The Volatility Advantage: How to Manage Commodity Price Swings

It's time to stop predicting commodity prices based on industry insights, some educated guesswork or plain gut instinct. In an era of price volatility, this "roll of the dice" mentality will undo even the toughest competitor. Today, the only way to beat the market is to have better information about the market. And the only way to get better information is to employ some down-to-earth forecasting techniques.

For many companies that buy commodities, the 2005 hurricane season turned a difficult year into a nightmare. Oil soared briefly to more than $70 a barrel the day after Hurricane Katrina struck the U.S. Gulf Coast. Lumber prices, which had dipped their lowest in nearly two years, spiked more than 15 percent. Copper hit a record high.

Companies across the board raised prices, lost profits or saw market share trickle away. The impact was not reserved for the U.S. market. French automaker Peugeot Citroen posted a 37 percent drop in net profits in 2005, which it blamed in part on the  unexpectedly high cost of raw materials. Cosmetics giant Avon reported a 7 percent drop in net profits in the third quarter of 2005 and cited higher energy costs and raw material prices for its petroleum-based products. In the airline industry, both Delta and Northwest filed for bankruptcy on the same day—their premature fates sealed by skyrocketing fuel prices in the Katrina aftermath.

The news, however, wasn't all bad. As many airlines struggled, Southwest flew to another profitable quarter, and Dow Chemical posted a 10 percent profit in 2005 despite spending $4 billion in additional energy and raw-material costs. Both companies managed the risk of constantly changing prices and limited supplies by using it to their advantage.

With volatility in commodity markets showing no sign of easing, companies across industries could learn a lesson or two from these leaders. The best companies will be able to forecast where commodity prices are going and when, understand supply market  dynamics, and adjust their strategies accordingly.

Where Are Prices Going?

The price spikes in 2005 were not just a blip on commodity buyers' radar screens. It's an unsettling reminder of the magnitude of the challenges businesses face in managing volatile prices and scarce supplies (see figure). Raw material prices have risen steadily over the past few years. A key index of the Commodities Research Bureau, which measures 22 types of commodities, rose 23 percent from 2005 to2006. And certain commodities have reached nosebleed levels: Crude oil is roughly 200 percent higher than in 2004 and natural gas prices have soared more than 650 percent since 2002.

Figure 1: Commodity prices have fluctuated dramatically in recent years and high volatility will likely continue

As global demand booms, the laws of supply and demand are settling in. China is turning into one of the world's largest consumers of raw materials. In 2004, it overtook the United States as the world's biggest consumer of copper and aluminum, and purchased nearly 45 percent of its cement and 30 to 35 percent of its steel, iron and coal. And even if China's consumption plateaus, India's emerging economy and growing middle class will more than pick up the slack. By 2020, some analysts estimate that these two nations alone will consume half of the world's natural resources.

Ongoing industry consolidation also means that suppliers are becoming bigger and stronger. Since 2004, mergers and acquisitions have been on the upswing, particularly in the power and gas utilities industry with its recent mergers of Exelon and PSEG, Duke and Cinergy, and the dramatic, high-profile steel deal between Mittal and Arcelor. As more companies make these power plays and knock off their competitors, they wield more power over their suppliers—suppliers that will not have anyone else to sell to.

With no end to these pressures in sight, companies have a choice: They can either ride out the rough patch of price swings without revising their supply strategies or adjust their strategies to deal more effectively with price volatility. As global demand rises and scarce resources dwindle, the choice will become clear. Both short-term volatility and long-term pressure will force companies to establish core capabilities in actively managing price  swings.

Strategies for Dealing with Tight Supply

The advantage of having sound supply strategies becomes more significant as volatility increases. Consider the electronics industry and its use of copper in the manufacturing process. Over the past decade, copper prices fluctuated an average of 25 percent within any given year, with prices rising 66 percent from 2003 to 2004. A copper buyer could turn this volatility into a competitive advantage by buying ahead of price increases, hedging, and knowing when to switch from contract to spot buying. This could mitigate one-quarter of the price increase or capture an additional quarter of the decrease, representing a potential 4 to 6 percent savings on copper costs.

Southwest Airlines used hedging strategies to its advantage. Hedging helps buyers  dampen price upswings and extend downswings—that is, if a company "bets" correctly on which way the future price is going to move. While rising oil prices were wreaking havoc on the airline industry, Southwest's aggressive, and complicated, hedging practices allowed it to pay an average of $26 per barrel, while the market price topped $70. Today, Southwest is the only U.S. airline to turn a profit consistently. "Southwest doesn't have to pass higher prices on to customers, or it can pass them on only by small degrees," Nigel Gault, an economist at Global Insight, told Regional Aviation News. "Everyone else has to live with that and follow the lead."

There are strategies beyond hedging. For example, when supply or pricing issues are expected to be protracted, and there's no feasible solution in sight, companies often look for alternative materials. They relax specifications and change processes to use less expensive substitutes. Palm kernel oil, for example, can replace the more expensive coconut oil in soap. Toyota took this "substitution" strategy a step further by switching to entirely new materials to produce its Raum model. It is the first vehicle to use Toyota Eco-Plastic, derived from plants rather than petroleum, to manufacture certain components.

Many businesses will simply pass a price increase on to their customers. One major chemical company increased prices across the board as a direct result of Hurricane Katrina—and increased sales by 10 percent over 2004. This relatively straightforward solution works well when demand outpaces supply, but it has its drawbacks: Competitors with lower-cost supply may use the opportunity to increase their market share, and price-sensitive consumers may look elsewhere.

Another option, albeit an extreme one, is to stop making the product altogether when supply costs become unreasonable. Few companies employ this option, however, because the potential damage to the brand—and lost customer loyalty—could ultimately be much costlier.

Forecasting Price Movements: Art or Science?

How well companies execute these strategies depends on their ability to forecast prices accurately. Most companies don't have much to go on: They know the current price and the vendor's explanations for that price. Not exactly the stuff of crystal balls. With limited information, most companies are forced to react to price. Or they can believe in efficient markets and use financial hedging as a standard across-the-board technique to eliminate volatility. But limiting risk this way is expensive, and companies that apply this approach also forgo the opportunity to create a competitive advantage by understanding the supply side better than their competitors.

The only way to beat the market is to have better information and insights about the market. Rather than using purely "technical" modeling approaches, we recommend pragmatic forecasting techniques that use industry and market insights. One company that adopted these techniques beat general market prices by about 3 percent. With deeper insights into market dynamics, executives had the confidence to act on the insights and adjust their supply strategy, and the supply organization passed the information on to the sales team, which in turn pushed for price increases once it educated its customers about supply issues. Our approach consists of three steps:

Know the content of the commodity and its price drivers. The first step involves analyzing feedstock and consumption flow, including examining all the materials, energy, and classes of labor needed to produce the commodity. While this sounds pretty obvious, this exercise can become highly complex. In the case of polypropylene, for instance, supply specialists must analyze more than 15 feedstock materials, raw materials and byproducts, and pay particular attention to the materials that have a major impact on the commodity's price. For example, electricity is the primary ingredient for making caustic soda, but it is not the ingredient that  determines its price. Caustic soda is a byproduct of chlorine production, which means chlorine is the primary factor influencing its price. Once supply specialists isolate the major price drivers, they must look at two economic models, which brings us to steps two and three.

Build a cost-push model. A company should pinpoint and analyze all factors that influence the supplier's production costs. These factors include feedstock prices, capital and labor costs, and production processes. Examining emerging technologies and identifying potential changes and industry shifts are also key parts of this step.

Naturally, suppliers want to recoup their raw materials costs. In the short run, they should price their products based on their variable costs, or no less than their variable costs. In the long run, they should price them based on actual costs. A company that understands all of the factors that influence a supplier's production costs can determine a lower baseline price and use the information at times of oversupply.

For the longer term, the economic modeler should also perform a reinvestment economic analysis to help with decisions about reinvesting in the company's fixed-cost items.

Build a supplier-margin model. This last step fills in the missing piece: how to explain market prices. In our experience, a few drivers explain a large portion of supplier margins in a competitive market. These include the industry operating rate, rivalry and  competitive behavior among companies, as well as the weight of current profitability against future reinvestments. Using historic data and regression analysis over the explanatory variables, a supply specialist can test and validate different hypotheses about margin drivers, which will ultimately lead to a high degree of forecasting accuracy. For example, a model developed for the chemical company in our earlier example explained historic prices with a maximum error margin of 5 percent.

Better Information, Better Results

Until now, executives have relied on their industry insights, some educated guesswork and plain "roll of the dice" gut instinct to predict commodity prices. By developing a pragmatic economic model, executives obtain better information and also foster the  confidence to act on the insights. For those who take the time to build the necessary capabilities into their organizations, the rewards will be well worth the effort.

Consulting Authors

Vance Scott is a vice president based in the firm's Chicago office. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

Paul Weissgarber is a vice president based in the firm's Dallas office. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

Patrick Haischer is a principal in the firm's New York office. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .