This is an observation we often hear. People who make it believe it to be true but things are not always as they seem. What follows is a description of commodity price exposure in the stainless steel industry and the pitfalls of complacency – which could just as easily apply to your business, with the names changed.
The stainless steel industry realized long ago that, in risk terms, it was basically a nickel trading industry with steel-making overtones. On top of that, nickel is one of the most volatile commodities known to man. To avoid disaster, the industry had to deal with that volatility and so it came up with what it called the “nickel surcharge”. If nickel prices go up (or down) the price list of a company’s many stainless steel products is automatically adjusted to nickel cost by an indexing formula. Later on the industry added indices for other alloy metals – et voila, back-to-back pricing with no metal price risk.
However, it did not work out quite so neatly. As with any Price Risk Management Program, the devil is in the details:
What is the answer? There is nothing wrong with indexing sales to raw material costs. In the long run it is beneficial. In the medium term however it is not enough on its own to smooth out unacceptable income volatility. The key steps to success are, firstly a detailed understanding of the mechanism of your financial exposure to nickel price fluctuations, and secondly, getting visibility of its financial impact within your business. With that in hand there are many tools to manage the exposure, including but not limited to financial hedging.
The lesson for all commodity processors is that a detailed understanding how commodity price exposure happens within the business must come first. How to manage it then becomes more obvious.Permanent Link