Navigating raw material risks: Challenges and opportunities in the automotive industry

Three steps to mitigating price risk for automakers

Automotive companies operate in a highly competitive and volatile industry susceptible to fluctuating input costs. These costs, including raw materials, can significantly impact automotive manufacturers’ profitability and cash flow. There are several tools that an automotive procurement manager or risk manager can use to determine the extent of the risk embedded in production costs. This article will explore why automotive companies may consider hedging their input costs as a risk management strategy and the steps needed to create a risk management process.

Mitigating price volatility

Input costs for electric vehicles (EVs) differ from combustion engine vehicles, due to battery technology, maintenance and repair, residual value and charging infrastructure. While EVs tend to have lower fuel costs and reduced maintenance needs, the upfront cost of purchasing an EV may be higher, mainly attributed to battery technology. These input cost differences may change as the EV market evolves and technological advancements accelerate.

Material costs in the automotive industry, such as steel, aluminum, lithium, cobalt and nickel, are subject to price volatility influenced by global economic factors, market demand, geopolitical issues and other unpredictable forces. By hedging their price risk, automotive companies can protect themselves against sudden price spikes or prolonged periods of elevated costs. This mechanism helps stabilize profit margins and allows for better planning and budgeting.

Ensuring cost predictability

Commodity hedging allows automotive companies to predict their budget more efficiently, which is crucial for long-term strategic planning and decision-making. By locking in prices for essential inputs, auto manufacturers can accurately forecast production costs, set competitive prices for their vehicles, and avoid sudden financial shocks. This plan helps improve business performance and offers a competitive advantage in a dynamic marketplace.

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Get your copy of this special 35-page report that breaks down the complex topic of price risk management, offering insights into the historical and projected volatility of the materials used in the production of automotives, and illuminating their price interplay.

Safeguarding against supply chain disruptions

Global supply chains in the automotive industry are vulnerable to disruptions caused by natural disasters, political conflicts, labor strikes, or unexpected events like the Covid-19 pandemic. By hedging input costs, automotive companies can mitigate the price risk of a supply chain disruption on manufacturing costs. This risk mitigation process can help create a competitive advantage, maintain customer satisfaction and protect revenue streams.

Enhancing profitability and competitiveness

A risk management strategy can give automotive companies a competitive edge by improving their profitability. Effective hedging mechanisms help manage expenses, optimize procurement strategies and stabilize pricing. With controlled input costs, manufacturers can offer competitive prices to consumers, invest in research and development and allocate resources for innovation and product improvement.

Assuring investor confidence

Financial stability is a significant factor for investors when assessing the viability of automotive companies. A robust risk management strategy can demonstrate that a company has taken proactive measures to manage risks and protect its financial position. When management uses a risk management strategy, their efforts can instill confidence in investors, establish credibility and enhance the perception of the company’s ability to navigate uncertainties in the market.

Complying with stakeholder expectations

Automotive companies often face pressure from stakeholders, including investors, customers, suppliers and regulatory bodies, to ensure sustainability and responsible business practices. Hedging input costs can contribute to a more sustainable and accountable approach, as it helps mitigate financial risks, ensures the stability of operations and supports long-term business viability.

How to create a risk management process

There are a few steps to design a risk mitigation plan.

Step one: Risk measurement

Price risk measurement refers to assessing and quantifying the potential volatility or variability in the prices of commodity input costs. It involves analyzing the potential fluctuations in prices and understanding the associated risks.

Various methods and tools are used for price risk measurement, including statistical analysis, historical data analysis and mathematical models. The objective is to estimate the potential losses or gains that may arise from price movements and assess the risk exposure level.

Download our risk measurement analysis to learn more.

Step two: Preparing for action

Once you have measured your input costs risks, you can set up your operations to accommodate your risk management program. You likely need to consider:

  • Legal and regulatory Compliance
  • Capital requirements
  • Technology infrastructure
  • Market access
  • Accounting
  • Operations for settlement, payment, invoicing and confirmations
  • Trading accounts and documentation

Step three: Risk management

Once your risk mitigation operation is set up, you can start considering the appropriate financial products that you should use to hedge your risk exposure. An appropriate strategy would be to match your future physical procurement with financial derivatives that will mitigate the variability of these physical prices. Automakers can use financial derivatives such as exchange-traded futures and options contracts and over-the-counter swaps and options to hedge price risks.

The bottom line

In an industry as complex and competitive as the automotive sector, hedging input costs is a prudent risk management strategy for automobile companies. By mitigating price volatility, ensuring cost predictability, safeguarding against supply chain disruptions and enhancing profitability, input cost hedging provides essential benefits that strengthen automotive manufacturers’ financial stability and resilience. Embracing effective hedging practices helps companies adapt to market changes, improve planning and secure their position in the global automotive industry.

Learn more about price risk management. Get your copy of this special 35-page report that breaks down the complex topic of price risk management for automotive buyers. The report offers insights into the historical and projected volatility of the materials used in the production of automotives and illuminates their price interplay. Get your copy here.

Glossary of price risk management terms used in the report

  • Autoregressive: A statistical model where future values are predicted based on past values.
  • Correlation matrices: A table showing the correlation coefficients between sets of variables, in this case, different commodity prices.
  • Forecast volatility: Historical volatility helps in determining forecast volatility. The method used to forecast is GARCH. The generalized autoregressive conditional heteroskedasticity (GARCH) describes an approach to estimate volatility. GARCH is a statistical model that can be used to analyze and forecast volatility.
  • Futures: Contracts that obligate the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price.
  • Hedge: A strategy used to reduce the risk of adverse price movements in an asset by taking an offsetting position, often through a derivative such as an option or a futures contract.
  • Historic volatility: Historical volatility is calculated using logarithmic returns. Historical volatility = the standard deviations of the logarithmic returns multiplied by the square root of time.
  • Monte Carlo Simulation: A computerized mathematical technique that allows people to account for risk in quantitative analysis and decision-making.
  • Notional value: The total value of a leveraged position’s assets. This term is commonly used in the options, futures, and foreign exchange markets.
  • Options: Financial contracts that provide the right, but not the obligation, to buy or sell an asset at a specified price within a specific time period.
  • Price volatility: The degree to which a commodity’s price varies over time, indicating the level of risk or uncertainty.
  • Probability bands: Forecasted potential price levels based on current volatility.
  • Risk reversal: An options strategy that involves the simultaneous buying of a call option and selling of a put option, or vice versa.
  • Strike price: The set price at which an options contract can be bought or sold when it is exercised.
  • Swaps: Financial agreements that involve the exchange of cash flows or liabilities under predetermined conditions.
  • Value at Risk (VaR): An estimate of the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval.
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