How Companies Are Coping with Unstable Commodities

With more price shocks, they're managing risk more aggressively and coming up with new contract provisions

It's one expensive breakfast menu: Wheat futures up 70 percent since June. Corn at a 24-month peak. Coffee at a 13-year high. And lunch? Forget about burgers. Futures on cattle are at a 24-month high. Tofu and edamame? Soybeans are at their highest level since June 2009.

Extreme price volatility in commodities of all kinds is forcing companies to rethink their strategies—not just for managing the risk to earnings, but for making sure they can get the raw materials they need to meet growing global demand for their products. Moves range from Chinese car and battery maker BYD's recent purchase of 18 percent of a Chinese lithium mine to Mars' recent work with IBM (IBM) and the U.S. Agriculture Dept. to sequence the cacao genome and, it hopes, breed a hardier cocoa tree.

Commodity price spikes are nothing new, and companies have long hedged against them. "The difference is that this cycle has a much bigger exogenous shock to it," says Harold L. Sirkin, a senior partner at Boston Consulting Group. "About one billion people from the developing countries will move from poverty into the world of consumerism over the next decade." Concern about tighter supply and more extreme weather has companies "absolutely more focused" on managing commodity exposure, says Sirkin.

Most companies hedge with financial derivatives such as futures contracts. General Mills' (GIS) earnings gain in the latest quarter was due in part to a jump in the value of hedges on grain it entered into when prices were lower. Such contracts roll over periodically, so companies face the risk of having to lock in higher prices. General Mills says it has locked in about 65 percent of its need for commodities and energy for fiscal 2011.

Buying into a supply chain, as BYD did, is the most extreme response to uncertainty. ArcelorMittal (MT), the world's largest steelmaker, purchases iron ore and coal mines so it has the materials it needs to make steel. On Sept. 16, ArcelorMittal said it would spend about $4 billion to expand iron ore production to 100 million tons by 2015. When you secure raw materials that way, "you're making a very big bet," says Hans-Kristian Bryn, a partner in the London office of consulting firm Oliver Wyman. "You're saying: How much capital am I willing to tie up to make sure I've got a bigger degree of control over my physical security?"

Some companies take a hands-on approach to ensuring supply. On Aug. 27, Nestlé launched a program to invest 500 million Swiss francs ($508.6 million) in coffee projects by 2020. Nestlé agronomists will provide advice to farmers and give them 220 million high-yield, disease-resistant coffee plants. Last October the company said it would spend 110 million Swiss francs to improve the quality of cocoa, pledging to give farmers 12 million cocoa plants by 2020. Japan's Bridgestone Group just announced a similar, smaller project for growers of rubber trees.

Companies can hike prices, which could alienate customers or cause them to opt for lower-margin private label goods. At Starbucks (SBUX), recent increases in the cost of buying beans and other necessities such as dairy, sugar, and cocoa led to a change in pricing strategy. On Aug. 17, Starbucks stated on its website that it intended to absorb rising bean prices. Then, on Sept. 22, it said it would raise prices on "labor-intensive and larger-sized beverages" in some markets. In a statement, Chief Executive Officer Howard Schultz said rising costs for key ingredients have "completely altered the economic and financial picture of many players in the coffee industry."

The likelihood of "permanent volatility" is leading to contracts that build in more flexibility, says Greg Cudahy, global managing director of Accenture's (ACN) Operational Strategy Practice. For example, a company may commit to buy a set amount of a commodity, but once it hits that amount it can cut back or ramp up as needed. The supplier gets some guarantee of demand; the buyer gets more flexibility. "You can't just squeeze a supplier anymore or count on a commodity going up or down," says Cudahy. "You have to help partners lower their cost of business."

Some buyers are also lengthening contracts. An executive at a major consulting firm sees some clients going from contracts of 12 to 24 months out to five years. More contracts have price escalator or deflator clauses, based on whether a company expects inflation or deflation. So if a company that's a big consumer of wheat is making a deal with a supplier, it could lock in a price that's either fixed or is linked to all or part of the move in an index over five years. That allows the producer to lock in profit or, now that it has a guarantee of demand, make a more informed decision about expanding its crop or mine. Both parties get more certainty. And certainty is a hot commodity.

The bottom line: Spiking raw materials prices and long-term supply worries are leading clients to rethink how they manage exposure to commodities.

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