Triple Point will join CPOs from Barilla and Chesapeake Packaging on a webinar panel on April 18th, to discuss commodity risk and potential solutions. For more details, click here.
Did you see the recent headline: Samoa Air to price tickets by passenger weight? All fat jokes aside, the underlying logic for the pricing change is so Samoa Air can find the best way to manage jet fuel costs. Each pound shed from a plane saves the company 14,000 gallons of fuel each year. At roughly $3.03 per gallon, that’s $42,400 per year that drops to the bottom line for every one pound reduction.
Analysts have been bifurcated in their opinions of Samoa Air’s new pricing scheme with some thinking it’s a brilliant idea and others that believe it can’t work. I’ll leave it to the pundits to debate the pros and cons of the best way to price airline tickets. But the concept of finding new ways to manage commodity risk is not at all surprising. Managing commodity input costs is the next major challenge for many organizations.
It’s not just airlines that have the daunting task of managing commodity input costs such as fuel. Faced with fundamental changes in the commodities and energy market environment, most manufacturers, including beverage, food, CP, chemical, and industrial, are wrestling with the best approach to protect margins from volatile and rising commodity costs. The risk runs a wide gamut of costs including energy to run plants and distribution fleets, raw materials that are inputs to products, and packaging for finished goods (e.g. aluminum, cardboard). Commodity costs are a major percentage, and the most volatile, of a manufacturer’s spend.
To preserve margins, manufacturers must move quickly to approach commodity procurement differently and more proactively than ever before. While not traditionally viewed as commodity trading organizations, manufacturers can learn from leading commodity trading houses and adopt new processes, tools, and measurements required to optimize raw material acquisition while ensuring compliance with new regulatory demands.
It’s shocking, but I still find many companies that manage commodity risk in spreadsheets. Today’s complex and volatile markets require Procurement to use sophisticated software tools such as Commodity XL™ from Triple Point to not only ensure coverage, stay within budget, and deliver the material when manufacturing needs it, but also to analyze commodity risk and perform scenario analysis. The new benchmark for procurement organizations is how well spend is managed relative to market prices and competitors, not just how well the budget is managed.
As I said, Commodity Management is the next big thing…
Just a few years back, there were many articles discussing “Peak Oil” and whether the world had already passed the peak. A typical headline was one in Fortune Magazine in 2008 with a headline predicting a dramatic increase in oil prices – “Here comes $500 oil.”
At the recent HIS CERA Week, it was reported that “Peak Oil” was already a distant thought for most presenters, and that much of the talk was about growth in natural gas and oil from unconventional shale resources in the U.S.
According to the U.S. Energy Information Administration (EIA), crude oil production in the U.S. exceeded an average seven million barrels per day (bbl/d) in November and December of 2012, the highest volume since December 1992.
The International Energy Agency (IEA) predicts that the United States will overtake Saudi Arabia and Russia to become the world’s leading oil producer by 2017.
The WSJ MarketBeat Blog notes we are only at the beginning. “U.S. tinkerers discovered a way to extract oil and gas from shale, the source rock for oil and gas that was previously deemed uneconomical. That has boosted U.S. production to levels not seen in two decades, and that’s only the beginning: shale recovery factors could improve, and vast shale formations in Argentina, China, Russia and other countries are yet to be tapped. If technology ever allows the industry to recover 70% of oil from conventional reservoirs and to double or triple the current recovery rate from unconventional resources, the world could almost quadruple the reserves of global liquids.”
In addition, Iraq passed a critical milestone last year by producing three million barrels a day of crude oil for the first time since before the Persian Gulf War, reaching a high of 3.4 million bbl/d in December. Given its access to vast reserves at low costs, Iraq could play a significant role in the growth of energy supply. Of course, in Iraq there is much geopolitical risk attached to supply.
Even with increased production, there was still not enough oil to meet demand in the beginning of 2013. The EIA estimates a 1.3 million bbl/d average draw-down in global oil stocks for January and February.
There are numerous uncertainties as we move forward including the rate of technology advancements, geopolitical risk in many energy rich nations, growth in demand as the world continues its economic recovery, etc. Perhaps the only certainty is continued volatility and the need for oil trading risk management software to manage the volatility.
As Jim Rogers, Chairman, President, and CEO of Duke Energy has been known to express in speeches, “Ben Franklin said there are two certainties in life: death and taxes. To that, I would add the price volatility of natural gas.”
The future of energy is going to be quite interesting!
The energy industry and its associated supply chains are fast-changing and very complex. Just a few years back, several companies built LNG import terminals to meet the energy needs of the U.S.
According to a NY Times article “the billion-dollar terminals were obsolete even before the concrete was dry as an unexpected drilling boom in new shale fields from Pennsylvania to Texas produced a glut of cheap domestic natural gas. Now, the same companies that had such high hopes for imports are proposing to salvage those white elephants by spending billions more to convert them into terminals to export some of the nation’s extra gas to Asia and Europe, where gas is roughly triple the American price.”
Currently there are 25 LNG-importing countries in Europe, Asia, South America, Central America, North America and the Middle East, up from 17 importing countries in 2007.
Cheniere’s Sabine Pass LNG Terminal in Louisiana was the first to receive approval to export LNG. According to Steven Chu, the U.S. Energy Secretary, “Our long term economic strength depends on safely and responsibly harnessing America’s domestic energy resources while developing new and innovative clean energy technologies. This project reflects a broad, ‘all of the above’ approach that will put Americans to work producing the energy the world needs.”
The open question is whether this a good investment, or is the market changing so rapidly that the investment in LNG export terminals will also be obsolete before the terminals are fully functional? The same NY Times article mentions, “countries around the world are importing drilling expertise and equipment in hopes of cracking open their own gas reserves through the same techniques of hydraulic fracturing and horizontal drilling that unleashed shale gas production in the United States. Demand for American gas — which would be shipped in a condensed form called liquefied natural gas, or LNG — could easily taper off by the time the new export terminals really get going, some energy specialists say.”
Whether it’s Crude, LNG, Natural Gas, Power, Biofuels or other energy commodities, the common denominator is volatility and complex supply chains. The combination of volatility and complexity is the reason Triple Point’s ETRM (energy trading and risk management) software has been in great demand over the last five years. Energy companies that have not invested in sophisticated ETRM software have put their businesses at a competitive disadvantage.
The US Midwest is suffering its worst drought in decades. The US Department of Agriculture (USDA) recently dropped its corn yield forecast from 166 bushels per acre, made earlier this year, to 123 bushels per acre. The expected shortage of corn is causing prices to surge.
Corn has multiple uses – it is used as fuel (ethanol), animal feed, or directly as food. Roughly 40% of US corn production goes towards ethanol, 36% towards feed, and the rest towards food.
There are several concerned groups that believe the Environmental Protection Agency (EPA) should relax the ethanol requirement under the Federal Renewable Fuels Standard act, which states that there must be 13.2 billion gallons of corn starch-derived biofuel produced in 2012. The UN has called for an immediate suspension of the US-mandated use of ethanol. In addition, a coalition of beef, pork, and poultry producer associations have called for a cessation of the ethanol requirement.
Whether the EPA will ease the ethanol requirement is not the most important question – the real question is how do we plan to deal with rising agricultural commodity prices and volatility in the long term? The corn shortage might be a one season event, but volatile agriculture and softs prices are here for the long term.
We have an expanding world population that is forecasted to grow from 7 billion to 10 billion in the next 35+ years. As part of this population growth, there is a rapidly growing middle class across China, India, and other parts of Asia. China and India alone are doubling their per capita incomes at approximately 10 times the rate and 200 times the scale achieved by Britain’s Industrial Revolution in the 1800s. This growing middle class wants to eat higher on the protein scale (more meat which needs more animal feed). And it appears we’ve hit a pattern of severe weather events including droughts, floods, extreme temperatures, etc. These long term trends will drive acute commodity price swings – which is, as we’ve said before, the new normal.
All companies in the food supply chain, from upstream to downstream, should be putting plans and commodity risk management systems in place to handle price volatility.
There have been several recent announcements from Delta Airlines related to jet fuel and oil trading.
According to Reuters, Delta Air Lines Inc. reported a second quarter loss because it took $561 million in charges for fuel hedges. Part of the loss was taken for mark-to-market adjustments on open hedge contracts.
It appears that Delta has chosen not to apply FAS commodity hedge accounting treatment. Many of the news reports called these derivative purchases “bets” when in fact they are hedges that reduce risk.
If Delta used hedge accounting it would match the loss of open fuel derivative contracts against future jet fuel purchases and not show the loss in the current period. Hedge accounting is extremely complex, and an advanced, auditable software system is required to support the adoption of these procedures.
Separately but related to managing fuel cost and risk, Delta announced that it completed its acquisition of the Trainer Refinery in Pennsylvania through its Monroe Energy subsidiary. Delta will move jet fuel from the refinery to its hub airports in the Northeast. Additional refined products such as gasoline and diesel fuels will be traded for jet fuel in other parts of the country. Delta spent about $12 billion on jet fuel in 2011 and expects to serve 80% of its domestic jet fuel needs from the Trainer refinery and related deals.
Delta is the first airline to own refining capacity. It will be interesting to observe if other airlines follow suit and move to vertically integrate their energy supply chains.
Supplying a refinery with crude oil and trading products requires sophisticated energy trading and risk management (ETRM) software. With volatility seemingly increasing daily in the commodity and crude oil markets, it seems prudent for Delta to invest in a hedge accounting and oil trading and risk management platform.
Four years ago Triple Point acquired INSSINC, the leading commodity hedge accounting software solution, and integrated it into its energy trading and risk management (ETRM) software solution. At that time, Triple Point recognized the need for an integrated commodity management platform that seamlessly integrates all key risk areas.
The new volatility reality demands that all industries with exposure to commodities and energy review their current risk systems to ensure they are appropriately protected.
Sempra was an amazingly successful commodities trading organization in the 1990s and 2000s before forming a joint venture (being sold) with RBS in 2008. At one point, Sempra had 44-straight profitable quarters. I recently read a very interesting article about how newly-formed Freepoint Commodities, which launched its North American operations in March of 2011, is really a “restart” of Sempra. David Messer, the former CEO of Sempra, is the CEO of Freepoint. In addition, roughly two-thirds of Freepoint’s employees are former Sempra employees.
I particularly liked this quote by Mr. Messer: “We started trading in June and I think that’s fairly remarkable to launch on March 1 and be trading 3 months later. I think that’s testimony to the fact we’ve been able to reassemble a team that is highly experienced and has worked together. We’re currently ahead of our plan.”
I’ll add from a Triple Point perspective that’s it’s also important to choose the correct Commodity Management partner and solution. Triple Point was able to implement Freepoint’s platform quickly to support its business requirements and also provide the robust functionality to support Freepoint’s rapid growth plans into additional commodities across the globe.
With the start of the new year, the US Legislature did not renew the 45-cent-per-gallon tax incentive for producing ethanol-blended gasoline or the 54-cent-per-gallon tax on foreign ethanol imports. The incentive cost taxpayers about $6B per year. This ends thirty some odd years of government support for the biofuels industry.
The real beneficiary could be Brazil’s sugarcane/ethanol industry. UNICA, the Brazilian sugarcane industry association, issued a press release titled “Time for the world’s top two ethanol producers, the United States and Brazil, to lead a global effort for increased production and free, unobstructed trade for biofuels.” According to Leticia Phillips of UNICA, “This means that in 2012, the world’s largest fuel consuming market (US) will be open to imports of less costly and more efficient ethanol, including sugarcane ethanol produced in Brazil.”
It will be interesting to see how the US biofuels industry fares in 2012 and what the change in policy will mean to corn prices.
A December Financial Times article that reported oil price volatility in 2012 could swing between $50 and $150 a barrel might prove quite prescient. The story, “Fat-tail fears catch oil traders between $50 and $150 bets,” noted that investors are concerned about events that could cause large swings in oil prices.
On the one hand, eurozone debt issues could drive oil prices much lower, but on the other hand, a crisis with Iran (or elsewhere in the Middle East) could send prices much higher. In the last few days, we’ve seen the saber-rattling between Iran and the US send Brent crude rising by more than $4 in a day to $111.
At the risk of stating the obvious, the commodity volatility trend of recent years will continue in 2012. Rapid and large price swings are not going away – if anything, volatility is getting more extreme. How commodity volatility is managed will be an incredibly important factor in determining company profitability moving forward.
The key phrase for organizations doing business in these volatile markets is “risk management.” With the proper processes and systems in place, risk can be turned to competitive advantage.
Here’s to a profitable 2012 for all!
Automotive World published an excellent article on the impact of rising and volatile raw material prices on the automotive industry.
A couple of weeks ago, I noted that commodity volatility had hurt Ford’s third quarter earnings. This article makes the point that raw material prices are creating difficulty for the entire supply chain.
“Materials suppliers struggle to make a profit; Tier suppliers and OEMs find themselves torn between raising prices and suffering the cost increases. Ultimately, it is the end-consumer who bears the brunt of increased finished product costs. The automotive industry is particularly sensitive to price rises, especially in emerging markets and in budget and cost-sensitive segments, where the equivalent of a €200 or US$200 sticker price increase can stop potential buyers setting foot on a dealer’s forecourt.”
Woven throughout the article are quotes by industry insiders that add rich supporting material. Dr Dieter Zetsche, chief executive, Daimler AG states, “We told the financial markets at our annual press conference that Daimler as an entity will see an increase in raw material prices in 2011 of about €700m (US$963m) versus 2010…On the car side there is very little chance to pass over what comes in from the raw material side.” Tim Bowen of Dow Automotive adds, “From our perspective, this appears to be the new norm. We are going to be operating under this escalated cost structure for years to come.”
The editor asked Triple Point for its views on how automotive purchasing needs to change. It feels a little odd to quote yourself, but here it goes: “According to Triple Point’s Michael Schwartz, ‘Automotive companies have some of the most diverse and complex procurement portfolios, which represent equally complex supply networks and a broad series of commodities markets – any one of which can be experiencing severe volatility at any given moment.’ The choice, he says, ‘is stark, but clear: continue to purchase commodities passively as just another link in the supply chain and be vulnerable to huge commodity price; or adopt a proactive approach to commodity procurement that utilises solutions that enable more accurate forecasts and protect the bottom line.’ By using the ‘right approach, tools and risk management set-up,’ vehicle manufacturers can take control of their commodity supply chains. Fail to do this, says Schwartz, and ‘that’s when the commodity supply chain controls you.’”
Here’s a link to the full article. It’s a long article but certainly worth the read.
Ford Motor Company reported 3rd quarter earnings and noted how commodity volatility hurt margins during its earnings’ call.
In fact, reported earnings were harmed both coming and going; as commodities rose in price and again as they came down. Ford’s operating margin was down 1.4% from a year ago, and this “margin decline can be more than explained by higher commodity costs,” stated Lewis Booth, Ford’s Chief Financial Officer. “Contribution costs, which include material cost, warranty expense and freight and duty, increased. About 2/3 of the increase is due to commodities.”
Okay… margins hurt by rising commodity prices is a familiar story we see these days with manufacturing companies that haven’t yet adopted advanced commodity risk management techniques and processes. But, in Ford’s case, their earnings were also hit as commodity prices came down.
“In addition to higher commodity cost compared to a year ago, we recognize the unfavorable mark-to-market adjustments of about $350 million on commodity hedges, driven by a sharp decline in commodity prices.”
Ford is not applying hedge accounting treatment so they recognize the loss on the financial instrument in the current period. “These changes in market value do not have an immediate cash impact, although the change in value is reflected in current earnings.”
The exact problems noted in Ford’s earning conference call are the issues that Triple Point is solving for its clients. Commodity volatility has risen dramatically in the past few years and manufacturing companies need to adopt new techniques to manage commodity risk. Triple Point introduced its Strategic Planning and Procurement (SPP) module to help manufacturing companies better track, measure, and control commodity risk. In addition, Triple Point provides the most robust commodity hedge accounting solution. As we’ve said on many occasion, this is not a wait and see problem. Those that tackle commodity risk now will gain competitive advantage.
Read earnings call transcript – http://seekingalpha.com/article/302387-ford-motor-s-ceo-discusses-q3-2011-results-earnings-call-transcript