Commodity price volatility and its inherent risk to profitability, costs, and availability is a supply chain challenge—and opportunity. Almost all businesses are exposed at some level to the financial risk stemming from commodity price volatility. Risk exposure may come from changes in direct materials prices, for example, wheat for a flour producer, aluminum for an automotive parts supplier, or plastic for a packaging producer. Indirect purchases such as utilities and transportation create price risk for many types of organizations including services. The greatest risk may be from purchases made by companies several tiers upstream in a supply chain, increasing the risk management challenge.
The commodity price risk management challenge transcends businesses and business functions and thus requires cross-functional and interorganizational perspectives. Commodity price volatility affects a number of strategic decisions including product design and development, product pricing, inventory management, negotiations, contracting, and managing supplier relationships. Supply chain management, which serves the critical role of managing product flows, finances, and information within and among firms, is in a prime position to provide a leadership role in managing the risk from commodity price volatility.
Objectives
The objective of this book is to provide supply chain and finance professionals an understanding of their organizations’ exposure to commodity price risk, tools to forecast commodity prices in the short- and long-term, and approaches for managing risk exposure by the firm and within the supply chain. These approaches can be combined creating a flexible approach for managing commodity price risk. Several specific objectives of this second edition are for you to begin attaining the supply chain skill sets for the following:
Understanding the importance of commodity price risk.
Assessing organizational exposure to commodity price volatility.
Forecasting short- and long-term commodity prices using technical and fundamental analysis.
Incorporating enablers and inhibitors in the commodity price risk management decision process.
Selecting the appropriate or set of appropriate commodity price risk management approaches for managing direct commodity purchases and value chain purchases.
Gleaning insight to emerging issues of political risk, with the example of heavy rare earth metals, and business loans in China using commodities as collateral.
Obtaining a greater appreciation for financial hedging instruments.
Structure
The book is organized into four sections: (1) background, (2) forecasting commodity prices, (3) managing commodity price risk, and (4) additional observations and cases.
Background
The Background section begins with Chapter 1—Introduction to Commodity Price Risk Management, which sets the stage for understanding the history and organizational challenges with and effects of commodity price volatility. Building from the first chapter, Chapter 2—Assessing Price Risk Exposure and Risk Tolerance, explains how to examine the extent of exposure, uncertainty, and an organization’s risk tolerance when deciding whether or not it makes economic and strategic sense to actively manage risk. If you determine that price volatility should be managed, the next step is to develop short- and long-term price forecasts.
Forecasting Commodity Prices
Many of the approaches for managing commodity price volatility discussed in this book take time to create or implement, and are done in response to price forecasts. Chapter 3—Short-Term Forecasting, provides a series of tools and examples for developing short-term forecasts, usually from one week to several quarters in the future, using an approach called Technical Analysis. Chapter 4—Long-Term Forecasting, on the other hand, examines how to forecast for 1 year or more in the future by understanding the dynamics and effects of the supply–demand balance using Fundamental Analysis. Both these approaches are necessary for understanding how to manage commodity price volatility for both the short- and long-term.
Managing Commodity Price Risk
Chapter 5—Direct Purchases, provides an array of approaches, listed in order of complexity and resources to implement, to manage commodity price volatility when acquiring commodities in their “raw form.” Organizational exposure to commodity price volatility, however, is not constrained only to direct purchases. As firms have become more specialized focusing on their core competencies, there is greater reliance on component and subassembly suppliers, many of which are exposed to commodity price volatility from their own raw material purchases. Chapter 6—Value Chain Purchases, explores approaches for managing commodity price volatility from suppliers. The insights from these two chapters are extended in the subsequent section on additional observations and cases.
Additional Observations and Cases
There are numerous examples of forecasting and management commodity price volatility throughout the book. This final section extends those examples by providing emerging supply chain challenges associated with commodity price volatility, and further insight to one of the management approaches discussed in the book. Chapter 7—Political Risk: The Case of Heavy Rare Earth Metals, provides additional insights to political issues within global supply chains and how complex supply chains are managed. Increasing demand for electronic devices and newer technologies has increased demand for heavy rare earth metals, and China policies influence sourcing strategies. The following Chapter 8—Using Commodities as Collateral: The Case of China, examines how commodity price volatility influences an alternative form of financing—collateral loans using commodities. The concluding Chapter 9—Further Insights on Financial Hedging Instruments, goes into much further depth in the use of financial hedging instruments, as introduced in both Chapters 4 and 5.
Updates from the First Edition
The second edition of this book provides a significant change and, what we believe, is an improvement from the first edition. Prior to the first edition, we were not familiar with any work focusing on commodity price volatility from a supply chain perspective. With our emerging work in this field, in conjunction with content we provide to our students and managers about commodity price volatility, as a subset of cost analysis, we saw an opportunity to write our first book on the subject. Business Expert Press, and their mission to provide “deep dives” into specific business topics oriented to executive students, was perfectly aligned with our target audience. We appreciated the opportunity for publishing the first edition. However, in the four short years since the publication of the first book, much has changed; thus, it was important to significantly update and add content to the second edition.
Several of the specific updates include the changing structure of the book, providing new approaches and perspectives for managing commodity price risk, and incorporating a more global perspective of commodity price volatility.
Changing Structure
Now with nine chapters, the order of the chapters was changed to provide a more logical flow and greater clarity for understanding and managing commodity price risk. Further, within these changes, we have updated the data and examples in the short- and long-term forecasting chapters, as well as sources of information.
The chapter on currency exchange rate volatility in the first edition was not included in the second edition. While the topic of currency risk is important, we believe much more depth would be needed to effectively cover this topic, detracting from our primary focus on commodities. However, we would like to encourage other scholars and practitioners to examine currency exchange rate risk in greater depth and publish those insights.
In lieu of currency exchange rate risk, we elaborate more on specific issues and topics related to commodities. Hence our concluding section provides additional observations and cases focused on elements of commodity price volatility. This includes a discussion of political risk with the example of heavy rare earth metals in Chapter 7, and an interesting by-product effect on commodity price risk by its effect on using commodities as collateral for business loans in China in Chapter 8, contributed by Mr. Antonio Cesarano. In addition to these two chapters, we also included an invited contribution by Mr. Ugo Montagnini providing additional insights on financial hedging instruments in Chapter 9.
Providing New Approaches for Managing Commodity Price Risk
Another significant update to this edition is we have expanded the number of management approaches described. Since the publication of the first edition, we were honored to receive a CAPS Research Grant titled “Managing Commodity Price Volatility and Risk.”1 The CAPS Research study consisted of 12 in-depth case studies of firms based in the United States, Germany, and Italy, studying how they assess and manage commodity price risk exposure with their purchases and key supplier purchases. This edition captures several additional approaches discovered from the CAPS Research study, and we wish to thank Professor Phil Carter, CAPS Research, and the Institute for Supply Management for their support. Therefore, this edition provides additional approaches for managing commodity price risk, including building in financial slack, staggering contracts, and switching suppliers for direct commodity purchases, and creating firm fixed-price contracts, piggyback contracting, and vertically integrating for value chain purchases.
We realized in the prior edition we did not clearly differentiate commodity price risk management approaches by their source. Specifically, we did not provide clear guidance on which approaches to use if the price risk comes from commodities directly purchased or from the risk associated with component and assembly suppliers. Therefore, we split the prior “Creating a Commodity Price Risk Management Strategy” into two chapters, the current Chapter 5, “Managing Commodity Price Risk— Direct Purchases,” and Chapter 6, “Managing Commodity Price Risk— Value Chain Purchases.” We believe this change provides greater clarity with regard to selecting commodity price risk management approaches, especially with regard to the level of complexity and investments required for adopting such approaches.
Incorporating a Global Perspective
The four authors of this second edition have had the pleasure to work closely with each other studying commodity price volatility assessment and management during the past 5 years. Prior projects have included working in partnership on translating and updating material from the first edition in German2 and Italian.3 In addition, as previously described, we worked on a large-scale international study investigating commodity price risk assessment and management.4 Throughout our work together we have had strong mutual desires for understanding this research phenomenon and managerial challenges from a global perspective. We believe the natural inclusion of Professors Gaudenzi and Kaufmann in this second edition adds significant value and a global perspective. This is further exemplified by including cases and perspectives from Italian practitioners managing commodity price volatility, as described in Chapters 8 and 9. Even throughout the manuscript we have provided more examples of assessment and management approaches from firms outside North America, as compared with the first edition. Commodity price risk and its management is truly global in scope, and this second edition incorporates a much-improved global perspective.