Chemical companies can improve risk management to deal with wild cards

16 November 2010 21:03  [Source: ICB]

Successful companies are improving their risk management capabilities to address supply threats posed by unforeseen risks

When Hurricane Katrina lashed the US Gulf Coast in August 2005, the devastation included the supply chains of thousands of companies that relied on petrochemical products with raw-material sources concentrated in that area.

Katrina shut down, for example, the production of 7% of the world's ethylene production, 5% of propylene, 9% of benzene and xylene, and 12% of paraxylene (PX). Many companies suddenly faced supply issues, including escalating prices and major shortages.

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In the ensuing five years, additional examples have demonstrated the profoundly disruptive impacts of similarly unpredictable "wild-card" risks: suddenly reduced market demand, volatility in raw material prices, currency devaluation crises, increases in regulatory activity, oil spills and volcanic eruptions.

These events have also demonstrated that many corporate entities perform poorly at managing such risks. The reasons are not scandalous. Human nature tends to be reactive (learning how to address a problem that has already occurred) rather than proactive (planning for the next problem). The human mind in fact has well-documented flaws in assessing risks and probabilities. And many companies lack a "risk owner" or even language or processes to systematically assess or plan for risks.

But in an increasingly globalized and interconnected world, the importance of risk management is growing. As innovation increases, supply chains lengthen, and product portfolios become more complex, they are met by greater macroeconomic and geopolitical risks. Tomorrow's successful companies will be the ones that excel at proactive risk management.

The chemical and related industries can, however, use a number of sound approaches to the management of risks such as supply discontinuity and price volatility associated with the things you buy.

IMPROVING RISK MANAGEMENT
The risk management capability for a given company can be characterized by one of four stages:

1. Risk response ("efficient firefighting"): plan to react quickly and effectively in mitigating risks once they occur.

2. Insurance and compliance: seek to transfer risk exposure through insurance and mitigate through limited monitoring.

3. Core risk management: centrally monitor, assess, quantify, prioritize, and plan for risk.

4. Risk return optimization: define tolerance levels, quantify risk, and risk-adjusted allocation of resources and investments.

Most chemical (and consumer) companies are at stage 1 or 2 overall, with limited systematic processes or governance structures to manage risk. However, most do have stronger capabilities focused on a handful of materials that are internally recognized as having high spend levels or enabling high product revenues.

In contrast, many agricultural processing companies have stage 4 capabilities to manage input commodity price risk because risks regarding harvest yields, logistics availability, and price volatility are an everyday part of their business operations.

Examples of effective risk management generally fall into three categories: planning for risk, taking control of commodity risks, and mitigating potential supply disruptions.

RISK ASSESSMENT AND PLANNING
You may be familiar with the financial risk assessments that many companies undertook in the aftermath of the global economic slowdown - for example, how to function in a ­liquidity crunch.

While this is helpful, wild-card risks are not limited to the financial realm. Successful companies are taking a more comprehensive approach to performing top-down assessments and prioritization of supply risks - ­either broadly, or more narrowly focused on a given set of materials or events.

Such efforts first assess risk exposure, which is the probability of an event occurring multiplied by its potential impact on the business. For high-exposure events or materials, companies can then seek to thoroughly understand the exposure and develop risk mitigation action plans using seven possible tactics:

1. Avoid: eliminate the possibility of an event.

2. Transfer: shift risks to a third party.

3. Mitigate: reduce the impact of an event.

4. Minimize: reduce the probability of an event occurring.

5. Respond: reduce the impact after an event occurs.

6. Monitor: continuously scan the environment and trigger certain actions if predefined thresholds are exceeded.

7. Accept: bear the full risk exposure.

For example, the vice president of procurement of a major global company studied its operations and realized that many of its products depended on three specific priority raw materials. The materials had long, complex, and vulnerable supply chains for which the company had no transparency upstream, ­beyond its current suppliers.

Taking action, the vice president commissioned supply market research on the materials and deployed a cross-functional team (with membership from the primary business, procurement, supply chain, quality, legal, and finance), to conduct workshops to systematically identify and prioritize risks. Once the priority risk events were identified, the team developed and carried out mitigation plans for each material that included researching alternative suppliers, diversifying the region of origin, altering product specifications, and changing the sequence and content of planned supplier audits.

TAKING CONTROL OF COMMODITY RISK
One of the primary supply risks that planning efforts often identify is commodity price volatility. To take control of this risk, leading companies thoroughly analyze the pricing dynamics and supply and demand drivers for their high-spend materials.

In an increasingly globalized and interconnected world, the importance of risk management is growing

One such analytical approach uses a commodity fingerprint to inform mitigation actions. The commodity fingerprint framework evaluates the supply market environment for both the purchased commodity material and all its raw materials, for current conditions and short-, medium- and long-term outlooks.

In each case, the framework evaluates market conditions against the critical operating rate for the commodity - the point beyond which the short-run marginal cost to produce another unit of output rises drastically.

The results of the analysis provide a richer and more actionable view than simply asking if a market is "long" (well-supplied) or "tight" (undersupplied) and what the expected trend is.

Common mitigating actions include changing the "deal structure" for the purchased material to change: 1) the spot versus contracted volume ratio; 2) the portfolio of contract expiration dates; and 3) the pricing mechanism (fixed versus indexed versus indexed through a "cost plus" formula mechanism).

For example, a major chemical company seeking to manage a methanol purchase of nearly $100m (€74m) created a three-year forecast of methanol supply/demand levels and industry operating rates.

With this insight, the company structured multiyear supply agreements with its suppliers that expired at precisely the time its forecasts predicted the market would be soft. In this instance, the prediction was accurate, and the company was able to re-bid and re-contract its methanol requirements for the next several years at very favorable pricing levels relative to the market.

MITIGATING SUPPLY DISRUPTIONS
The other key area of supply risk management is exemplified by the Katrina example: sometimes essential supplies are unavailable at any price. Awareness of such risks is growing.

To quantify the impact of a shortage, it's important to focus not on the amount of spend for a given raw material, but rather the amount of revenue and margin that the raw material enables in the product portfolio

For example, recently, Armajaro, a UK-based hedge fund, purchased 7% of the world's annual cocoa bean production, believing that production would soon crater. If hedge funds are making such big bets on potential supply disruptions, shouldn't industrial companies pause to consider which raw materials could face risks similar to cocoa?

Several examples of material shortages throughout chemical supply chains arose from capacity reductions last year, including butadiene (BD), propylene, and acrylic monomers.

One interesting example is styrene. When the economy slowed down drastically in late 2008, low prevailing prices in a long styrene market caused several producers to take capacity off line, some permanently. In the first half of 2009, the market became tight, catching some buyers short. Their understanding of their risk exposure, though "forward looking," was not sufficiently sophisticated.

The key to managing supply disruption risks is developing a full understanding of both probability and impact. Understanding probability requires two perspectives:

The material perspective, including its value chain, regulatory environment, and ­vulnerabilities (for example, weather).

The supplier perspective, including a ­supplier's operational performance, quality performance, financial viability, and other factors.

For example, if companies had performed detailed analyses from the supplier pers­pective, and understood the potential economic incentive for producers to remove capacity, they could have better predicted the styrene shortage.

EFFECTIVE RISK MANAGEMENT
Meanwhile, to quantify the impact of a shortage, it is important to focus not on the amount of spend for a given raw material, but rather on the amount of revenue and margin that the raw material enables in the product portfolio.

Surveying these and other examples suggests a list of guiding principles that can lay the foundation of effective risk management:

1. Develop a big-picture view of risk ­exposure across the enterprise and supply base, and focus activities on the most important exposures.

2. Establish a language system to discuss and categorize risks (for example, definitions and frameworks to assess probabilities and impacts of risk events).

3. Define a clear governance structure (that is, clear accountability) that works across functions.

4. Over time, embed a risk-management ­culture in the organization.

5. Keep it simple and understandable.

Finally, it is important to keep risk in perspective. In the Chinese language, "risk" is represented by two characters: the first means "danger" and the second "opportunity."

As a consequence, pure risk avoidance is rarely the right behavior, because it constricts opportunities.

Instead, companies need to develop ­thresholds for acceptable risk tolerance levels that will control downside risk while maintaining upside potential. In this way, investing in risk-management capabilities not only improves performance by avoiding danger, but also identifies and enables new opportunities for growth.

GAUGING RISK MANAGEMENT PRACTICES
To gauge whether your company is well-positioned to manage and respond to risks, you may want to consider the following questions:

People
Who in the organization is responsible for managing risk?

What forums and governance processes are in place to facilitate cross-functional risk ­decision-making?

Does risk management receive the appropriate management attention?

Processes
What processes are in place to monitor, assess, prioritize, and plan for risks?

Do you know what your key risks are? What is their impact and how likely are they to occur?

What is your risk tolerance? Are you a risk taker? Does risk management hold you back from pursuing market opportunities?

Systems
What systems are in place to monitor and manage risk?

What risk metrics are in place? Do they give you the full picture of your exposure, across the most relevant risk types?

Kish Khemani is a partner with A.T. Kearney and is based in Chicago, Illinois, US. He can be reached at kish.khemani@atkearney.com.

Andrew Walberer is a principal with A.T. Kearney and is also based in Chicago. He can be reached at andrew.walberer@atkearney.com

Oliver Zeranski is a consultant with A.T. Kearney and can be reached at oliver.zeranski@atkearney.com.

Author: Kish Khemani Andrew Walberer and Oliver Zeranski

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