Risk Management

Commodity Prices: High and Volatile

Finance chiefs are contending with increasingly unpredictable prices for raw materials.
Sarah JohnsonMarch 1, 2011

For Catherine D’Amico, CFO of Monro Muffler, relief from the uncertainty of commodity prices came in the form of tires — some $8 million worth.

The automotive-service company upped its total inventory by 11% between March and December of 2010, to $95.6 million. Two-thirds of that increase went toward tires to stay ahead of volatile commodity prices, a growing problem plaguing many CFOs these days.

Reluctant to pass cost increases to
still-frugal customers, finance chiefs have been exploring other ways to work around the price pressure they’re feeling from their suppliers. For D’Amico, that meant not only building up Monro’s tire and oil inventory but also pushing back on vendors for better pricing and visibility. (The company’s contracts require one-to-three-month warnings for pricing increases.) In turn, she can be confident in the information she relays to investors and can pass higher costs to customers only when absolutely necessary.

“It’s still a tight economy,” says D’Amico. “If we’re not competitive, people can go somewhere else, or they can defer [car repairs].”

Since last summer, coping with commodity prices has been anything but a smooth ride. Various raw materials have experienced price hikes, including oil, steel, wheat, and cotton (see chart). In February the Thomson Reuters/Jefferies CRB Index, which tracks the prices of 19 commodities, hit its highest level (344.47) since September 2008.

Commodity prices

Prices have been rising in large part because of the economic recovery. “Everyone knows when the economy begins to recover, you’re going to see an increase in commodity prices because demand is there,” says Chris Kuehl, economic analyst for the National Association of Credit Management. Making matters worse has been constricted supply, thanks to extreme weather conditions (drought in Russia and Ukraine, floods in Australia) and political turmoil (see the Middle East).

As a result, CFOs have to explain to investors why their earnings have become less predictable. “We see more and more businesses facing earnings volatility from raw-material price volatility,” said John Drzik, CEO of consulting firm Oliver Wyman Group, during a press conference last month.

Indeed, for some industries, dealing with volatile commodity costs has become the norm. Food companies have been carrying the burden of rising commodity prices for the past decade, according to General Mills CFO Don Mulligan. “Inflation will remain a central factor for our industry,” he says, predicting the average 4% to 5% cost inflation his sector has seen in recent years will continue this year as well.

The size of recent commodity-price jumps has thrown off forecasts at many companies. During a call with investors last month, Procter & Gamble CFO Jon Moeller said the impact of commodity costs on his business was double what the company expected at the beginning of the year, creating an “earnings headwind” of about $1 billion after tax (although the company has not adjusted its earnings-per-share guidance). The costs rose by about 20% compared with a year ago, he added. To compensate, P&G plans to raise prices on some products, substitute cheaper materials in others, and work on reducing its selling, general, and administrative costs.

The price rise for some commodities will likely continue, predicts David MacLennan, CFO of agribusiness giant Cargill, which buys and sells a wide range of commodities. “Higher agricultural prices in the short term are probably here to stay, notwithstanding some type of shock to the system,” he says.

Last month the privately held company reported earning $2.37 billion in the first half of fiscal year 2011, double the amount for the same period a year ago. Cargill is able to predict and adjust to pricing changes mostly due to the diversity of the work it does; it operates agricultural, steel, shipping, energy, and risk-management businesses across some 65 countries. “A big part of our strategy is keeping different parts of the company connected in terms of information flow, because you never know how something happening in one market in one part of the world is going to impact something in another part of the world,” says MacLennan.

Some companies may need to revisit their business models if they’re unable to work around the unpredictable costs, which could mean divestments of business units deemed more risky because of price increases, according to Oliver Wyman’s Drzik.

Outlook: Foggy
CFOs whose businesses rely heavily on commodities say they pay attention to prices on a daily basis and read all they can about geopolitical events that could have an impact. Still, “you can do all of that, but it doesn’t necessarily give you a perfect answer of where things are going,” says Peter Ingram, CFO of Hawaiian Holdings, parent company of Hawaiian Airlines.

Indeed, the price jumps have made it challenging for CFOs across industries to stay ahead of the changes, feel confident in their forecasts, and maintain their gross margins. “Having this kind of volatility has a significant impact on margins, which means organizations will have challenges in accurately forecasting results,” says Gary Lynch, who leads the global supply-chain risk-management practice at Marsh. It’s also a time when companies could lose their market share if their competitors have a better strategy for mitigating the risk of high prices, he adds.

To work around the price pressure, companies have found ways to redirect consumers’ interests to less-expensive products. For example, Darden Restaurants, which operates the Olive Garden, Red Lobster, and Capital Grille chains, makes quick changes to its advertising when certain foods are suffering from sudden price hikes. “We can influence what consumers are craving and their reason for coming into the restaurant,” says Darden CFO Brad Richmond.

Darden predicts that 80% of its cost increases in the next 18 months will come from beef and seafood. But Richmond is wary of transferring any immediate costs to customers. “We don’t overreact to short-term market movements,” he says. The company has instead locked in prices through supplier contracts, such as for wheat, and has reduced energy costs.

Other industries have less control over their customers’ behavior. Hawaiian Airlines, for example, is at the mercy of its “leisure-oriented” consumers, says Ingram. “What we are able to charge has very little to do with the cost to produce our product,” he says, and much more with ticket demand and seat availability.

In fact, Ingram doesn’t mind the high price of oil. What’s been bothering him, he says, is the uncertainty: “Volatility to me is even more of a problem than the high level of cost.”