Since the turn of the century, they have experienced the wrath of volatile price fluctuations (mainly price up) in their commodity markets. The Holy Grail in procurement is to achieve a position in the firm where its function is no longer justifying its existence and focusing on an internal sales job. This goal is made a lot harder to achieve when procurement must defend why costs exceed expectations. I can only imagine how many CPOs have been hauled into boardrooms to explain the reasons why their budgets are in tatters. That’s why I want to talk today about risk management. Because of these challenges, risk management is a topic that has helped raise procurement’s profile.

Commodity markets became newsworthy in the 1970s when oil and many other commodities shot up in price due to perceived supply shortages. This volatility caused havoc with many P&L accounts and balance sheets and acted as the burning platform for organizations to explore hedging – one of the tools used to manage risk. Commodity markets settled down in the 1980s & 1990s as monetary authorities grappled with the inflationary effects that rising commodity prices brought. Gradually, commodity markets became benign, and we were lulled into a false sense of security. I was a Purchasing Director during this time, and it was a salutary lesson in experiencing the challenges this role holds for most people; it is hard to win either way!

Commodity prices are inherently unpredictable because many factors have an impact on them. However, many CPOs’ and commodity managers’ careers are closely tied to what happens to these prices during their time on watch. Many organizations view them as their price predictors and expect them to correctly anticipate the market. Why employ them if they can’t do that? Wrong. Fact: Because markets are unpredictable, risk management is a business responsibility that involves procurement, finance, supply chain, marketing and the executive. This requires a (price-management) strategy and a process to support that strategy. The commodity manager’s job is to apply the appropriate policies, and he or she shouldn’t be measured the predicted direction of the market.

So, having come to the rescue of the hapless commodity manager, what to do? The advent and explosive growth of derivatives to help manage complex risks has provided commodity-users with a means to hedge. However, like insurance, you must pay a premium to hedge; it’s not a free one-way bet. And, what’s more, is there a “to hedge or not to hedge” question, or should one always hedge?

Commodity managers can use physical supplies (inventory) or derivatives (futures, options, swaps) to protect themselves from adverse changes in prices and/or supply interruptions. But here’s the conundrum where the commodity manager uses both physical supplies and derivatives to manage price risk. In a bear market (price down), the commodity manager will always be able to buy at a better price than he or she did last time around. This means physical supplies are likely to cost less than budget – good news. However, if he or she has been using derivatives to purchase forward, the derivatives account will likely show losses. If the executive and other departments have an incomplete understanding of why this happens, they will put the commodity manager’s back to the wall. Conversely, a commodity manager grappling with a bull market (price up) may be asked to explain why physical supply costs were over budget while he or she comes to the rescue with profits in the derivatives account.

Procurement “errors” affect market capitalization, competitiveness and the well-thought out plans for the business. Price risk can affect any of the aforementioned as well. It is therefore imperative for organizations to have a clearly articulated and well-defined plan for (price) risk management.

Part 2 of this blog will explain what companies should consider when developing their hedging strategies.