The Far-reaching Impact of Commodity Price Volatility | StoneX

The Far-reaching Impact of Commodity Price Volatility

Some firms don’t look any further than production budgets when it comes to the impact of price volatility. But the fact is, unaddressed price volatility can have effects that find their way into every corner of your business. We have prepared this article to help you recognize some of these effects and perhaps consider taking action to minimize the effects of commodity price volatility on your business.

Exposure to Price Volatility

Creating uncertainty in earnings per share and reporting issues for CFOs

Commodity volatility can have both positive and negative implications. Short-term price volatility, fueled by supply/demand imbalances and extreme weather conditions, can create uncertainty in the marketplace underpinned by the interconnected, global geopolitical landscape. This uncertainty can have far-reaching consequences.

• When prices are uncertain, accurate earnings predictions become more difficult. Equity prices rise and fall on earnings expectations.
  • A company that announces that its earnings outpaced expectations generally sees its stock price rise.
  • An earnings miss on the downside can send a stock price into freefall.
• Wall Street analysts compute a host of ratios to determine a company’s financial health and estimate its earnings, such as how well a company manages its inventory, collects its revenue, repays long-term debt, and meets its obligations to suppliers.
• Companies’ quarterly reports include an earnings forecast, and analysts pounce when they see a negative change.
• Commodity price changes can quickly make forecasts obsolete, making it tough for the CFO to deliver accurate guidance.

Commodity hedging strategies can help firms meet budgets, increasing the likelihood that actual earnings are in line with previously provided estimates.

Negative Cash Flow

Short-term working capital issues for company treasurers

Predicting prices is a challenge facing every company treasurer, who is tasked with maximizing the financial side of operational efficiency. It includes managing inventory, accounts receivable, and accounts payable. That job is compounded by price volatility for commodities, the major source of a company’s raw products.

• Supply chains that depend on current assets, such as raw materials needed for the manufacturing process, can extend for six months or longer, putting a strain on working capital.
• Purchasing commodities at a price that achieves profitability goals is often beyond the company’s immediate control. For example, erratic weather patterns and global events can wreak havoc:
  • Hurricanes can shut down refineries, causing fuel shortages.
  • A severe drought can cause prices for corn and soybeans to soar.
  • Global macroeconomic issues often play a significant role, as evidenced by the recent short-term spike in oil prices when Iran destroyed Saudi oil production facilities.
• To continue to manufacture products, companies often must pay more for inputs in the short term, thus reducing working capital.
• In some cases, a corporate treasurer may be forced to finance these higher raw materials at a time when interest rates are rising, increasing the company’s cost of capital, adding to its credit exposure, and in some cases, even violating its short-term loan covenants.
• An effective hedging strategy that works to stabilize commodity prices can optimize inventory, ease the strain on working capital, and keep the company’s lenders satisfied.

Lack of Margin Optimization

Company not able to capture earnings upside due to commodity volatility

Companies thrive when its earnings rise, a function of properly managing its balance sheet. Commodities affect assets (raw materials) and liabilities (payments due suppliers), both of which determine earnings and, ultimately, the company’s profit margin. Adverse scenarios can have a negative impact on a company’s margins.

• When the price of a raw material plummets, its asset value must be written down, yet obligations for payments to suppliers for products already contracted for, or contracts already agreed to at higher prices, do not change.
• A customer who spots a commodity price decrease may demand a lower finished goods price, which could have adverse effects on accounts receivable.
• Although companies that depend on raw materials for the manufacturing process tend to feel a greater pinch, nonmanufacturing companies are not immune.
  • Companies that lease office space have energy exposure. Consulting firms, for example, suffer when a spike in energy results in higher electrical and heating bills.
  • Employees feel the pinch in higher commuting costs, causing upward pressure on wage demands.
• On the other hand, leveraging pricing capabilities can drive profits: Research indicates that a 1% increase in realized price translates to a 10%-12% gain in operating profit.
• Hedging strategies that help navigate these price movements, whether you’re using futures, options, or Over-the-Counter (OTC) products, can protect a company against price and revenue fluctuations, ensure more accurate wage cost estimates, and ultimately preserve margins.

Earnings Comparability

Commodity volatility eats into company’s core earnings, creating differences between company and peer group

Studies show that comparability determines the degree of analyst following, credit risk, stock price volatility, and the cost of debt and equity—all key elements that contribute to a company’s earnings—and is even more pronounced after passage of the Sarbanes-Oxley Act.

• Analysts routinely compare a company’s earnings performance to its peers, measured by the future earnings response coefficient (FERC).
• Favorable comparability is one metric both analysts and investors employ to evaluate the financial statement information used to predict future earnings.
• Comparability bolsters confidence that analysts and investors can rely on the company’s expectations for future performance, typically based on its earnings outlook, which drives its stock price.
• Companies that are forced to pay more for raw materials often see their earnings decline. In contrast, their peers may have better managed their price inputs, thereby avoiding the earnings hit.
• Additionally, when analysts and investors discover a company is paying higher prices for commodities relative to its peers, it raises a red flag, suggesting that it may not be managing procurement and allocating assets in the most efficient way.
• A well-timed hedging strategy can alleviate potential earnings diversions.

Headline Risk

Unlimited or unmanaged commodity volatility creates public perception that company does not understand business drivers

Headline risk—negative news coverage that can depress its stock price in the near term or, in extreme cases, cause a massive shareholder exodus—is anathema to all companies. Commodity volatility is highest among the various asset classes, and volatile prices attract speculators and traders.

• Commodity markets are highly transparent, and some are extremely thin, making it difficult to conceal mistakes.
• Commodity trading errors may be called out in the media, shining an unwelcome light on companies that must purchase those raw materials.
• Unmanaged commodity price volatility can send a message that the company is not on top of its game.
• Pricing problems find their way into the public domain, causing customers to question whether the company truly understands the forces driving its business.
• A properly managed and implemented hedging strategy can dispel those concerns, giving customers (and investors) confidence that the company warrants their ongoing trust.

Earnings Degradation

Commodity volatility can cause significant earnings loss due to increase in input costs

Commodity prices create a dichotomy—producers crave high prices, but corporate buyers are always scouting for lower costs. And higher interest rates and currency fluctuations can compound the issue. Corporate buyers of raw materials are subject to the whims of both the marketplace and the financial markets. When the price of raw materials rises, costs cannot always be passed along immediately to customers.

• Even when input costs are stable, soaring interest rates make commodities more expensive for foreign purchasers to buy them, thus lowering demand and adversely affecting sales (and earnings).
• Higher interest rates also increase the cost to store raw materials until needed for the manufacturing process. All of these inputs can erode earnings.
• Managing commodities to reduce their negative impact on the corporate balance sheet is a challenge facing CFOs, because powerful forces drive commodity markets, and new catalysts continue to emerge.
• A well-executed commodity hedging strategy helps to predict accurate prices and maintain stable earnings.