CPOs diversify their risk management toolkit
More businesses are turning to price reporting agencies like Fastmarkets and chief procurement officers (CPOs) are looking for protection against adverse price movements and to identify new buying opportunities
Read an extract from the latest report, which appeared in the Sunday Times supply chains and procurement supplement on Sunday March 19, 2023. The report includes commentary from Fastmarkets senior price development manager, Peter Hannah and risk solutions director, David Becker.
Supply chains have suffered unprecedented disruption in recent years. Brexit, the Covid-19 pandemic, the war in Ukraine and a succession of adverse weather events have caused volatility in the price and availability of commodities and products, including those with little history of scarcity or delay.
Although the intense period of disruption has ended, long-term uncertainty persists due to changes in supply chains. Secular super trends such as the energy transition are also fundamentally altering the nature of many markets, which means there will be no return to the pre-Covid approach to procurement.
This disruption has pushed supply chain management to the top of the business agenda and put a spotlight on the role of chief procurement officers (CPOs). Senior executives are increasingly aware of the need to prioritize investment in and support for procurement in order to protect supply chains and ensure business continuity. The aim is insulating the business from volatility as much as possible, mitigating the impact of rising costs and fulfilling delivery schedules.
Commodity risk management strategies can help to generate a more stable cash flow. That, in turn, can breed greater investor confidence
“CPOs have experienced a huge amount of uncertainty over recent years,” says David Becker, director of the risk solutions practice at cross-commodity price reporting agency Fastmarkets. “Markets have become unpredictable. Prices have whipsawed and input prices have risen well beyond what can be passed on to customers. There has been a growing shift in the methodology needed to do business in the current market environment.”
Fastmarkets has seen how markets in commodities and energy that were relatively stable or slow-moving in the past have become more volatile and now require active management. Peter Hannah, senior price development manager at Fastmarkets, says the markets for the materials used in batteries exemplify the changes that have taken place.
“For example, lithium prices could once be negotiated between a buyer and seller and fixed for up to a year,” says Hannah. “Everyone had more certainty. Now procurement teams have to manage market-orientated pricing mechanisms, which have become necessary to match up supply with demand.”
This is all being driven by secular trends. The global energy balance is shifting away from fossil fuels, toward renewable energy and electrification. Demand for clean energy means that commodities such as lithium, copper and sustainable aviation fuel have a big role to play in the energy transition. The growth of the electric vehicle sector in particular has increased the size and global significance of the market, as well as its volatility. The price gyrations of recent years have required a more dynamic contracting approach, and most supply agreements have evolved to reference spot indices.
“But with that you’re much more exposed to the volatility of the market,” says Hannah. “Fortunately, with this challenge also comes a more effective solution. Exchanges have launched futures contracts for battery materials such as lithium and cobalt, which cash-settle on the basis of the Fastmarkets indices for those products. These financial instruments allow market participants the option to independently lock in future prices, hedging as much or as little exposure as required.
“We see this becoming the norm in many of our markets as they develop,” he continues. “Risk management in less mature markets tends to be more geared around counterparty relationships and sharing the risk burden. Then, as markets mature and become trickier to navigate, the toolkit for doing so often becomes more sophisticated accordingly. This has already played out across bulk materials such as iron ore, and is well under way in battery materials, forest products and biofuel feedstocks.”
Fastmarkets provides access to price data that shows the market-reflective value of each battery material, together with short- and long-term forecasts that give supply/demand balances and help businesses navigate market volatility. For instance, Fastmarkets’ Battery Cost Index gives in-depth insights into the cost of lithium-ion cell components, and a suite of risk management tools helps reduce exposure to price volatility.
The risk management toolkit has recently become much more sophisticated, according to Becker and Hannah. By deploying appropriate risk management tools, including derivatives, CPOs can hedge exposure to future price volatility and protect profit margins. This increases the certainty of cost budgeting and cash flows; improves procurement, planning and inventory requirements; and mitigates counterparty risk.
Evidence of effective risk management also helps to secure financing for new projects or developments. Price reporting agencies such as Fastmarkets can be valuable sources of pricing data, forecasts and market analyses, giving businesses a strategic advantage in complex, volatile and often opaque markets. Commodity markets served by Fastmarkets are critical to the transition to a low-carbon economy, including new generation energy, agriculture, forest products and metals and mining. Access to up-to-the-minute market information, together with market intelligence, helps companies manage their supply chains, while also promoting healthier commodity markets.
“It is positive for CPOs to have access to market information, including spot prices and forecasts,” says Hannah. “But there can always be black swan events or things that you don’t see coming. So, the key thing for CPOs is to have risk management strategies in place.”
Fundamentally, Fastmarkets’ products help businesses understand risks. These may certainly include price risks, but they also likely incorporate counterparty, geopolitical, technological and ESG risks too, to name but a few. Understanding these risks at a granular level is the key to addressing them.
And the insights don’t stop there. Fastmarkets’ products and services can also provide CPOs with risk management pointers, particularly regarding strategies to diversify their sourcing, make their contract structuring more flexible, and use derivative instruments where available.
Becker explains that when carried out effectively, commodity risk management strategies can help to generate a more stable cash flow. That, in turn, can breed greater investor confidence
The value of the business could even increase since investors will enjoy more consistent returns. And effective risk management can also encourage banks to lend more money to grow the business.
These practices used to be the domain of large organisations with substantial resources. But this is changing, given the increased complexity of markets and the development of innovative, effective tools. “It is now possible for smaller organisations to leverage the market information and insight to their advantage,” says Becker. “In many ways, this is even more important for them given the concentrated nature of their business.”