Commodities volatility – It may not go away soon!
The volatility of major commodities between 2000 and 2010 leapt up by more than 6 times from the previous decade, measured by changes in standard deviation. Chemicals, metals and mining companies (mainly basic materials) have suffered from an increasing amount volatility affecting both their costs and revenues. Executives continue to cite this as a major operational issue.
Impacts of volatility
Volatility negatively affects chemicals, metals and mining companies, specifically in their ability to predict the cost of production, selling price and cost of capital. Volatility passes through to their margin results and adds complexity to their financial and operational planning. Besides hard mineral market factors, hard mineral prices are also affected by crude oil cost volatility, since energy is responsible for 10% to 20% of mining and mineral processing costs and up to 80% or more of petrochemicals costs. There are two aspects of price movement which must be understood and that are not necessarily directly related: general price escalation and volatility.
Between 2000 and 2010, metals and minerals commodity prices rose, on average, 10.8% per year. Medium- to long-term price rises are mainly related to tighter supply/demand fundamentals. For oil and minerals, much is related to the higher cost of incremental new production, since resources are in harder to reach places. For chemicals, under-investment was not as apparent, although imbalances occurred due to changing feedstock costs. Access to capital inhibited investment in recent years as well.
On the demand side, the liberation of emerging economies in the past decade aided “above normal” commodities demand increases propelled by investments in factories, commercial structures, residences and infrastructure; increased personal consumption; and the proliferation of new low cost finished goods and disposable products around the globe.
Amplification of volatility
Uncertainty sentiments are clear in stock prices and the rise of gold prices (a hedge for uncertainty). The poor performance of equities, as reflected by the S&P 500 stock price index, reflects uncertainty in the market and exacerbates a widespread lack of enthusiasm in stocks. The last S&P 500 index high in recent years was in June 2007, and even then it was only 2% above the previous decade’s high of August 2000. In December 2011, it was still 18 percent lower than the 2007 high. Uncertainty is also proved by the rise in gold price, a hedge for uncertain investors. Gold prices rose sharply, 507%, since the August 2000 S&P 500 high. Therefore, investors have looked to commodities for better returns. Oil is one of the mostly widely used by speculators and other financial traders, but metals and coal are traded as well.
Commodity commercial pricing terms have been evolving from producer B2B transactions to transparent price reference models (examples include coal, iron ore and other metals). Volatility tends to be increased by more frequent changes in and visible publishing of price quotations, but it may also be magnified by the high flow of funds associated with financial trades.
With that structure, price movements get more linked to global events. Also, the broadening of markets geographically and the entry of emerging market players increased pricing exposure. This situation, which strengthens the links of eco-political events to commodities prices, is one of the key factors causing volatility. Exacerbating this are leaner inventories/just-in-time delivery trends, which have unintentionally decreased inventory price buffers. Other factors affecting volatility include: weather, natural disasters; price speculation; conflict in producing or transit countries; exchange rate changes; breakdown of international commodity agreements; export dumping; government export policies; national holiday calendars; market seasonality; etc.
Basic materials companies must not wait for volatility to go away. It will continue to be linked with sentiments of uncertainty, so prevalent globally today. Some actions companies can do to cope with volatility include:
- Moving to shorter term contracts with end-users, such as in the case of iron ore
- Using more rigorous forecasting techniques (more analytics)
- Adopting commodity price risk management
- Back integration, as appropriate for the commodity
Of course, many new avenues to risk management continue to develop.
Data sources: Accenture Research analysis of InFinancials, World Bank and US Energy Information Administration
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