INSIGHT COMMODITY RISK: BREWING

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IN AN INTERVIEW with Britain’s Daily Telegraph in 2011, Jørgen Buhl Rasmussen, the chief executive of global brewing giant Carlsberg, commented on the effect that hedge funds were having on commodity prices. The weather had had an undoubted impact on price fluctuations, he acknowledged, but so too did outright financial speculation.

“It’s a combination: the trigger is clearly a bad harvest, but on top of that you get speculation,” he said. “Some of the hedge

funds, especially those [engaged in] short selling, I do not see as contributing to value creation. That’s why we never talk to analysts about how much we’ve hedged or not hedged, because that can sometimes trigger even more speculation.”

And what could be done about the problem? Not much, it seemed. It was doubtful, said Rasmussen, that regulation could be effective – because to be effective, regulation had to be global, and this seemed unlikely.

Trouble brewingCOMPANIES IN the brewing industry and, indeed, within the wider food and beverage sector, face

a unique set of challenges that can only be managed with the application of increasingly advanced techniques.

With ongoing price volatility of key commodities, squeezed margins and a consumer base happy to switch products dependent on which brand is providing the best offer at the time, procurement has the potential to become increasingly relevant to the business.

But to do so requires a change of approach from procurement, adoption of new techniques, and true alignment and engagement with the business – after all, a relatively benign swing in commodity prices can wipe out product margins in the blink of an eye.

In the pages that follow, we report on the challenges brewers and food companies face, and how old approaches to new problems simply don’t work.

David RaeContent and community director

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INSIGHT

The brewing industry is particularly vulnerable to commodity price fluctuations, which makes managing risk vital

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Meanwhile, he reported, Carlsberg had set up a special centre in Switzerland, staffed with a “significant number” of experts specifically tasked with looking into commodity pricing trends.

“We have to get used to more volatility on commodity prices,” he said. “[And] how to manage that volatility in terms of consumer pricing is a new challenge. We can’t have prices going up and down in line with commodities.”

Over at fellow brewing giant SABMiller, meanwhile, chief financial officer Malcolm Wyman was making a similar point in

the company’s annual report to investors for 2011. Margins for the forthcoming year, he reported, were threatened by “rising commodity prices, which have adversely impacted the cost of brewing raw materials in particular”.

As at the end of March 2011, he noted, half of the group’s barley requirements for the forthcoming financial year were covered by supplier contracts, but at somewhat higher prices than in the previous year, following the year’s poor wheat and barley harvests. In addition, certain

packaging raw material costs, as well as distribution costs, were expected to be affected by the increase in crude oil prices.

Perfect stormNor are Carlsberg and SABMiller alone among brewers in being concerned about the impact of volatile commodity prices on their profit margins and business models. Brewers, as with all food and beverage companies, are greatly exposed to the vagaries of commodity markets.

From physical ingredients such as barley and wheat, to the natural

In today’s era of rising commodity prices, why aren’t traditional strategies working?Historically, there have been two strategies that consumer products companies have used to maintain margins in the face of rising commodity and raw material input costs: first, to pass through increased costs to consumers by raising point-of-sale prices; and second, to cut costs in the supply chain.

However, you can only raise prices to a certain point before consumers start buying less of your product or switch to lower-priced competing brands and generics. When retail price increases can no longer cover increased input costs, manufacturers have taken aim at the supply chain cost structure. Yet most leading consumer product companies have already wrung out available supply chain savings through cost cutting and productivity improvements.

What can be learned from the approach of leading organisations?Best-in-class food and beverage companies are implementing real-time technology infrastructures within their procurement organisations to view, aggregate, and evaluate all cost models and conduct forward-looking scenario analysis as plans change and markets move. The procurement function in your typical food and

beverage company is not equipped with this type of infrastructure, and doesn’t have the real-time transparency, business intelligence, analysis tools, market data, and position reporting required to make the most profitable, cost-efficient decisions around commodity coverage and procurement.

Consumer product companies must make a choice – continue to purchase commodities using the same processes they have in the past, or adopt real-time technology infrastructures like their best-in-class peers.

What benefits have been experienced by those organisations that do just that?It’s shocking, but I still find that many companies manage commodity risk in spreadsheets. When organisations adopt the Triple Point solution they are able to move from a position of reacting to market volatility to a much more proactive strategy of actively controlling volatility, smoothing earnings, and increasing profitability. Triple Point customers can not only ensure coverage, stay within budget, and deliver materials when manufacturing needs it, but can also analyse commodity risk and perform scenario analysis. The new benchmark for procurement organisations is how well spend is managed relative to market prices and competitors, not just how well the budget is managed.

Q&A: Michael Schwartz, chief marketing officer, Triple Point Technology

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gas and electricity used to power the fermentation process and bottling and canning plants, and from the energy-intensive aluminium and oil-based plastics that package the product, to the diesel fuel used to truck it to wholesalers and retailers, it seems that brewers are vulnerable to input-price volatility at just about every point on their value chains.

“Looked at that way, beer is almost the perfect commodity-centric product,” says Mickey North Rizza, a former Gartner analyst, veteran industry observer, and vice-president of strategic services at Chicago-based BravoSolution, a supply chain consulting and services provider.

“The bill of materials is heavily commodity-centric, the packaging is commodity-centric, and the manufacturing and transportation processes are heavily commodity-centric.”

Worse, point out industry insiders, the effect of rising input prices is to adversely impact profit margins, as the nature of the market for beer and its competitive characteristics renders short-term price increases difficult to impose.

In both draft beers and canned and bottled product, for instance, consumers are well-attuned to prevailing price levels, thanks to the market’s pattern of regular consumption. This is similar to most other high-turnover consumer products and unlike products where purchases are made infrequently – allowing time for consumers to forget the precise price paid on their previous purchase – beer drinkers for the most part tend to purchase

and consume with a frequency that renders them liable to ‘sticker shock’ if prices are markedly out of line with expectations formed by recent past experience.

The corporate buyers at supermarket, restaurant and pub chains, too, are well-attuned to both prevailing price levels and consumer sensitivities. The profit margins enjoyed by the market leaders are clearly known to buyers, who can balance consumer demands for specific brands on the one hand with the option of product substitution with the other. For while the major brands carry weight and engender consumer ‘stickiness’, buyers also know that a sizeable proportion of the market is promiscuous, allowing their brand preferences to be overridden by price and promotional considerations.

“The consumer has a consumption pattern, and is very aware of the price of beer,” sums up Rizza. “The tiniest difference in

the price of aluminum, grain or natural gas will make a difference to product profit margins.”

Worsening volatilityBut – as acknowledged by Carlsberg’s chief executive Rasmussen – input-price volatility not only isn’t going to go away, it looks as if it is set to increase. SABMiller goes further, noting price volatility as a specific risk in its annual report for 2011: “The prices of our key raw materials remain highly volatile, and the level of volatility is increasing.”

Indeed, as long ago as 2004, a United Nations Food and Agriculture Organisation (FAO) report, The state of agricultural commodity markets, noted that although increases in productivity had delivered a long-term decline in the price of agricultural commodities, attempts to deal with price volatility had, for the most part, failed.

Market power, it noted, was increasingly concentrated

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into the hands of a few transnational corporations. Just three companies, for instance, controlled almost half the coffee roasting in the world, and the 30 largest supermarket chains controlled almost one third of grocery sales worldwide.

What’s more, commodity demand from China’s fast-growing economy will come to play an increasingly significant role in world markets. According to estimates prepared by the UN Population Division and investment bank Goldman Sachs, and reported in Forbes, by 2030 China should have approximately 1.4 billion middle class consumers – compared with 365 million in the United States, and 414 million in Western Europe.

And, as a paper published in 2012 by International Monetary Fund economist Shaun Roache points out, China’s undoubted

muscle in metals markets has yet to be felt in foodstuffs.

“In terms of broad commodity groups, China has come to play a dominant role in base metals markets and, to a somewhat lesser extent, agricultural raw material markets,” he writes in China’s impact on world commodity markets. “In contrast, China has not yet assumed a large role in global food and energy markets, although its share of world imports is rising.”

The ‘new normal’Nor, it seems, are present levels of commodity price volatility a transient phenomenon. A recent seminal paper – jointly authored by Prof Martin Christopher of Cranfield University School of Management, and Matthias Holweg of the University of Cambridge’s Judge Business School, and published in 2011 – argues forcefully that this

volatility must be recognised as the ‘new normal’.

Using published data going back more than 40 years, the authors constructed a supply chain volatility index based on a composite of commodity cost. Among others, the price variables in question included the price of oil, the Baltic Dry Index shipping rate index, measures of relative exchange rates and interest rates, and the Chicago Board Options Exchange Market Volatility Index.

The key finding: over the period of the study, the level of volatility currently being experienced within manufacturers’ supply chains is fundamentally different from that which has been experienced during previous events such as oil crises, or political instability and terrorism.

“As of 2008, we have left behind an almost 30-year lasting period of stability, and are now entering a

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period of turbulence that was last seen during the oil crisis of 1973,” observed the authors. “The environment in which we do business is changing, and so must our supply chain strategies.”

The argument: most current supply chain management models emanate from a period of relative stability, which calls into question the issue of whether they are suitable to meet the challenge of increased turbulence. Simply put, current supply chain management models were all conceived during a long period of relative stability, and this assumption of stability no longer holds.

“Supply chain management has quite literally transformed our thinking about how markets may best be served, and how significant competitive advantage can be gained, and lost, if it is neglected,” writes Christopher and Holweg. “What we often forget is that supply chain management as an idea is relatively new, [and] first emerged in an early form less than 30 years ago.”

In short, tactics that have worked to date cannot be relied upon to continue to work in the future. Something more is required.

Broadening the focusAnd self-evidently, tactics that deliver value in the global brewing industry will have broader appli-cability than just the production of beer. Brewing is part of a much broader industry – the food and beverage industry – which shares a similar commodity exposure, and faces a set of broadly comparable competitive challenges.

And the impact of the issue on the global economy is difficult to ignore. According to the IMAP Food and Beverage Industry

Global Report: 2010, the global food and beverage sector was valued at $5.7 trillion in 2008, and is expected to grow to $7 trillion by 2014. Yet for all its size, the industry is highly fragmented, notes the report,

and the top few players – companies such as Nestlé, Kraft Foods, Unilever and Cargill – account for less than 5% of the industry’s overall value.

Among consumers of basic commodities, in short, it is a lack of scale that contrasts sharply with some of the market concentration seen among producers, where the ownership of key raw materials, particularly at critical stages of the value chain, can reside in relatively few hands.

Worse still, when selling their products, manufacturers in the food and beverage industry not only face a similar resistance to price increases as brewers, but must address a tougher competitive paradigm. For not

only do a relatively small number of supermarket chains dominate a significant portion of the market – as noted earlier – but profit margins are generally tighter.

“As direct material cost is a greater proportion of overall cost than in other industries, volatility in raw material prices in the food and beverage industry is a much bigger issue than in other sectors,” says Alex Davison, a managing consultant at PA Consulting Group and a

The shocks to the balance of supply and demand induced by [natural] phenomena are having an amplified effect

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125

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90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

FAO Food Price Index

Source: United Nations FAO

2002-2004 = 100

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former food industry executive. “Not only is it more difficult to

pass price increases on to customers, but as margins are generally lower, a rise in raw material costs can easily move a product from profit to loss.”

Price rise susceptibilityAnd the industry’s present susceptibility to those rises in raw-material input prices is undoubted: in 2011, for instance, the United Nations’ FAO Food Price Index reached an all-time high of 227.6, up from 126.6 as recently as 2006 – a 100-point rise in foodstuff costs in just five years, and an increase in percentage terms of some 80%.

Over a shorter timescale, price volatility has been less extreme, but is still significant. The overall Food Price Index averaged 212 points in March 2013, the most recently available data point at the time of writing – up 1% on the previous month, but 1.7% below March last year, and nearly 11% below its peak in February 2011. The FAO Cereal Price Index – of particular interest to brewers, and many food manufacturers – was 7% higher than in March 2012, but still 11% below its peak in April 2008.

The causal factors? Natural phenomena, in the main, as business advisors Grant Thornton’s food and beverage international business report 2011 makes clear.

“In the past six months of 2010, as drought and wildfires ravaged wheat crops in Russia, global wheat prices soared 95%,” it reported. “During this period, corn and soybean prices also climbed 64% and 39%, respectively, as adverse weather conditions in the US led to smaller-than-expected harvests.”

Yet natural phenomena are nothing new, and from a historic perspective which are an ever-present fact of life. What appears to be happening – for whatever reason – is that the shocks to the balance of supply and demand induced by such phenomena are having an amplified effect, compared with historic norms.

For as the accompanying chart

(previous page) shows, the sudden surge in volatility seen since 2007 contrasts sharply with prior experience. Simply put, the FAO Food Price Index largely went nowhere for almost 20 years, fluctuating slowly in a narrow band of 100-120. What surprises there were, were chiefly on the downside, such as the falls below 90 in the period 1999-2003.

In short, the extent of the fluctuations since 2007 has been dramatic, adding weight to the Christopher-Holweg argument that the industry is experiencing a ‘new normal’.

“Most food and beverage companies are caught between rising commodity prices and a

competitive environment, which makes it difficult to pass along those increases to customers,” sums up the Grant Thornton report. “Rising commodity prices are affecting food production, selling prices, and profitability.”

The search for solutionsIn the face of such price volatility, brewers – and food and beverage manufacturers generally – have traditionally relied upon a number of mitigating tactics. No tactic will eliminate the need to raise product prices if input costs rise over a long-term horizon. The real key to success is to increase smoothness and predictability of input costs while having the ability to ‘out-price’ competitors. If a food and beverage manufacturer can maintain consumer pricing because of better commodity management while a competitor raises prices, it’s an opportunity to take market share.

Hedging, for instance, provides protection over the period of the hedge. In the ‘new normal’ of greater volatility, hedging enables manufacturers to maintain commodity costs in alignment with plan and budget.

Other well-worn options include changing specifications or recipes, and reducing pack sizes in order to eliminate ‘sticker shock’, says Alan Braithwaite, chairman of supply chain consultants LCP Consulting.

“With their hefty promotional budgets, companies are very nervous about having their gross margins being seen to be eroded,” says Braithwaite, a former executive with Heinz. “Reducing pack sizes allows them to hit

The tiniest difference in the price of aluminium, grain or natural gas will make a difference to product profit margins

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specific price points without affecting margins.”

But again, the relief is short term, and runs the risk of encountering a customer backlash. In early 2013, for instance, UK consumer activist group Which? pointed out that resizing programmes carried out by multinational majors such as Nestlé, Mars and PepsiCo had seen pack size reductions of 6-25%, yet pack prices had been held or even increased. Adverse media coverage duly followed.

That said, pack size reductions are only possible in certain situations: some foodstuffs, as well as alcoholic beverages, are often subject to legislation mandating them to be sold in fixed quantities – specifically to avoid consumers receiving short measure.

A common option is to ‘unbundle’ the commodity-sensitive part of the cost of a supplied product or ingredient. Customers then pay a fixed, agreed price for the conversion or manufacturing process that is applied to the commodity, but allow the cost of the commodity content to vary with the market price. In industry jargon, this segments costs into ‘compressible’ and ‘non-compressible’. ‘Compressible’ costs are negotiated with the supplier, and ‘non-compressible’ costs can be hedged to fix them.

An aluminium can to hold beer, for instance, might cost five cents – of which two cents might represent the cost of the aluminium, and three cents the cost of the conversion process. Buyers of cans, then, can ‘fix’ 60% of the cost of the cans that they buy, retaining only a 40%

content that is subject to commodity price variation.

None of these solutions – or others that the industry has adopted over the years – are cost-free, either in terms of cash, or management time, or both. Hedges cost money, as do long-term contracts and fixed-price agreements. Even pack size reductions necessitate re-tooling packaging lines, and running the risk of consumer backlash.

However, the industry regards these costs as a lesser evil than margin erosion or loss of competitive position, and thus accepts them as part of the cost of doing business.

Alternative approachesThere are alternative techniques available to companies that are willing to embrace technology, however, and one, in particular, has been adopted by some of the world’s leading food and beverage manufacturers, including brewers such as Heineken and Anheuser Busch InBev.

These and other food and beverage manufacturers, such as Unilever and General Mills, use software provided by Triple Point Technology, together with its commodity experience and expertise, to deliver actionable mitigation against commodity cost volatility. More explicitly, argues chief marketing officer Michael Schwartz, Triple Point’s Commodity XL suite is the only commodity management system that “works across multiple commodities, in real-time, integrating procurement, risk management, finance, supply chain and the executive suite”.

Underpinning the Triple Point platform is a blend of risk management and financial engineering, adds Kris Timmermans, global head of the sourcing and procurement practice at Accenture. “Anyone can do hedging: it’s a fixed price, for a fixed period, at a fixed premium,” he explains. “Triple Point’s hedge optimisation is different, combining hedging

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with derivatives, giving protection when the market price moves up, as well as when it moves down.”

The trick, explains Sean Timmins, senior principal consultant at Triple Point, is to be able to do this dynamically, and with enough granularity of vision to be able to exert meaningful control over the complete range of significant commodity exposures that a food and beverage business might face.

“For a business such as a brewer, the goal is to be able to look – on a continual basis, and as forecasts and orders change – at the individual future consumption of commodities such as grain, natural gas, aluminium, paper, diesel fuel and other commodities, and calculate the projected volumes of these, and calculate the projected exposures,” he explains. “And then, in essence, to use derivatives to lock in the forward cost, eliminating the projected exposure.”

In short, says Schwartz, the idea is for manufacturers to use Triple Point’s technology platform to provide the data and tools to protect themselves from adverse cost volatility. And to do it better than competitors in order to gain market share.

Take the example of the brewer buying cans at five cents, with a two cent aluminium content and a three cent conversion cost.

“The brewer – or any other beverage manufacturer – will happily pay the market price for the aluminium content of the cans, because they have a futures contract bought at the beginning of the year,” explains Timmins.

“When they take delivery of the cans, they sell the derivatives, recording a profit, which offsets the additional price of the cans. As a hedge, it costs a tiny fraction of the amount of the physical aluminium involved.”

Granted, says Schwartz, it’s an approach that involves a change of mindset from the traditional purchasing approach. It’s no longer good enough to buy to budget, he notes. With large swings in commodity prices, the real measure will be how procurement performs relative to market prices and competitors.

In essence, he sums up, Triple Point’s technology gives food and beverage manufacturers the ability to tie together the physical and risk-management aspects of procurement at a detailed and roll-up level, maximising flexibility, control, and profit.

“But you can’t do it without a platform like Commodity XL,” he stresses. “You need to have the

operating units, headquarters, and all associated departments seeing the same data, at the right level of granularity – by brand, by region, and by commodity.”

Food and beverage manufacturers operate in a ‘new normal’ which is noted by much greater input cost volatility, he sums up. “Organisations that adopt best-practice processes and systems to operate in the ‘new-normal’ will have a large competitive advantage and gain market share.”

Malcolm Wheatley

ABOUT OUR SPONSORSTriple Point Technology® is the leading global provider of on-premise and in-cloud commodity management software delivering advanced analytics for optimising end-to-end commodity and energy value chains. The company provides innovative solutions for managing trading, procurement, enterprise risk, logistics, scheduling, storage/inventory, processing, settlement, and accounting. More than 400 customers in 35+ countries across industries including energy, metals, minerals, chemicals, agriculture, shipping, consumer products, food and beverage, retail, and

manufacturing depend on Triple Point. Triple Point was named a ‘Leader’ in Gartner’s ETRM Magic Quadrant in 2009, 2010, 2011, and 2012.

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With large swings in commodity prices, the measure will be how procurement performs relative to market prices and competitors

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