $ pd Truckers Net Expense JAN $198 $100 $298 FEB 181 100 281 MAR (130) 120 (10) APR (93) 160 67 MAY (114) 140 26 JUN (107) 240 133 JUL (138) 205 67 AUG (198) 150 (48) SEPT (409) 205 (204) OCT (380) 340 (40) NOV (123) 314 191 DEC (373) 314 (59) YTD $(1,686) $2,388 $702

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

Awareness
Internal External

Prevention
Identification Assessment Treatment Monitoring

Remediation
Plan how to minimize: Impact Duration Resources Execution

Knowledge Management
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?