A five-part strategy to defeat price volatility

13 February 2012 00:00  [Source: ICB]

Price volatility, short- and long-term, is here to stay, and chemical companies must find ways to protect their profitability

If the uncertainty of the recession and the generally weak recovery were not enough to stop short even the most optimistic chemical company executive, recent price volatility in the sector surely is. More than anything else, sharp shifts in chemical prices have seriously impacted the profitability and share performance of some of the top chemical firms during the past few years - and it is likely that this trend will continue until 2015, if not longer.

Copyright: Martin Abegglen

These challenges are not isolated to ­specific segments of the chemical industry but, rather, are reflected across the board, affecting feedstocks, precursors and polymers throughout the value chain. And, importantly, are influenced by short- and long-term volatility drivers.

The more cyclical, short-term forces ­include imbalanced supply and demand markets, the result of, among other things, underinvestment by European companies in chemical capacity because of market uncertainty and, simultaneously, the failure to anticipate the recent rapid growth of Asian ­orders; lower than usual supply chain ­inventory levels, due to the recession; and growing numbers of more volatile spot market trades, particularly in Asia, where supply and demand is robust and mutable. These spot trades, and the easing of trade restrictions, are positioning countries such as China and India as global price setters.

Such short-term cyclical issues would ­perhaps be less troublesome if they were not combined with long-term, structural volatility drivers, which indicate that the chemicals industry may be going through a more ­permanent and disruptive transformation.

On the long-term side, there have been ­fundamental changes in the marginal cost of producing chemical raw materials as a consequence of shifts in underlying feedstock costs. This trend is manifested best by the decoupling of oil and natural gas prices, which in turn has created a widening gap between the price of oil-derived propylene on the high end and lower-priced ethylene, a by-product of natural gas cracking (see ­diagrams below).

In addition, several chemical commodities are moving towards monthly and even weekly price cycles, quite a bit shorter than the traditional quarterly to half-year cycles. This array of pricing problems is a two-pronged threat: on the one hand, they require immediate attention because they are significantly affecting the profitability of chemical companies, and on the other hand they could potentially alter the make-up of the chemical industry for many years. Consequently, chemical companies cannot attempt to address these systemic challenges by merely foisting the problem on procurement, asking that function to anticipate and mitigate price volatility that is so deep-seated, intractable and consequential.

With such a shortsighted approach, companies may fix individual price risk exposures but fail to address all of them comprehensively and fail to minimize the emergence of new volatility risks.

Indeed, to design a pathway to stable and sustainable profitability in the face of volatile prices, companies must develop a holistic strategy that involves identifying key sources of price risk exposure in the entire value chain. This can only be done with a cross-functional EBIT (earnings before interest and tax) protection program that assesses the criticality of individual raw materials and the likelihood of price volatility across a number of facets - including supply-and-demand balance, speed of innovation, supplier dependency and annual sales exposure.

Based on the results of these metrics, a set of pragmatic strategies to protect the most essential raw materials from exposure to price volatility can be designed. In our experience, the five most effective volatility mitigation strategies are as described below.

RE-EXAMINE SUPPLIER CONTRACTS
One of the key levers to manage price ­volatility is to review supply agreements with an eye toward minimizing vulnerability in the contract and the spot markets, and toward sharing price risk with the suppliers. In general, when the market for specific raw materials is expected to be "long" - that is, supply outpaces demand by more than 5-7% - it is wise to increase spot exposure to as much as 40% in annual volume needs.

By contrast, when the market is likely to be short, an astute buyer would significantly decrease annual spot exposure to 5-10% of yearly requirements. The smartest chemicals firms have implemented sophisticated market intelligence tools that provide an accurate and insightful assessment of supply-demand dynamics that incorporate import-export inter-flows - and they use this data to adjust their spot market exposure more rapidly than competitors.

Equally important is to design pricing ­agreements that evenly allocate price risk exposure to suppliers. While it is tempting to press for contracted prices that push most of the risk on to suppliers, that strategy could backfire even when it is successful. In the long run, it may result in damage to the supply chain as suppliers either exit the market, victims of being forced to sell pricy materials at a discount, or insist on indexing prices to raw materials in future contracts, moving more risk to the purchaser.

A good approach to share risk and benefits fairly between the seller and buyer is collar pricing (or price escalators).

In this model, the supplier agrees to ­provide chemicals at a quarterly negotiated price as long as the cost of key inputs remains within a predetermined range - say 5-10% of the ­quoted price at the time the contract is ­initially negotiated. If the price of the ­materials rises above or falls below that range, the contract is ­renegotiated. An effective supply contracts management strategy increases ­margin ­protection potential by 40-70%, ­thereby significantly reducing overall price volatility exposure.

RE-EVALUATE SALES CONTRACTS
Fixed long-term price contracts with ­customers, especially one-year and longer, can generate substantial losses if raw materials costs rise during that time (particularly when supplier agreements are renegotiated on a monthly or quarterly basis). To protect against this possibility, chemical companies need to consider ways to pass on at least some of the potential cost volatility to customers. One approach is cost indexing, in which end-user prices rise or fall based on changes in ­underlying key raw materials costs.

This is not to say that fixed pricing does not have its place. It can be useful in specialty products, such as expensive inks, to protect high margins. But in low-margin commodities markets, where volatile raw materials prices have a big effect on EBIT, cost indexing is a perfect solution. A downside of cost indexing is that it gives the customer a window into the manufacturer's cost structure, potentially giving the buyer a strategic advantage during contract ­negotiations. To avoid this, link prices to consumer price indices rather than actual supplier agreements. Sales contract optimization potentially increases margin protection by 60-80%, thereby significantly reducing overall price volatility exposure.

MAKE IT YOURSELF
By manufacturing at least a portion of the raw material instead of buying it, a chemical company can avoid some of the price risks in supplier contracts. While this strategy does not necessarily ensure cost savings - in fact, a four-year study showed no financial benefit to manufacturing specific polymers in-house over using a third party supplier - there are other potential advantages related to smoothing price volatility. For one thing, this approach ensures a continual supply of the material at a reasonably stable price, which may be otherwise at risk if a natural disaster, act of terrorism or political upheaval occurs in countries where suppliers are located.

In-house manufacturing can also prevent disclosures of trade secrets related to the production and application of feedstocks, stymieing competitors from making the end product and forestalling commoditization and reduced profits. Moreover, by controlling the manufacturing of some raw materials, companies can protect the quality and integrity of these feedstocks.

But perhaps best of all, in-house ­manufacturing can provide a laboratory for product developers and purchasing ­executives to better evaluate the impact of new and impending technologies on prices as well as understand the costs associated with specific raw materials. This provides critical intelligence for developing sourcing strategies and negotiating contracts with suppliers and end users.

For example, in mid-2008, the cost of corn rose to $9 (€6.87) a bushel. Chemical companies that understood the process of growing corn knew that the structural costs of corn production would only justify a price of $3.50 per bushel. That meant that the higher price was likely the result of speculation and would be short-lived. Indeed, by the end of 2008 prices had dropped to about $3 per bushel.

FIND ALTERNATIVE BUILDINGS BLOCKS
To mitigate price volatility resulting from ­fluctuations in underlying feedstock, developing alternative chemical building blocks is a good long-term option. Of course, this may require significant research and development (R&D) expenditures, which is not a particularly attractive avenue for a chemical that has been successfully manufactured for years using well-established materials and methods. But for products experiencing severe price fluctuations, the additional R&D costs may be justified and necessary. To illustrate, consider the ­possibility of developing ­epichlorohydrin (ECH) from glycerin instead of propylene, its typical feedstock. Over the past half dozen years or so, prices for glycerin have been less volatile than propylene; hence, glycerine-based ECH could carry lower cost-risk exposure than propylene-derived (see diagram top left).

Rather than entirely substituting one ­alternative feedstock for another - and create a new price risk exposure to the new material - chemical companies should gradually and carefully diversify from dominant feedstocks. A good rule of thumb is to initially start by using alternative raw materials for 5-20% of volume requirements.

IMPLEMENT FINANCIAL HEDGING
When price volatility risk persists, companies can often mitigate "residual risk" through direct hedging on the underlying commodity - for example, by purchasing futures or calls that give the chemicals firm the option of purchasing the raw material at current prices well into the future (see remaining diagrams). Although a bit more risky and complex than feedstock calls, in some circumstances indirect hedging is a good option. This involves purchasing a contract on a related or co-related product - for example, ­buying corn oil calls instead of ­options on corn.

It is important to recognize the distinction ­between hedging against risks and speculation. Hedging is when price risk in the physical commodity market is offset with a corresponding transaction in the commodity's derivatives market; speculation does not offset risk. Companies that opt for a direct hedging strategy must decide about a number of major elements:

• Hedge ratio: What volume requirements should be hedged? Typically, 80% of total raw material volume requirements are hedged by taking futures positions or forward buying;
• Forward coverage: What forward horizon should be considered for hedging? In general, the hedging horizon is driven by the length of the sales contract for the raw materials;
• Market view: To what extent does the ­company use market insight to guide ­purchasing decisions?

Nothing is guaranteed in life or taxes, of course - and certainly not in EBIT. But one thing is next to certain: price volatility in the chemicals industry will remain for a long time and have an outsized effect on the sector.

Nimbly negotiating this difficult course and protecting company performance will not be easy. But ignoring the problem is not an option any longer. Implementing this five-step strategy is a good sign that your company is taking price volatility seriously.

Amit Gautam is a principal in US-based consultancy Booz & Company's Amsterdam office in the Netherlands

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