Capitalizing on Commodity Volatility

Eight ways to leapfrog competitors

Managing rising commodity prices is becoming a mission-critical agenda item for global food and beverage CEOs and their executive teams as unprecedented volatility in agricultural markets drives prices to historic highs and the old ways of defending territory no longer work. On the positive side, for astute companies that are ready to outdo the competition—and recognize the need for fresh, outside-the-box initiatives to gain that critical advantage—the volatility is creating more than a few commercial opportunities.

Establishing commodity prices is typically a dull exercise, driven mostly by weather and crop capacity. But the past year has been anything but dull. The summer heat wave in the American Midwest stressed corn crops as they entered the critical pollination stage, threatening both the quality and yield of the 2011 crop. Such environmental factors translate directly into bottom-line margin pressure. Since last year, the price of corn has almost doubled. Weather is not the only factor. Capacity, or crop yield, also drives up prices. Because of high oil prices, for example, more than 40 percent of the U.S. corn crop is used to produce ethanol, a biofuel.

Several "wild cards" are further shaking things up. Speculators, increased demand in emerging markets, land and water issues, geopolitical risks and monetary policies are all part of the volatility in commodities markets. Already, one wild card—China—is raising new questions about the availability of corn supply. In early July, the U.S. government confirmed that China, once a self-sufficient corn producer, had purchased at least 540,000 tons of this year's U.S. corn crop, significantly more than the 500,000 tons the government had projected China would buy for the entire year.¹ Another wild card—political unrest—is affecting the cocoa market as turmoil in the Ivory Coast shuts down cocoa exports. At the same time, a London-based hedge fund snapped up a large part of the world's supply of cocoa beans in a speculative move, causing world cocoa prices to jump to a 33-year high.²

We are in the eye of a perfect storm of price increases and volatility in the agriculture commodity markets. The question for food and beverage manufacturers is how to turn turmoil into returns.

Turning Turmoil into Returns

Figure 1: Projected farm price and consumer price indices

The agricultural commodity world is becoming more complex as cost-driving wild cards accelerate price volatility, inevitably leading to further market instability and rising food prices (see figure 1). Within this unprecedented environment, there is an opportunity for food and beverage companies to leapfrog competitors. (Covering commodity positions and managing margins by passing the cost inflation burden on to your retail customers and consumers will never set you apart from the competition.)

Over the past few years A.T. Kearney has done significant work for leading multinational food and beverage companies struggling to operate in this highly unstable environment. In the course of our work, we've identified eight best practices to help you get in front of your competition.

1. Capitalize on Changes in Competitive Position

Major fluctuations in the prices of raw materials are fundamentally changing how companies act, react, and are positioned up and down the value chain. As your competitors wane, you can capitalize on new opportunities.

Adopt a direct sourcing strategy. By sourcing commodities directly, such as Starbucks does with its coffee beans, you can reposition your company in the value chain and reduce your exposure to large agriculture commodity traders. To succeed, however, this strategy will require full leadership commitment since it requires significant investment in resources and infrastructure, and draws on quite a different talent pool. Fail to thoroughly plan and execute, and you could be exposed to even more risk stemming from a single-source crop failure or political unrest.

Find value in new entrants. Fluctuations in raw material streams can open the door to low-cost new entrants, putting pressure on the established manufacturers. A few years ago, for example, the abundance of cheap corn in China put a strain on leading non-Chinese suppliers of wood-based xylitol, a critical sweetener for candy gums; they were suddenly outperformed by their Chinese peers. The availability of a less costly supply source can create powerful opportunities for established players to discover—or create—new value.

Change the balance of power. Volatile commodity markets can be an opportunity to strengthen your position with retailers—reversing the decades-long trend of retailers growing less dependent on brand manufacturers. Doing so could have a profound impact on the fate of private label products.

As commodity prices rise, retailers may find it easier to increase prices on popular branded products—which consumers are more inclined to pay a price premium for—than the less price elastic private label products. This varies, of course, based on product category, the relative strength of a brand, availability of cheaper alternatives and overall consumer behavior. Buyers of cold and allergy medicines, for example, are more inclined to switch to a cheaper store product than, say, buyers of chocolate or beer.

Most branded manufacturers have sophisticated commodity management strategies and infrastructures in place to monitor and anticipate market changes. Private label manufacturers do not have nearly the same amount of information. Use the information to your advantage by making a larger retail margin contribution; this is an opportunity to create a better bargaining position with your retailer customers.

2. Adapt the Product Portfolio

There are two commonly employed ways to react to increasing commodity prices: Either take the hit or pass along cost increases to the retailer and ultimately the consumer. Neither of these options is promising, however. If you take the hit, margins fall; if you pass on increases to consumers sales fall, as people either buy less of your product or move to store brands—or both. A better idea is to adopt alternative pricing and packaging strategies. Here are three ideas:

Change package size, not price points. Some consumer packaged goods companies opt to maintain item costs while reducing the amount of product in the package. Heinz Ketchup reduced the bottle size of its flagship Heinz 57 sauce by four ounces with no price reduction when wholesale tomato costs more than tripled last year. Similarly, in an effort to help offset the dramatic rise in citrus prices resulting from a series of prolonged frosts in 2010, some orange-juice bottlers reduced their half-gallon cartons from 64 ounces to 59 ounces.³

Reformulate to reduce exposure to limited commodities. Tate & Lyle, a leading global food ingredients manufacturer, is proposing a reformulated pomegranate-grape juice drink that uses a blend of sweeteners to reduce sugar content by up to 45 percent.⁴ In so doing, the company creates a natural protection against fluctuating commodity markets.

Diversify the product portfolio. Food companies with narrow product portfolios will suffer the most in a volatile commodities market. For instance, a confectionery company that addresses rising cocoa costs by raising prices could inadvertently shift consumer demand from chocolates to other candies. Yet Kraft Foods or Nestle, both of which produce a large range of other product categories, will have a very different exposure, risk profile and response potential than a company focused solely on the chocolate market.

3. Rethink Product Pricing

Figure 2: Typical pricing structure along the food value chain

The current retail fixed-price-for-a-year approach to contracting with food and beverage manufacturers is counterproductive, adds an additional source of volatility, and is quickly being relegated to the dustbin of old ideas. The fixed-price approach will be replaced with "natural hedges," such as changing end-consumer prices more frequently in several food categories (think how often your local gas station raises and decreases prices). Grocery retailers will behave more like restaurants (think about the market price for lobster) with constantly changing price points reflecting changes in commodity pricing. Frequent price changes are already the norm for high-commodity items such as ground coffee.

Sophisticated pricing mechanisms, when applied up and down the entire value chain, can lead to more stable margins even in the most volatile categories (such as coffee) that are subject to high commodity price fluctuations (see figure 2). Of course, this strategy will require collaborating closely with your retailer customers to design the optimal mix of natural and financial hedges to share the benefits and the risks.

4. Watch "Unrelated" Commodities

As markets become increasingly interconnected, it is necessary to monitor not only your mission-critical commodity markets, but also commodities that are seemingly unrelated. Consider a beverage company that finds higher resin prices pushing up the price of the polyethylene terephthalate, or PET, used to make soda bottles. The price hikes may trace back to clothing manufacturers buying more polyester than cotton since cotton prices are at a 140-year high. This increased demand drives up the price of PET—which is made from the same raw material as polyester—and forces the company to monitor cotton prices to anticipate movements in resin prices.

The picture is even worse when you take a long-term view. The Organisation for Economic Co-operation and Development (OECD) predicts that, if no new policies are introduced, almost half the world population (47 percent) will be living under severe water stress by 2030.⁵ Water is bound to become the new scarce commodity, creating a new geopolitical wild card as global population growth triggers more demand for agricultural irrigation.

5. Recognize the Pitfalls of Financial Derivatives

Companies often turn to financial derivatives to hedge against rising commodity costs and manage their pricing. But there are significant problems with hedging. For one thing, trading futures on, say, 10 percent of the global physical volume of select commodities can in and of itself move markets. There is a distinct possibility of becoming a victim of sophisticated speculators who anticipate every market-moving action. Indeed, global commodity markets are actually more open to manipulation as regulations in these markets are far less sophisticated than regulations governing equity and bond markets. What's more, many developing countries treat their agricultural sector as a strategic asset and protect their farms and farmers from undue risk associated with market fluctuations.

So while financial derivatives are the de facto standard approach for managing price risk, some of the largest consumer packaged goods companies are being forced to consider alternatives.

6. Disconnect from the Market

Disconnecting from the market through vertical or virtual integration is an attractive way to avoid the volatility and resource scarcity trap. As supply sources become restricted, vigilance is key: It is wise to continually look for new sources of supply while having a well-established vendor qualification process at the ready to verify new suppliers quickly.

PepsiCo, for example, manages potato farms in China and invests significantly in infrastructure (roads and electricity), sand-dune-stabilizing crops, and technology such as water-conserving irrigation. As a result, PepsiCo-owned farms in China annually supply more than 40,000 tons of pota-toes.⁶ (Certainly, these advantages will quickly erode in the event of a trade war between China and the United States.)

Mitigating supply risk also means entering into long-term strategic partnerships with key suppliers further up the value chain. In September 2010, Kraft Foods and Barry Callebaut, the world's leading manufacturer of high-quality cocoa and chocolate, signed a long-term global master supply agreement naming Barry Callebaut Kraft's key global cocoa and industrial chocolate supplier.⁷ Swiss-based Barry Callebaut has since invested $65 million to expand its global production capacity in the United States, Canada, Europe, Ivory Coast and Malaysia.

7. Unbundle Costs

Raw material commodities make up only a portion of the total landed cost of ingredients, with transportation, conversion and overhead making up a significant share. Focusing primarily on commodity price risk management and paying less attention to negotiating the processing and transportation costs makes it difficult to capitalize on some high-level cost unbundling. In fact, extracting value from the non-commodity components of your total commodity price can isolate the impact of commodity price fluctuations. Two non-commodity areas deserve attention:

Figure 3: Risk management organizational models

Transportation. We recently worked with a major U.S. food and beverage company to address both inbound and outbound transportation for its commodity raw materials. Once the company had visibility into its lanes and volumes, it was able to leverage its under-utilized routes and optimize load factors. We also uncovered hidden value within the inbound commodity raw material prices paid to suppliers, which was split among the logistics firms executing the outbound transportation.

Conversion and overhead. We helped another global food and beverage company reduce its commodity processing costs by entering into long-term partnerships with key suppliers. Because the suppliers committed to significant volumes over the long term, they were able to invest in additional capacity and reduce their own fixed costs, passing on some of these cost reductions to our client.

8. Adapt the Organizational Structure

There are two kinds of risk management strategies—proactive (anticipating future market changes) and reactive (responding to market fluctuations). In both strategies, commodity price risks are covered either by taking direct positions through treasury or your commodity risk management group, or indirectly through suppliers.

From an organizational point of view the critical issue is not which risk management strategy you adopt, but how well it is executed. Figure 3 illustrates four organizational models, with the last one, risk trader, leading to the highest level of value creation. The focus has to be on structure, coordination and the integration of key functions. Let's go over each:

• What risk management structure is in place? Hedging risks takes talent, a clear governance structure to make decisions quickly, and a rigorous system of checks and balances.
• How coordinated are your global businesses? Each business unit should have a singular view on the market, with information and market intelligence shared among units.
• How integrated are your procurement, finance and risk management organizations? These should not operate as silos, with little interaction or sharing of information. Rather, there should be a clear forum for real time intra-corporate information exchange.

Get a Complete View

Competitive position, pricing strategy, product portfolio, innovation and new product development, manufacturing footprint, and supply chains are all affected by fluctuations in commodity prices. This is not a short-term phenomenon, which means ill-prepared companies will be at a serious disadvantage.

To get a complete view of the volatility, we recommend analyzing commodities along the following dimensions and asking some tough questions:

• Competitive positioning. Do you understand the macro changes triggered by inflation? Do you have plans in place on how to compete when new rules come into play? Have you anticipated the gamut of future scenarios that could stress your organization? Are you looking at technologies and other factors that may be a source of discontinuous change?
• Product portfolio. Is your product portfolio inflation-proof? How does it stack up to competitors'? Will consumers trade away from your best sellers? Do you have proper pricing structures in place to pass on increases to consumers?
• Supply management. Do you have the right relationships with your suppliers to ensure supply in tight times and access to the right innovations? Have you considered the entire make-versus-buy opportunities to mitigate supply risk? Are your sources of supply flexible enough?
• Risk management. Do you understand your entire financial risk exposure? How much are you able to hedge away, and how much risk exposure is residual? Are you applying all possible levers and techniques to manage your risk?
• Organization. Commodities may be on the agenda, but are they on the right agenda? Are appropriate governance structures in place, both regionally and globally?

Preparation is Essential

Your next steps will be the most important. Use scenario planning to develop contingency plans for resource and price volatility. Get a deeper understanding of the full impact of commodity price fluctuations on your competitive position. Focus on the full range of opportunities and risks associated with commodity inflation—not solely on immediate mission-critical commodities or easy-to-spot impacts on margins. In these challenging times, relying on old strategies, traditional approaches to business relationships, conventional wisdom, or antiquated communication and decision-making tools is the riskiest strategy of all. And don't focus so much on the details that you miss the larger goal—getting a jump on your competitors.

Authors

Dave Donnan is a partner in the Chicago office.

Stephane Remy is a partner in the Paris office.

Gotfred Berntsen is a principal in the Oslo office.

Yves Thill is a principal in the Chicago office.

¹ Tom Polansek, Ian Berry, and Scott Kilman, "Chinas Hunger for Corn Turns Market on Ear," Wall Street Journal, 9 July 2011
² Katie Allen, "Hedge funds accused of gambling with lives of the poorest as food prices soar," The Guardian, 19 July 2010
³ Douglas Mclntyre, "U.S. Companies Shrink Packages as Food Prices Rise," Daily Finance, 4 April 2011
⁴ "Cost optimization in beverages: Tate & Lyle develops new sugar reduction concepts," Webwire, 9 May 2011
⁵ "Fostering Nanotechnology to Address Global Challenges: Water," Organisation for Economic Co-operation and Development (OECD), 2011
⁶ Performance with Purpose: Environmental Sustainability available at www.pepsico.com
⁷ "Barry Callebaut and Kraft Foods sign global supply agreement," Callebaut press release, 9 September 2010