The Commodity Imperative: Making the Journey from Procurement to Management of Integrated Margin

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Contents

Introduction 3

Changing market environment 4

Reaction 9

Benefits 13

Challenges 15

Potential 16Risk Management Case Study 16

Market View Case Study 17

Illiquid Commodities Case Study 19

Where to start 21

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3

Introduction

In today’s market environment, exposure to commodity prices will either put a company at risk or provide a sustainable competitive advantage. For many businesses, from food companies to airlines and from car manufacturers to construction companies, commodity price movements are the single most volatile drivers of profit. Historically, these price movements have been managed by the procurement function. But companies with market-leading practices are increasingly learning from industries, such as energy, that have developed a more sophisticated approach to commodity management. They are developing specialist Commodity Price Risk Management (CPRM) capabilities to help manage price risk proactively. For them, CPRM is not simply a way to help control risk and determine capital requirements. It is a commercially driven approach that examines potential rewards in order to determine the optimal trade-off between risk and return.

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Changing market environment

Since the marked commodity price peaks and troughs that took place between 2007 and 2008 (Figure 1), there has been a step-change in commodity volatility. To illustrate this, a comparison of the S&P 500 annualised equity volatility since 2007 about 20 percent commodity price swings shows it being overshadowed by, for example, crude volatility of approximately 40 percent and US wheat volatility of about 30 percent.1

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Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13

WTI Crude Henry Hub Natural Gas Platinum LPPM Aluminium LME EEX ElectricityMalaysian Palm Oil US Corn China Cold Rolled Steel US Wheat

Sources: Bloomberg; Accenture analysis

Notes: The following Bloomberg indexes are shown in the graph. WTI Crude (USCRWTIC Index); Henry Hub Natural Gas (NGUSHHUB INCX Index); Platinum LPPM (PLDMLNPM Index); Aluminium LME (MBALAL02 Index); EEX Electricity (LPXBHRBS Index); Malaysian Palm Oil (PAL2MALY Index); US Corn (CORNILNC Index); China Cold Rolled Steel (CDSPCRAV Index); US Wheat (WEATHO1H Index). Rebased with price on January 30th 2003 set to 100.

Figure 1: Commodity prices by quarter 2000-2013 (2003=100)

1 S&P 500; WTI Cushing Crude Oil Spot; USDA No.1 Hard Red Winter Wheat Spot; Accenture analysis

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As a result, businesses face huge commodity-driven swings in key raw material and outputs costs (Figure 2). For example, a manufacturer buying gas for powering machinery will at different times have faced prices of almost double and less than half the average across the period. Not all of these swings can be passed on to customers. In price elasticity research spanning multiple industries, Accenture found that the pricing-in of commodity price increases is asymmetric. Decreases are typically passed on in full to customers

through lower prices, but the same customers resist commodity price increases. Commodity swings therefore can squeeze margins. By way of illustration, Accenture analysis shows that while over the past 13 years the price of bread has increased by about 50 percent, the cost of wheat – its principal ingredient – has risen by almost 150 percent.

To assess the impact of commodity price swings, we analysed a small number of companies in different sectors, looking at

their commodity-exposed cost of goods sold (COGS) and the particular basket of commodities to which each is exposed (Figure 3). We then calculated the impact of lowest and highest prices between 2008-2012 on their COGS, assuming that none of the rises is passed on to customers (which is typically true, at least in the short run). We found that under this stress-scenario the airline, automotive and food manufacturing sample companies are all pushed into unprofitability (Figure 4).

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Figure 2: Commodity price swings 2008-2012: high and low prices against average over period

Sources: Bloomberg; Accenture analysis

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Figure 3: Commodity costs versus consumer goods prices 2000-2013

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Figure 4: Impact of low and high commodity prices (based on 2008-2012 range) on gross margin by sector

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Non-Commodity COGS Commodity COGS Gross Margin (%) Low Case High CaseAverage Case

Sources: Bloomberg; US Department of Labor Statistics; Accenture analysis

Sources: Bloomberg; Accenture analysis; gross margin and commodity basket assumptions based on anonymised sample of Accenture clients

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Reaction

This vulnerability to price swings has been moving commodity price management up the agenda for most companies since 2008 (Figure 5). In line with this trend, we have seen increasing investments in CPRM enablement during the period.

However, these investments remain the exception. We continue to see a wide capability gap between most companies and their CPRM-enabled peers; the gap with leading practice companies is wider still (Figure 6).

The gap is not just between companies, however. It is also between industries. For example, energy companies, having dealt with extreme price volatility for half a century, are relatively mature compared with companies that are experiencing volatility as a more recent phenomenon. Accenture carried out a study based on energy contract prices for firms in multiple industries, and compared these prices against spot prices.

We found that industries with typically less mature CPRM capabilities, such as food manufacturing and agribusiness pay a significant premium over spot prices (Figure 7). In part this is owing to suboptimal contract structuring, but it also happens because the lack of CPRM denies companies the opportunity to lock in prices when they are low.

Figure 5: CPRM capability evolution since 2008

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Figure 6: Accenture capability maturity stages

CPRM Capability Maturity Journey

• Risk of unexpected price shocks for each business unit is quantified and reported

• Financial instruments complement supplier contracts as a hedging mechanism

• Central specialist CPRM organization

• Sta� with quantitative risk management experience

• Minimal risk quantification or reporting

• Price risk managed wholly through contractual arrangements with suppliers

• No specialist CPRM capability within Procurement, and price risk primarily managed by business units

• Portfolio risk measured, and quantity of cash reserves optimised accordingly

• Scenario / what-if analysis performed

• Illiquid commodities hedged using proxies

• Price risk management o�ered as a service to customers

• Forward price view feeds into pricing and integrated planning

• Centralised CPRM organization with advanced analytical capabilities and tools

• Incremental CPRM value contribution is measured

Lagging CPRM Enabled Leading

Figure 7: Energy premium paid by different industries

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Source: Accenture analysis

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Figure 8: Growth in commodity trading volume

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2120%Rosario Futures Exchange525,303

JSE South Africa2,532,674

London Metals Exchange159,719,781

Dalian Commodity Exchange633,042,976

Multi Commodity Exchange of India959,613,240

Sydney Futures Exchange587,858

Tokyo Commodity Exchange75,413,190

CME Group2,890,036,506

3567%

Exchange nameNo. contracts traded 2012

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Of course, many companies – even in less mature industries – have been hedging and managing price risks for a long time. But these actions are becoming wider and deeper in response to high volatility. Accenture believes that for companies in immature sectors there can be a significant ‘leading practice dividend’ to be gained from adopting CPRM practices that are commonly used elsewhere.

Adoption of CPRM practices is enabled by markets’ increasing liquidity. We show in Figure 8 the emergence and growing maturity of commodity trading volume in markets in regions in which it has hitherto been very difficult to manage risk.

Sources: Accenture analysis; Forward Industry Association, ASX website, JSE South Africa website, Rosario Futures Exchange website

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Benefits

CPRM has three major benefits. First, it is usually cheaper than managing risk through suppliers. This approach is often expensive owing to suppliers’ operational immaturity and suboptimal scale, leaving a business with no control over an inflated cost item. Developing a CPRM capability that can manage hedging means a business may hedge more cheaply. In addition, CPRM broadens the range of suppliers and facilitates shopping around for best-value deals.

Accenture Trading, Investments and Optimisation Strategy (ATIOS) worked with a European food company to reduce the cost of price fixing, which was executed through fixed-price contracts with multiple suppliers. By hedging across the portfolio as a whole and avoiding the supplier risk premium, costs were reduced by c.1 percent of total commodity spend.

Second, CPRM can help reduce margin volatility. The difference between the choppy spot price and the rolling average represents a significantly more stable spend. This can be achieved through simple, coverage-based hedging rules. These can be complemented with accurate demand forecasting to reduce volumetric risk. Stability reduces the liquidity required to protect against price movements. A substantial body of academic literature demonstrates how hedging reduces both working capital requirements and the likelihood of financial distress. Further, by reducing the volatility of earnings, CPRM can help drive a significant uplift in equity valuation.

Accenture simulated multiple hedging scenarios (Figure 9), with different hedging strategies (hedging coverage levels at different times from delivery). These were applied to 191 simulated price curves. For each strategy, we calculate the average volatility across all scenarios. Both strategies that fully hedge a long time out and strategies that do not hedge at all incur significant volatility. They both lock into prices at a fixed point, whether close to or far from delivery. The best way to reduce volatility seems to be to ramp up hedge coverage gradually, effectively taking an average price over time. This spreads exposure and can reduce risk.

Third, hedging offers companies the opportunity to decide when to lock in prices in order to reduce their COGS. Rather than being tied to the spot price at time of delivery – or to whatever prices that options suppliers offer that are fixed – prices can be locked when they are judged to be low (Figure 10).

ATIOS supported a global beverage company as it developed its own proprietary market view based on commodity supply and demand fundamentals. By laying hedges in line with this market view, the company has saved $25 million a year from an approximately $1 billion annual commodity spend, about a 2.5 percent savings. Even simple mean regression strategies, used over a sufficient period, can produce major savings. Figure 10 shows that locking in prices at the 10th-lowest price of the 27 available weekly spot prices represents about a 10 percent savings.

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Figure 9: Average daily volatility of returns for different hedging strategies under 191 price scenarios

Figure 10: Volatility reduction and average commodity cost savings from illustrative CPRM strategy

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Weekly spot UK bread wheat price (GBP/tonne) 6-month rolling average UK bread wheat priceMarket call wheat price (locks in the 10th-lowest price of the preceding 27 weeks)

By identifying periods of advantaged pricing, companies can reduce their average COGS

Source: Accenture Hedge to Perform Strategy Simulation Tool

Source: United Kingdom Aggregate Bread Wheat Weekly Spot Index; rolling average price over 6 months; post-market call price assumes that of the 27 available weekly spot prices in the previous 6 months, the price was locked in at the 10th-lowest price; for the margin at risk calculation; we assume that the rises cannot be passed on to customers, and that all European wheat is bought on the same index. Data is displayed quarterly.

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Challenges

While CPRM presents a great opportunity for companies in maturing sectors, that same lack of maturity also presents challenges that prevent many companies from realizing the leading practice dividend.

In our experience, the main challenge lies in developing awareness and understanding of CPRM – particularly among senior leadership. Even the best CPRM strategy will lose money in some months, because its very essence is managing uncertainty. Uncertainty can have positive and negative effects – if the market falls, a completely unmanaged purchasing position will gain more than one that is hedged to lock in a margin. But such uncertainty erodes value and puts the business at the mercy of factors beyond its control. Therefore, senior leaders should understand that the purpose of CPRM is risk measurement and management. Rather than fixing on opportunistic results over a single short period, senior management needs to be able to understand the benefits of the strategy over the medium term. Without this broader understanding and longer-term view, there is a risk that leaders will attach disproportionate significance to negative results that are still within the expected and planned range.

The need for a broader understanding reaches beyond senior levels. Most companies have employees with deep commodity knowledge in their procurement function. And they have Treasury employees with deep knowledge of financial instruments. The challenge is to bring these two capabilities together in order to successfully address the specialist nature of commodity hedging. Achieving that may require investment in either developing the right skills or in recruiting experienced staff. Once in place, those specialists have to be given the authority to manage market risk centrally on behalf of the whole business.

The final challenge is achieving consistent implementation of the hedging and risk strategy by embedding it in a system. The biggest practical obstacle here is finding the data needed to support a centralised CPRM program. That means not only pricing data, but also the demand forecasts and contracts required to understand current exposure. This can be difficult for businesses with a highly fragmented and complex IT landscape and will require the effective management of interfacing and integration issues.

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Despite these challenges, companies across all sectors are realising the benefits of CPRM – often drawing upon examples from the energy industry as a template. But we believe that CPRM is one of the key high-return initiatives available to almost all companies. It can offer the potential to increase margins, achieve differentiation and gain sustained competitive advantage in crowded markets.

Risk Management Case StudyA global airline moved from not knowing how at risk its business was from fuel price swings and economic performance, to deploying a risk perspective in order to inform better partnering, procurement and financing decisions.

The airline understood that it was heavily exposed to jet fuel prices, and also that the relative performance of its business depended on regional economic outlooks. But its leadership team was struggling to

answer critical risk-related questions. For example: What sort of monthly swings in jet fuel costs could it expect? What proportion of these changes could be passed on to customers? Would an alliance or acquisition in a new region make the business more or less risky? And did it have enough cash to survive severe but plausible shocks?

The airline began its risk capability development by quantifying risk from commodity and economic shocks. It then created a weekly report that provided a summary that the business’s leadership could easily understand. The headline result from the risk report was that once in every 20 months the airline could expect margins to be hit by market risk greater than a calculated financial sum.

Armed with clarity about the level of risk it faced, the airline was able to make sure it had sufficient liquidity should the risk materialize. The business developed a waterfall showing its liquidity position (Figure 11) (broken down into cash, credit lines and all other sources of liquidity), and then all the drains on that

liquidity, from interest repayments to plane leases. The amount left over was the liquidity available to meet its market risk. Based on these calculations, the airline found that once in every five years it would not be able to cover the expected cash drains from its risk. It moved quickly to increase liquidity.

The airline was able to use these new risk capabilities to realize value in other areas of the business. For example, by taking a risk perspective for its M&A and alliance deals it gained a competitive advantage in the industry. It calculated the impact of a deal using its new risk modelling capability and tools. This took into account natural hedging, exposure to different regional economies and the exact structure of the deal. This enabled the airline to see whether a deal moved it closer to the risk-return ‘efficient frontier’. Taking the risk dimension into account transformed the assessment of prospective deals. For example, a deal that had previously been assessed as marginal was elevated to the highest priority and was pushed to conclusion because of its risk-dampening effects.

Potential

Figure 11: Illustrative liquidity waterfall

Sources of Liquidity

Uses of Liquidity

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Jet Fuel Risk

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Capital Adequacy Ratio+42%

Maximum tolerable 99% 1 Day VaR (here actual VaR is higher, putting company at risk)

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Market View Case StudyA leading beverage company started timing its hedging so that it was locking in prices at times when they were abnormally low, reducing per unit commodity spend by about 6 percent.

While the company had an active hedging strategy, it was based on a set of predetermined rules. In each of the 12 months preceding delivery, it locked in prices for a predetermined percentage of the spend as can be seen in Figure 12. However, while this reduced the volatility of prices, the effect on the overall level of commodity spend was neutral. For some months, hedging actually locked in a higher price than the market was offering at time of delivery. After a protracted period of rising commodity spend, the CPRM function was tasked with using its capabilities to lower the average price.

The CPRM function invested in a set of market analysis tools. This included supply and demand analysis tools that incorporated the company’s operational insights and data. It identified upcoming market undersupply or oversupply. The CPRM team then issued a weekly market view report projecting price movements of major commodities over the next 18 months. The financial policy was amended to provide discretion to increase coverage when prices were expected to rise and decrease when expected to fall (Figure 13).

The ability to choose when to lock in prices meant that, even though the market retained its capacity to surprise, over time the company was able to achieve lower prices. Further, by reviewing historical performance it was able to refine and improve its market analysis. This ability has given the business a sustained competitive advantage, because its competitors remain tied solely to the whims of the market.

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Figure 12: Static hedging policy

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Figure 13: Dynamic hedging policy

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Figure 14: Dairy market illiquidity

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Illiquid Commodities Case StudyA consumer foods company developed the capability to hedge commodities that are not traded, and so could offer its customers unique fixed price contracts at a higher margin.

This company is primarily based in EU markets, and has a 25 million Pounds dairy spend (primarily butter and milk). Customer prices are negotiated once a year, and customers are resistant to more frequent revisions.

However, dairy markets in Europe are illiquid with limited availability of futures and swaps. Suppliers and third parties charge a prohibitive premium for hedging the commodity.

To address this challenge, the company’s CPRM team developed a toolset to manage illiquid commodities such as dairy. They did this by identifying a basket of commodities that together moved in the same way as the illiquid commodity. By using an advanced regression model, deploying an analytically skilled team and maintaining ongoing back-testing and calibration, the CPRM function achieved a correlation of 85 percent.

In a market with squeezed margins and increasingly commoditised products, the ability to offer fixed price contracts on dairy products is a truly differentiating factor and therefore commands a premium. Moreover, removing dairy volatility from earnings can significantly improve earnings stability. Owing to its success, the initiative is now being extended to other illiquid commodities.

Sources: Bloomberg Eurex butter futures; Accenture analysis

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Our work with multiple companies developing CPRM capabilities offers two principal lessons. First: Start small with a pilot for a single business or for a single commodity. This provides the opportunity to validate the business case and to demonstrate success. It also promotes the gradual education of the organisation in a way that a ‘big-bang’ approach may not. Second: In addition to starting small, think big. At the end of the diagnostic, combine the pilot with a longer-term roadmap. Define the value CPRM should be adding in a year, and in three years. This means that when wins from the program start to accumulate, the business can be well-placed to maintain momentum.

Typically, the first step for companies is to run a 6-to-12-week diagnostic engagement, comparing CPRM against leading practices and identifying both quick-wins and medium-term opportunities.

If you would like to learn more about how a CPRM capability could benefit your business, please get in touch with us. We would be delighted to have a conversation with you about the specific challenges and opportunities facing your business.

Where to start

Figure 15: Typical CPRM journey

1. Diagnosis and quick wins

2. Getting visibility

3. Developing hedging strategy

4. Driving integrated margin

5. Using financial

Building Blocks Improvement Optimisation

• Quantification of value loss from commodity moves

• Quick wins can involve:

- Pricing risk and optionality into customer contracts

- Identifying ways to improve supplier contractual structures

- Identifying excessive supplier risk premiums

Illustrative components

• Full cost modelling to derive commodity exposure

• Full position reporting (for example, call-o�s, supplier contracts and hedges)

• Quantification and reporting of margin @ risk

• Demand forecasting accuracy improvements

• Financial policy and hedge accounting updates

• Hedging KPIs

• Hedging strategy determined within financial policy parameters

• Market view analytics integrated into hedging strategy

• Treasury and cash flow management optimisation

• Use of suppliers and third parties to manage risk

• Storage and inventory integrated into market strategy

• Contracts managed to maximise take-up of advantaged swing terms

• Customer o�ers structured with priced-in risk management

• Elasticity analysis used to optimise response to commodity price movements

• Use of futures and options to optimise risk/reward trade-o�

• Capability to create hedging ‘baskets’ for illiquid commodities

• Back-o�ce automated margining capability

Contact Us

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Ogan KoseOgan Kose is the global managing director of Accenture Trading, Investments & Optimisation Strategy, which is part of Accenture Strategy & Sustainability Group. Overall, he has more than 15 years’ experience helping commodity players manage their earnings and risk management. His primary focus areas are commodity trading, risk management, investment evaluation and financial analysis, pricing, and commodity contract structuring. At Accenture, Ogan has worked to help clients across multiple geographies, such as the United States, Europe, China and Southeast Asia. He holds bachelor of science and master of science degrees in chemical engineering (Imperial College, London) and a master of business administration from Georgetown University. He is a member of the Global Association of Risk Professionals and is a financial risk manager. He is based in London.

Email: ogan.a.kose@accenture.com

Miguel Gonzalez-TorreiraMiguel is a director in the Accenture Trading, Investments & Optimisation Strategy practice. Overall Miguel has more than 10 years’ experience working with commodity players. His primary focus area is Commercial Optimisation, helping clients define their operating models in order to bring strategic and operational synergies across production, supply, trading, pricing and marketing of commodity products. Miguel has worked with multiple clients on trading strategy, risk management, pricing performance and profitability analysis, working capital reduction, customer portfolio optimisation, supply and demand modelling, and competitive positioning. He holds a bachelor of science and master of science in physics from the University of Santiago de Compostela, Spain, and a doctorate degree in engineering from the University of Birmingham. He is based in London.

Email: m.gonzalez-torreira@accenture.com

Jamie GardinerJamie Gardiner is a manager in the Accenture Trading, Investments & Optimisation Strategy practice. Jamie has commercial optimisation experience across a range of hard and soft commodity industries, including coal, downstream fuel, LNG, airlines, and beverages and ingredients. His functional experience includes commodity trading, pricing, forecasting, risk management, and integrated planning. Jamie holds a bachelor of honours degree in politics, philosophy, and economics from the University of Oxford, and a bar vocational qualification from the Inns of Court School of Law. He practiced at the English Bar prior to joining Accenture, and is based in London.

Email: jamie.gardiner@accenture.com

James SmythJames Smyth is a senior consultant in Accenture Trading, Investments and Optimisation Strategy, which is part of Accenture Strategy & Sustainability Group. James primarily focuses on commodities markets fundamentals analysis, commodity trading strategy, and commercial optimisation. James has worked with multiple mining majors and juniors, national oil companies and oil majors. Prior to Accenture, James spent three years in the financial services industry, working for a global bank and for an asset management firm, within the fixed income, equity, and commodity markets. James is a Member of the Chartered Institute of Securities and Investment and holds a first class honours degree in economics from the University of Warwick. He is based in London

Email: james.p.smyth@accenture.com

Other major contributors:Rory Skrebowski, trading, investment and optimisation strategy director, London

Hannah Daly, trading, investment and optimisation strategy analyst, London

About AccentureAccenture is a global management consulting, technology services and outsourcing company, with approximately 289,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the world’s most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$28.6 billion for the fiscal year ended Aug. 31, 2013. Its home page is www.accenture.com.

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