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10. Planning for Scarcity and Price Shocks

Published onApr 08, 2020
10. Planning for Scarcity and Price Shocks

Between 1994 and 2004, the price of diesel fuel varied from week to week by only an average of one cent per gallon. But between 2004 and 2009, weekly price volatility increased as the price of diesel fuel in the United States tripled from $1.50 per gallon to $4.75 per gallon and then slumped to $2 per gallon during the recession, but then rose again during 2011–2013 to around $4 per gallon.1 Such rapidly increasing prices created difficulties for supply chain designs and operating strategies that depended on low transportation costs. The markedly increased fuel price affected every company dependent on transportation for supply, internal operations, or distribution.

Nor was fuel the only commodity that experienced significant price increases. Metals, rubber, and agricultural commodities all saw rapid price rises as well as spot shortages, affecting both materials producers and manufacturers. “Commodity prices have gotten more volatile,” said Gerard Chick of the Chartered Institute of Purchasing and Supply. According to Mr. Chick, the situation is “potentially fatal for some organizations. Think of airlines procuring fuel—do you go for the long or short term? How do you outguess the market?”2 Extreme volatility in energy and agricultural prices was ranked as a top-five global risk by the World Economic Forum in 2012.3

Fuel Price Fever

The US trucking industry spent $146.2 billion on diesel fuel in 2008, and the doubling of fuel prices from the prior year induced about a 22 percent increase in total truck transportation costs.4 As one supply chain conference participant put it, “all hell broke loose.”5 Previously sedate and periodic discussions between shippers and carriers about fuel prices became heated. A 2008 survey found that 35 percent of companies had experienced a supply chain disruption in the prior 12 months because of fuel price increases or shortages.6 Supply chains that had been optimized for low oil prices came under fierce scrutiny.

Demand Inelasticity

Transportation’s key role in global supply chains—and the difficulty in changing shipping distances, shipping volumes, or shipping modes in the short term—exposes companies to fuel price risks. A 1 percent rise in the price of gasoline induces only a 0.034 to 0.090 percent change in gas consumption.7 These numbers imply that demand for fuel is inelastic, meaning that even small disruptions in supply can have a major effect on prices—a 1 percent drop in global supply can potentially induce an 11 to 30 percent rise in fuel prices. (And prices plummeted as supply from new North American sources flooded the market in 2014 and 2015.) Although only a limited response to a rising fuel price is possible in the short term, transportation demand is more elastic in the long term because shippers can change, for example, facility locations and suppliers, while carriers can purchase more fuel-efficient assets or even change the fuel type on which their vehicles run.

The 2008 energy situation was a perfect storm comprising three factors.8 First, growth in the developing world was creating rising energy demand. Second, price elasticity of demand in the United States and other developed countries was dropping such that even a large spike in oil prices would not blunt near-term demand.9 Third, oil production was stagnating as the rate of new production capacity failed to keep pace with demand. “I don’t think anybody really knows where fuel prices are going in the next three months,” said Southwest Airlines CEO Gary Kelly to analysts in 2008. “All I have to do is look back at the last three months and the three months before as evidence of that,” Kelly explained.10

Large increases in the price of such a crucial raw material make it difficult for companies to make decisions related to costs and prices. Violent swings in fuel and electricity costs create a “supply chain whiplash,” said Rick Blasgen, president of the Council of Supply Chain Management Professionals.11 Fuel price increases also affected the vehicle mix of automobile makers. General Motors, for example, had expected about 27 to 28 percent of consumers to pick the six-cylinder variant over the four-cylinder variant of one of its cars, but the surge in fuel prices meant that only 2 to 10 percent picked the bigger engine, requiring unexpected changes to manufacturing schedules, supplier agreements, inventory levels, and related factors, according to GM’s manager of vehicle scheduling, Annette Prochaska.12

Response: Go Slow and Full

Companies mitigated some of the impacts of high fuel prices in the short term by diverting shipments to less fuel-hungry modes and less fuel-intensive operating strategies. UPS saw its customers shift some of their business away from minimizing inventory levels to minimizing transportation expenditures. Where possible, companies shifted from just-in-time supplies to using full conveyances; deploying inventories to multiple distribution centers close to customer locations; and shifting to slower, more fuel-efficient transportation modes (air to truck, truck to rail, and international air to maritime). The extent of such changes is limited, however, because they may require adjustments to other operational parameters such as inventory policies, order patterns, delivery commitments, and production schedules.

Limited Brands offered mode choice to its retail customers, and 60 percent of them took advantage of the cost savings offered by a slower mode. Overall, the apparel company’s international shipments mix changed from 35/65 percent ocean/air to 60/40 percent ocean/air.13 Limited Brands also curtailed prolonged design cycles to reduce last-minute air shipments. Adidas consolidated orders where possible and held retailers to minimum order sizes to reduce the impact of transportation costs on the costs of its shoes. Several companies used advanced Transportation Management Systems to improve mode selection by optimizing the transportation choices in real time, such as creating “milk runs” instead of using less-than-truckload transportation, or by delaying some shipment tendering until the last minute to create bigger, more cost-efficient shipments.14

The shift from air to ocean helped companies cope with higher transportation prices, but, as mentioned above, it involved many other operational changes. An additional challenge was the relatively lower delivery time reliability of ocean shipping vs. air (or rail shipping vs. trucking). In response, some ocean carriers created enhanced door-to-door service offerings with delivery guarantees. APL, a large ocean carrier, for example, offered a guaranteed on-time freight ocean product, taking control of the inland logistics in addition to the ocean portion.15

The Mother of Invention

The proverbial saying, “necessity is the mother of invention” (the Latin mater atrium necessitas) is sometimes ascribed to Plato’s Republic but most likely was added by a translator in the 15th century. Regardless of who said it, the surge in fuel prices created a surge in necessity and a surge in innovation related to fuel-saving technologies. An exhaustive study of major US trucking fleets, by the North American Council for Freight Efficiency, found that the fuel-saving technologies with the fastest adoption included trailer skirts, use of synthetic transmission oil and synthetic transmission fluid, and installing speed limiters.16 On the average, the use of these technologies reduced the annual fuel costs per truck by $7,200, which is over 10 percent of the average annual fuel cost.17

The same trends were seen in other transportation modes. For example, ocean carrier Maersk commissioned the development of new ships dubbed Triple-E (“Economy of scale, Energy efficient and Environmentally improved,” according to Maersk). The Triple-Es—the largest container ships in the world (as of 2013)18—can carry 18,000 TEU (twenty-foot equivalent unit) of shipping containers while consuming 35 percent less fuel per container than the contemporaneous 13,100 TEU vessels. The savings come from a combination of the Triple E’s size, innovative hull design, twin-skeg ultralong stroke propulsion system, and its advanced heat recovery system.19

In the air, Boeing developed the 787 aircraft to be 20 percent more fuel efficient than the 767 aircraft it replaces. The savings come from using lighter materials (including 50 percent composites and 20 percent aluminum), new engines, lighter-weight batteries, and electrically powered systems (instead of pneumatic systems that bleed high pressure air from the engines and rob the airplane of thrust).20

What Goes Up May Come Down

Big pickup trucks have always been big fuel guzzlers. Ford embarked on a complete redesign of its big F-series pickup truck, the best-selling vehicle in the United States for 32 years running (1982–2014), to use a lighter-weight all-aluminum body. Ford spent $3 billion and took nearly five years of intensive design, prototyping, testing, retooling, and retraining to develop the innovative truck. Ford even had to help train independent auto repair shops on how to work on the new aluminum bodies. The resulting vehicle was exactly what Ford had hoped for. The new truck weighed 700 pounds less than the prior model, could tow up to 11 percent more, and got up to 20 percent better fuel economy.21

Just as Ford released its new aluminum F-150 full-size truck in late 2014, however, crude oil prices slumped, falling from $115 a barrel in June 2014 to $69 in December of that year. Gasoline prices in the US dropped below $3 a gallon and even fell below $2 a gallon in some locations such as Texas and Oklahoma.22 During November 2014, sales of gas-guzzling SUVs and trucks surged23 as consumers were less concerned about fuel economy. Oil prices continued to collapse and on March 17, 2015, the price of West Texas Intermediate crude fell below $43 a barrel.

For Ford, “the world seems to have fundamentally changed from when the product was first planned,” said Barclay’s senior analyst, Brian Johnson, to the Wall Street Journal. “Getting a premium based on future lifetime fuel-economy savings isn’t going to happen.”24 The price reversal can be a disruption to those companies that make large strategic investments to benefit from high prices. Thus, many US shale oil producers were expected to default in 2015. As James Wicklund, managing director of energy research at Credit Suisse said, “The [oil] producers with the most debt are at the most risk.”25

A Raw Deal on Raw Materials

Whereas energy price risks have an impact on multiple aspects of virtually every company’s supply chain, specific material price risks affect only specific supply chains. Yet, despite the specificity of material price disruptions, their impacts may be quite common. A 2008 Aberdeen survey found that 49 percent of companies had experienced a supply chain disruption in the 12 months preceding the survey because of raw materials price increases or shortages.26 High technology supply chains, especially, depend on a very large number of commodities and unusual chemical elements. “Twenty or thirty years ago electronics were being made with 11 different elements. Today’s computers and smartphones use something like 63 different elements,” explained Thomas Gradael, a professor of geology and geophysics at the Yale School of Forestry and Environmental Studies.27

Of Rare Earths and Precious Metals

Rare earth elements (REE) are a set of 17 metals that play a crucial role in many automotive, electronic, and high-tech applications. Rare earths go into iPhones, wind turbines, solar cells, jet engines, fiber optics, hard disk drives, compact fluorescent bulbs, and many other products.28 In 2007, the metal europium (an REE) cost $300 per kilogram.29 By 2010, that price had more than doubled to $625; in 2012, it surged to $3,800.30

The average Ford car contains about half a kilogram of rare earths scattered in the vehicle’s sensors, electric motors, displays, and catalytic converter. In 2002, those rare earths cost only about $10 per car. As of 2012, they cost $100. New electric cars require even larger amounts of rare-earth materials in their batteries and electric motors—about $1000 per car (in 2012 REE prices).31

Although the scarcity of rare earths or precious metals may not be surprising, other base metals, such as aluminum, titanium, manganese, and cobalt, could see worsening imbalances of supply and demand in the future.32 Such imbalances may create disruptions because some countries’ supply chains can be heavily dependent on imports. For example, the United States is more than 90 percent import-reliant for many minerals, such as manganese (100%), bauxite for aluminum (100%), platinum (94%), and uranium (90%).33 Other material scarcity stress points in global supply chains include indium (used in computer display panels), silicon (chips and solar power), and wood fiber (paper, furniture, and biofuel).34

Shortages and significant price shocks can take place in many types of commodities, even ordinary ones, as a result of a confluence of events. For example, between 2006 and 2012, corn prices tripled,35 affecting food prices, meat prices (for corn-fed animals), sugar prices (derived from corn syrup), and ethanol prices (biofuels derived from corn). High food prices can also lead to social unrest (see chapter 12).

Scarcity and price spikes can also hit manufactured goods. After the 2011 Thailand floods, prices for large-capacity hard disk drives for servers and high-end desktops rose by double- or triple-digit percentages. “We’re looking easily at $75 more per computer,” said Matt Bullock, chief technology officer at Nova Mesa Computer Systems. “This is just one more factor that will separate the strong from the weak,” added David Milman, CEO of Rescuecom, which builds and repairs PCs. Also, during 2006, the prices of very large truck tires quadrupled because of the booms in mining, construction, industrialization in emerging markets, and US defense needs in Iraq and Afghanistan. “Right now the entire mining industry is going berserk, and we’re feeding into it,” said Michael Hickman, owner of H&H Industries, one of the United States’s largest retreaders of used mining tires, whose company tripled its work force between 2004 and 2006.36

Of course, a sharp drop in the price of any commodity, while a boon to customers, can threaten manufacturers. Just as the price of crude oil slumped in the second half of 2014, the price of other commodities, such as copper, lead and nickel, fell between 2011 and 2014.37 Nomura gold analyst Tyler Broda estimated that 15 percent of global gold miners would be under water given the 2013 slump in gold prices. “Any company that hasn’t been focused on efficiencies and costs for the last three to four years is going to fail in this market,” said Gavin Thomas, chief executive officer of Sydney-based gold miner Kingsgate Consolidated Ltd.38 Primary materials producers often have expensive capital assets and large debts, making them susceptible to bankruptcy if the price of the commodity falls below their costs of production.39

Commodity price increases can lead, indirectly, to other supply chain problems, such as theft. For example, in 2012, thieves stole 359 ingots of copper, each weighing over 800 pounds, from a mining facility in Arizona. The criminals tried to smuggle the $1.25 million in copper to China but were interdicted at the Port of Los Angeles. In addition, shortages of high-tech manufactured products create strong incentives for counterfeiting, as discussed in chapter 7.

Resource Nationalism

In July 2010, China restricted exports of rare-earth elements. Its chokehold on 95 percent of the world supply of REE basically cut off many companies that make products using these materials.40 In response, the United States lodged a formal protest with the World Trade Organization (WTO). EU trade commissioner Karel De Gucht said, “China’s restrictions on rare earths and other products violate international trade rules and must be removed. These measures hurt our producers and consumers in the EU and across the world, including manufacturers of pioneering high-tech and ‘green’ business applications.”41

China countered that the move was to conserve natural resources and protect the environment, which was devastated by mining.42 Yet restricting exports also serves China’s strategic economic development plans by ensuring that Chinese makers of rare earth–containing products get preferential allocations of scarce supplies. This helps China develop into a maker of high-value goods.43 Although some viewed China’s requirement for environment permits as a thinly veiled scheme to prevent exports, it should be noted that refining rare-earth minerals does produce a witch’s brew of toxic and radioactive byproducts. In fact, radioactive wastewater leaks contributed to the shutdown of the largest rare-earth mine in the United States in 2002.44

China’s rare-earth export policy was but one of many examples of resource nationalism in which governments restricted the availability of commodities produced within their borders. Besides export restrictions, special taxes on mining are another kind of resource nationalism. Countries that announced or enacted increases to taxes or royalties during 2011 and 2012 include major producers such as Australia, China, the Democratic Republic of Congo, Indonesia, Ghana, Mongolia, Peru, Poland, South Africa, and the United States.45 Governments’ rationale for these actions include Australia’s desire to reap higher tax revenues from surging commodities prices,46 Indonesia’s strategic intentions to move the country up the value chain,47 and China’s desire to ensure that its local industries have access to sufficient supplies.48

Inputs’ Price and Availability Risks

Companies can mitigate the risks of scarcity and price shocks with specific procurement practices. For short-term protection, companies can create buffer stocks. For example, following Hurricane Katrina—which knocked out 95 percent of oil production in the Gulf of Mexico and induced a 40 cent per gallon fuel price spike49—UPS began building 1,200 underground automated storage tanks in the United States that it could tap in the event of another hurricane.

When the Rate Is Against You

With global supply chains come the risks of fluctuations in foreign exchange (FX) rates. A company might be buying raw materials in US dollars, paying for labor in Thai baht, and getting customer revenues in euros. “When the dollar slips in value, as it did sharply in 2008, US companies sourcing and operating internationally in countries with currencies appreciating against the dollar can face rising material and shipping costs as well as increasing labor costs,” explained Tim Dumond, corporate advisory and restructuring services principal.50 Naturally, when the dollar appreciates in value, companies with US operations are at a disadvantage in export markets. For chemicals giant BASF, even a one-cent shift in the US dollar/euro exchange rate has the potential to add or subtract €50 million in annual earnings.51 These exposures are significant enough that over one quarter of executives in a 2011 World Economic Forum survey cited currency risks as triggers of global supply chain disruptions ahead of the risk of energy shortages, labor shortages, and pandemics.52

Hedging and Long-Term Contracts

“Our goal in hedging currencies and commodities in our auto manufacturing operations is to lock in some near term certainty for the revenues and costs of our vehicle production worldwide,” said Neil Schloss, vice president and treasurer of the Ford Motor Company.53 A company can avoid price surprises for fuel, commodities, and exchange rates by negotiating long-term, fixed-price contracts denominated in the company’s preferred currency. But if a company’s suppliers refuse to accept those terms, then the company can use financial derivatives (so called because these contracts derive their value from the performance of the underlying commodity). One type of derivatives contract locks in a fixed price, while another allows the company more nuanced control over exposure to a range of price changes. Derivatives tend to be highly leveraged, such that small amounts of corporate capital can control large positions in futures contracts.

With the first type of hedging, the company uses forward contracts in the financial markets to buy (or sell) the same or a related commodity on some future delivery date but at a fixed price. Through this hedge, the company can keep its floating price relationship with its preferred suppliers while creating a financial position in the futures markets that offsets the fluctuations in commodities costs from those suppliers. For example, BASF uses derivatives to hedge the risks of price increases in raw materials including crude oil, oil products, natural gas, precious metals, and electricity. The company also uses financial derivatives to manage foreign currency risks, interest rate risks, and sales price risks for agricultural products.54 A 2010 survey by the Association for Financial Professionals found that 72 percent of organizations with exposure to foreign-exchange risks hedge their exposure.55

In the second strategy, companies buy and sell options, which are contracts that give the option-holder the right, but not the obligation, to buy or sell a commodity at a given price regardless of the prevailing market price. This creates an upper (or lower) bound on the effective price of the commodity. For example, a company might buy call options at 20 percent above the current base price on a key material to limit the possibility of high cost of that material. If the price jumps higher than 20 percent above the base price, the company can exercise the option and pay just 20 percent above the base price (even if the prevailing price has doubled). But if the future price falls or only rises 10 percent, then the company would not exercise the option but would buy the key material at the prevailing price. Similarly, a producer of a commodity might use put options that set a floor price for its goods. Using options for hedging protects the company while still preserving the chance that if prices move favorably, the company can benefit from the price changes.

Although options sound like they have no downside, they do have significant upfront costs. Options expire on a certain date and are worthless if the price does not move past the threshold defined by the option. In that regard, options are like insurance—the company pays a premium for a contract and the contract covers the risk of a price change event if the event occurs. Options are particularly useful during volatile times, and naturally they are more expensive during such periods. They are also costly if the company wants to avoid even small exposures to price fluctuations, and if the company needs price protection over a longer duration.

Derivatives contracts are assets on a company’s balance sheet that can create financial risks even as they mitigate supply risks. After Southwest Airlines bought futures contracts to cover much of its fuel needs, it enjoyed a $511 million gain in early 2008 when fuel prices surged. But when the financial crisis hit and fuel prices plummeted later in 2008, the value of those futures contracts plummeted from $6 billion to $2.5 billion, forcing the carrier to take a $247 million one-time charge and declare its first loss in 17 years.56 Similarly, the large decline in the price of fuel at the end of 2014 caused Delta Airlines to project a $1.2 billion write-off as a result of fuel hedging, while American Airlines, which does not hedge fuel prices, was set to enjoy windfall profits as a result of the lower fuel price.57 By the same token, a hedged supplier of a commodity foregoes the windfall profits that would occur if prices increase. Some oil producers lost out on potential high profits during the early 2008 surge in oil prices.58 Moreover, derivatives positions may require cash collateral to create and maintain the hedge.59

Yet, both sides to a futures contract can avoid significant losses albeit forgoing windfall gains. The supplier ensures that its sales price is not lower than its cost, and the buyer ensures that its costs are no higher than its selling price. “I’m just trying to ensure we know what our costs are. We know when we quote a price to a customer that we’ve locked in our profit,” said Gary Wool, chief financial officer at Preferred Plastics & Packaging.60 To the extent that a company optimizes its operations based on a certain price of fuel, then futures contracts can ensure that the price of fuel the company uses will not deviate from that price regardless of the market price. Despite Southwest’s roller-coaster experience with hedging in 2008, it continued to buy derivatives to lock in fuel prices up to four to five years into the future.61

Localizing Production

“The weak U.S. dollar [during 2009] has made it more competitive for foreign companies to do business in the U.S.,” said Jeff Olin, national managing partner of International Tax Services at Grant Thornton.62 Speaking about the company’s LEAF electric vehicle program, Nissan’s CEO, Carlos Ghosn said, “When we started the offensive on the LEAF, it was back in 2006, 2007, where the yen to the dollar exchange rate was about 110. When we started selling the LEAF, the dollar to the yen was about 80, which, obviously, we had to absorb more than 25 percent over cost, compared to what we were planning. Not because our guys did not work well, but because we had a major element in the competitive environment, which played against us.” To cope with exchange rate risks, the company started producing the LEAF in the United States and will also be producing it in Europe, thus matching manufacturing costs to selling prices. “The trajectory of localizing production, cutting the cost, reducing the cost, is going very well,” the CEO said.63

Exchange rates, however, are not the only rationale for locating manufacturing closer to the demand, or reshoring. Rising wages in China, higher fuel prices, better operational controls, and proximity to customers also motivate a return of manufacturing from distant shores. High fuel prices motivated Stonyfield Farms to consider moving sourcing and manufacturing closer to the point of consumption to minimize total transportation requirements.64 A 2012 survey found that more than a third (37 percent) of large manufacturers were planning or considering reshoring to the United States.65 These considerations change direction with the strength of the US dollar in 2015 and the collapse in the price of the euro.

Vertical Integration: Procure the Producer

Delta Airlines made an unusual move to protect itself against large increases in the spread between the cost of oil and the cost of jet fuel, known in the oil industry as the crack spread. In 2012, the airline bought an oil refinery in Delaware for $150 million, spent $100 million upgrading the facility to increase jet fuel production, and is buying crude oil directly.66 Delta expects the arrangement to save about $300 million annually67 on the airline’s $12 billion cost of fuel. Moreover, by trading the gasoline and diesel fuel that’s coproduced by the refinery for more jet fuel, Delta will acquire 80 percent of its fuel needs at a discount. CFO Paul Jacobson said Delta expects the deal “to be accretive to Delta’s earnings, expand our margins, and to fully recover our investment in the first year of operations.”68 Some companies in other commodity-intensive industries, such as steel, have chosen vertical integration to address price and availability risks of raw material such as coal and iron ore.69

Yet, like most other risk mitigation strategies, vertical integration may swap one supply chain risk for another (possibly smaller one), as well as involve unexpected costs. Delta’s vertical integration strategy brought it some of each. Hurricane Sandy delayed the start of the acquired refinery, and a gasoline-production outage created early losses for the project.70 With vertical integration, Delta may be less exposed to global jet fuel price increases but more affected by its own local refinery’s facilities risks. Analysis of vertical integration in the steel industry finds similar risk issues, especially because mining iron ore is a far riskier business than steel making.71

Turning Down the Volume on Price Increases

Companies can respond to scarcity and price increases of inputs in a variety of ways. In the short run, a company might absorb such a disruption by using inventories or hedging. But large or long-term scarcity or price disruption requires larger or longer-term supply chain changes. Three strategies with respect to input materials can reduce the impacts of long-term scarcity and price increases: efficiency, substitution, and recycling. All three materials strategies displace primary resource consumption and reduce pressure on primary supplies.

Efficiency: Use Less, Pay Less

Efficiency is the first input-material strategy for reducing the impact of price spikes. When palladium prices spiked in the late 1990s, catalytic-converter makers found ways to use less of the precious metal. Thinner coatings reduced the amount of palladium per converter, and less-polluting engine designs reduced the need for large convertors.72 The price spike also encouraged investment in the efficiency of palladium-refining processes. For example, Norilsk Nickel, a major producer of palladium, invested in improving its metal recovery from ores, resulting in increases in production efficiency.73

When bunker fuel prices doubled in 2008, ocean carriers started using slow steaming to reduce fuel consumption. The strong relationship between speed and drag means that most transportation modes use less fuel at lower speeds. Running vessels more slowly can save owners significant outlays. For example, operating a 12,000 TEU container ship at 18 knots instead of 20 knots can reduce the fuel consumption by almost 30 percent.74 Of course, spending more time at sea offsets some of these savings—a trip from the port of Shanghai to the port of Rotterdam takes 28 days at 20 knots vs. 25 days at 18 knots, a 12 percent increase in the labor and asset costs.75 The higher the cost of fuel the more the savings on fuel justifies the added expense of a longer journey time. By late 2011, 75 percent of carriers surveyed by Man Diesel and Turbo SE had implemented slow steaming.76

The same physical phenomena that cause ocean ships’ fuel consumption to climb rapidly with speed also affect other transportation modes. Thus, carriers in other modes have looked at slowing down as a fuel-saving strategy, such as by using speed limiters on trucks. Limiting a truck’s speed to 65 mph, instead of 75 mph, saves 15-20 percent on fuel over a trip.77 In fact, the US 55 mph limit on highway speed was originally enacted during the 1973 oil price spike and supply disruptions (limiting truck speeds to 55 mph would save almost 30 percent in fuel). Aircraft also consume less fuel at lower cruising speeds and can optimize fuel use through management of the vertical flight profile, as well as other operational enhancements.

Slow steaming’s longer transit times affect the supply chain, though. More than half of shippers (52 percent) cited increased inventory levels (cycle stock) and the related holding costs as the main effect of slow steaming. The second impact cited was customer service levels owing to the difficulties of supplying parts as fast as customers asked for them. In addition, companies had to adjust production scheduling to account for the longer lead times.78 On the other hand, ocean carriers have become more reliable than in the past because the slow speed allows for buffer time in transit. This can mitigate somewhat the effects of slow steaming on another inventory element: safety stock.79

Substitution and Flexibility

Substitution is a second strategy for reducing price risks by reducing exposure to the risky commodity. In the face of scarcity or surging prices, companies seek technological innovations that use cheaper materials to substitute for the more expensive ones. For example, one of the largest uses of rare-earth metals is in ultrastrong magnets, which are used in everything from disk drives to automobile power windows, electric car motors, and wind turbine generators. Given the large increases of REE prices and their availability risk, wind turbine makers are looking at new generator designs that don’t need rare-earth magnets, substituting other electronic technologies to reduce use of these materials.80

In fact, price increases can reach a tipping point that causes permanent change. In 1980, Zaire, now known as the Democratic Republic of the Congo, had only 0.06 percent of the world’s population but produced 40 percent of the world’s cobalt, a metal used in steel, magnets, and other applications. A revolution in Zaire in 1980 caused cobalt prices to spike six-fold and made cobalt-based magnets too expensive. Some magnet makers went out of business. The one-time price spike created a permanent dislocation, however. Magnet buyers and surviving magnet makers made material substitutions and never went back to using cobalt, even when cobalt prices returned to normal.81 Ironically, the substitute magnet material was neodymium, which is one of the rare earths that spiked in price in 2010.

Companies can also substitute fuels. For example, the growing supply of natural gas made available by hydraulic fracturing of shale formations in the United States decreased prices of that energy source. Those falling prices have encouraged trucking companies and truck makers to switch from diesel to natural gas. Switching fuels can require substantial upfront capital investments that are then repaid through lower ongoing fuel costs. For example, Waste Management is buying compressed natural gas-fueled garbage trucks82 that cost $30,000 more per truck, but then save the company $27,000 a year per truck in fuel costs.83 “The economics favoring natural gas are overwhelming,” said Scott Perry, a vice president at Ryder Systems Inc., in 2012.84 Even with the low crude oil prices, by the end of 2014 natural gas prices85 corresponded to about half the price of diesel fuel.86

In some cases, companies can flexibly substitute commodities at will. For example, companies can use flexible fuel vehicles that can run on either diesel or LNG. Kathryn Clay, executive director of the Drive Natural Gas initiative of the American Gas Association, says, “The new technology is really game changing because the trucker can run on either fuel.”87 Similarly, both palladium and platinum can be used in automotive catalytic convertors, industrial process catalysts, and jewelry. Users of these metals switch between the two depending on their relative prices.88 To respond dynamically to price changes, companies can pre-identify, when feasible, substitute materials at the outset and design product variants for different raw materials to give themselves flexibility in the event of a disruption in the source of one of the materials.

Flexibility through substitution helps ensure continuity of supply, which a 2011 PWC survey found to be the most important lever for supply chain flexibility.89 In the survey, 71 percent of respondents were working on setting up flexible production and assembly facilities—capable of using various factor inputs—when prices or availability change.

Recycle Materials to Create a Secondary Source

Recycling is a third strategy for reducing scarcity and price risks. An MIT study of the platinum market found that recycling can play a role in both lowering prices and stabilizing the price of this precious metal.90 Three factors help recycling reduce risks of availability and price increases. First, recycling creates a new, diffuse source of the commodity that is independent of the factors that induce price increase in the primary supply, such as geopolitical instabilities. Second, for many materials, recycling consumes less energy than does primary extraction and refinement. This uncouples, to some extent, the price of the material from energy price increases. Third, recycling stabilizes prices because in times of short primary supply, recyclers can more quickly increase recycling capacity than miners can increase primary supply.91

As a material’s price rises, the economic motivations for reclaiming the material from industrial and postconsumer sources increase. For Johnson Controls, the benefits of recycling automotive batteries are obvious: up to 80 to 90 percent of the lead used to make batteries can come from recycled content, providing a significant price advantage and protection from availability risks. To collect the batteries after use, the company encourages retailers, mechanics, and even junkyards to hold on to the batteries consumers leave behind. The batteries are collected either when new ones are delivered or on special runs.92

Similarly, specialized e-waste recycling efforts target the recoverable materials in consumer electronics. Intel, for example, works with PC makers to ensure that recyclers can reclaim the valuable metals and materials in chips and electronic equipment. Dell had by 2014 already recycled a billion pounds of electronic waste toward its stated goal of 2 billion pounds. The company partnered with Goodwill Industries to enable electronic waste recycling at 2,000 Goodwill sites in the United States.93

Recycling has other benefits beyond mitigating price risks. It also is an environmental sustainability initiative (see chapter 11) that can also reduce disposal costs. Recycling can often take advantage of empty backhaul capacity for the reverse logistics that move recovered materials from retail outlets upstream.

Although recycling may be easier than developing new primary sources, it faces technological, social, and regulatory challenges. First, recyclable materials tend to be commingled with other materials in the end product, creating physical challenges in separating the desirable recyclable materials from each other and from waste materials. For example, a personal computer contains a wide range of different materials94 such as plastics, metals, lead, gold, and rare earths that are physically and chemically intermingled. Second, cultural and social norms create barriers in the form of consumer habits, market resistance, and transaction frictions in getting discarded goods to a pickup point and recycling center. The Japanese carefully recycle 77 percent of their plastic waste, while Americans recycle only 20 percent of their plastic.95 Third, regulatory policies might have unexpected (and unintended) consequences on recycling. For example, the US Toxic Substances Control Act (TSCA) creates a compliance burden for companies attempting to recycle electronic waste.96

Surcharges: Transferring the Risk to Others

A company can transfer its price risks to its customers via a surcharge linked to the price of the risky commodity. When oil prices surged, many transportation providers—including trucking companies, ocean carriers, and air carriers—levied fuel surcharges that were separate from the baseline. In addition to fuel and energy surcharges, suppliers have also added surcharges for steel,97 copper, rare earths,98 helium,99 and other commodities.

The Magic Formula

Adding a surcharge can solve the problem of risks latent in the conflicted time frames between long-term, fixed-price supply contracts sought by customers and the short-term commodity price volatility that can wreck the finances of suppliers. To solve this conflict in a “fair” way, the contract for the product or service would have two components. First, the contract includes a baseline, long-term, fixed price that covers known costs such as equipment, maintenance, and labor, as well as baseline costs for the risky input element at some pre-agreed “peg” or baseline market price. Second, the contract specifies a surcharge price component that references an independent price index, the peg price, and an escalator (the amount the cost of the product or service escalates for each dollar of price increase in the price index). The index comes from an impartial third party—for fuel in the United States, truckers and shippers commonly use the US Energy Information Administration’s weekly regional survey of fuel prices.100 The escalator reflects the amount of the risky commodity consumed by the product or service, such as fuel consumed per mile, steel used per screw, or the amount of plastic in a bottle. Commercial real estate leases have long included detailed terms for a base rent plus a litany of escalators and pass-through costs for power, water, taxes, gas, inflation, and all sorts of other special charges.

The escalator term is especially important because it controls the amount of risk transfer. If the escalator is too low, the supplier is still exposed to some price risks. If the escalator is too high, the supplier profits from high commodity prices while the customer sees excessive price increases. The correct value of the escalator is determined by the amount of resource used by the supplier and its efficiency. In the case of fuel surcharges, it’s the fuel efficiency of the truck (or other transportation mode)—how much fuel is used per mile traveled (including the effects of empty miles). In the case of materials surcharges (e.g., the price of screws vs. the price of steel), the value is determined by the material content of the part (which is the weight of the part plus scrap minus any recycled or reworked scrap). For example, if the global price of steel increases by 10 percent, and the net steel content in a screw amounts to 40 percent of the screw’s cost, then the price increase should be 4 percent.

Perceptions of Fairness

Suppliers and customers often bargain vigorously over the particulars of risk transfer mechanisms. Discussions at a supply chain roundtable at the MIT Center for Transportation and Logistics during 2008 revealed that many shippers felt gouged by transportation carriers’ surcharges through two mechanisms. First, shippers thought that while the price of fuel in the surcharge formula was tied to a government index, the index did not reflect the carriers’ actual fuel costs. Carriers could buy diesel fuel in bulk and therefore pay less than the index price. Moreover, motor carriers can use the 1,000–2,000 mile range between refueling to exploit regional variations between fuel prices and buy fuel at lower-than-index prices. Also, carriers can hedge fuel costs. Thus, although fuel prices may rise at the pump (and on the fuel price index used to calculate the surcharge), the carriers’ actual cost of fuel might be lower. While shippers applauded carriers’ efforts to minimize fuel costs, they wanted to see those savings reflected in the transportation price.

Second, shippers thought that carriers, especially in airfreight, were selectively timing the surcharge for the carrier’s benefit. Shippers felt that airlines were quick to add a fuel surcharge when fuel prices rose but seemed slow in reducing the surcharge after fuel prices dropped. Shippers noted that after fuel prices dropped to presurcharge levels, air carriers were still charging 12 cents more per pound shipped. Yet the story may not be so simple, because airlines buy fuel on contracts that may be a year out, so their average cost of fuel might remain high even after a price drop. (Of course, this also means that surcharge increases should lag fuel price increases.) According to Tom Linton, chief procurement and supply chain officer at Flextronics, in some cases the buyer may want to audit the supplier’s processes before agreeing to an escalation clause.

Finally, while suppliers seek to protect themselves from significant cost increases of key inputs, customers want to motivate suppliers to reduce consumption of the risky commodity, such as by becoming more efficient, substituting another input, or recycling, as mentioned in the previous section. Customers may not want the surcharge to insulate the supplier from commodity price increases so much that the supplier has no incentive to invest in efficiency.

Managing Price Risks

Although managing commodity risks does parallel the methods for managing other causes of supply disruptions (see chapters 3 and 7), it differs in four key areas. First, commodity scarcity risks are not tied to specific suppliers, which means dual sourcing offers little benefit because the source of the risk is broader than any given supplier. Second, unlike earthquakes or accidents, commodity price volatility events are global, not local occurrences in the sense that the price of the commodity might surge or plunge on global markets affecting all users regardless other location or choice of supplier. Third, salient information about the risk might not reside in the bill of materials (BOM) because the underlying types and amounts of commodities used may not be defined for any but the most trivial parts. Complex parts (e.g., a door assembly or circuit board) may contain a multitude of materials that are not called out on the OEM’s BOM. Only the deeper tier BOMs might have the raw materials listed. Fourth, scarcity risks can arise from demand growth or spikes in unrelated industries, thus putting the cause outside the supply chain of the company.

Assessing Exposure to Risk

The first step in estimating the potential of price and availability risks is to identify what commodities prices the company may be exposed to and the amount of exposure. Whether this is easy or difficult varies by material and its uses. For example, when Ford analyzed the effects of rare-earths price volatility on vehicle costs, it took 18 months to find all the rare earths used in its cars, because Ford doesn’t purchase rare earths directly.101 In addition, rare earths comprise more than a dozen different elements, with a great many obscure applications in sensors, electronics, displays, motors, and catalysts. One tricky aspect of this step is finding hidden consumption or dependencies deeper in the supply chain—materials required by suppliers that aren’t in the supplier’s products but are used in their processes. The most common hidden commodity is energy used in production and transport; many key metals such as aluminum, gold, and copper require substantial amounts of energy to refine, which makes their prices sensitive to surges in oil and energy costs. They may also be indirect materials such as cleansers, catalysts, or materials used by manufacturing processes but not present in the finished product.

Ironically, deep-tier or indirect commodities exposures can imply that financial hedging makes a company’s financial statements more volatile, even as the hedging makes their cash flows and ultimate costs-of-goods less volatile. For example, Ford hedges various metals that go into the components that it buys from its suppliers. Yet because Ford does not buy these metals directly, it is prohibited under accounting rules from designating the hedges as an offset to specific costs. Under these rules, to the extent that the market value of so-called nondesignated hedges fluctuate, Ford must declare the gain or loss immediately, which causes Ford’s earnings to appear to fluctuate.102

Understanding Each Commodity’s Risk

The second step is to identify causes of risk based on factors such as the origins of the raw materials, total known reserves of raw materials, and trends in demand. Price volatility events don’t follow power laws like earthquakes and accidents do. Instead, they are driven by patterns of supply and demand, mismatches in the growth of the two, and the effects of inelasticity that can amplify small changes in supply or demand into large changes in price.

For example, the fact that China provides most of the world’s rare earths (and magnesium) brings risks of resource nationalism that could (and did) constrain supply and cause a price spike. Some materials are sourced from one limited geographic area, such as South Africa, which provides most of the world’s platinum. This creates exposure to natural disasters or political upheavals that could threaten supply and cause price spikes. Even if the commodity comes from many geographic sources (e.g., oil), price inelasticity can imply large global effects from modest local disruptions. Demand trends can drive risks, too. Prices for copper, for example, rose fivefold between 2003 and 2008, slumped by two-thirds during the financial crisis and then rose again to record levels after the crisis only to drop by one-third toward the end of 2014.103

Companies can also face causes of price or availability risks that come from outside their industry. For example, Tyson raises and sells chicken as well as other food products. Corn, soybean meal, and other feed ingredients account for 71 percent of the cost of growing a chicken. Prices of these grains fluctuate wildly with the vagaries of weather and farming. Yet the company also cites the renewable energy industry as a contributor to grain price risk because ethanol and biodiesel makers compete with Tyson for grain supplies.104

Price risk might have some natural bounds or cycles. Trends in price can affect supply (e.g., motivating development of new sources of supply) and demand (e.g., motivating efficiency or substitution). Many basic materials are under long-term price pressures because of the inexorable economic growth in demand and the environmental difficulties in developing new supplies. At the same time, speculation about increasing commodity prices can lead to short-term price bubbles in commodities, which, in turn, leads to hoarding, causing artificial shortages and further escalating prices. But then after supply catches up with demand, the price collapses as the bubble bursts and the hoarders dump their stockpiles. The behavior of suppliers, middlemen, and customers amplifies volatility up the supply chain in a bullwhip effect, exacerbating price volatility in commodities including rice, cotton, copper, oil, iron, and steel.105 Other materials, such as natural rubber, can be easily substituted and might cycle up and down in price with less likelihood of severe prolonged shortages.

Assessing Mitigation Options

The third step is to choose among many strategies for coping with price risks. These can include: minimizing consumption of the commodity subject to price risk; transferring price risks to suppliers by negotiating long-term fixed-price contracts; transferring price risks to customers via surcharges; assuming price risks via flexible operations; and hedging price risks in the financial markets or with physical inventories. Part of this assessment considers the time required for the company to mitigate the problem, as is the case with any other disruption. This can include lead time to create new primary supplies (e.g., new mines or factories), time to convert to using recycled material, or product development times that would reduce consumption of the scarce material or allow substitution of materials.

In assessing these options, a company estimates the extent to which cost increases could be passed on to customers (via surcharges or price increases), to suppliers (via long-term fixed-price contracts), or to other third parties (via hedging). Whereas restaurant chains such as Morton’s Steakhouse or Capital Grille in the United States can raise prices modestly, McDonald’s cannot, because McDonald’s customers will notice if their Big Mac is priced a few cents higher. Passing price risks to a business partner such as a supplier or B2B customer involves negotiation and depends on the relative strengths in the relationship and whether the partner’s business model can manage the risk. A company might also use hedging in the financial markets, assuming that the scarce commodity, or a related commodity, trades on these markets.

Ford’s commodity price risk mitigation strategy varies by material. Ford uses derivatives hedging for materials such as precious metals, aluminum, and copper that have a deep and liquid financial hedging market. The company uses long-term fixed-price contracts to lock in the price with suppliers for materials such as plastics and steel where derivative markets are not fully developed or available.106

The various hedging strategies work on different timescales and can complement each other. For example, in the short term, surcharges are adjusted “automatically” based on the underlying index. Of medium duration, financial hedging strategies generally cover months or a few years at most. Ford’s hedging of commodities, for example, covers a maximum of two years.107 A 2011 survey found that 62 percent of companies hedge foreign exchange risks on a horizon of 12 months or less.108 Other strategies may take much longer because they involve more substantive changes in products, processes, and facilities. For example, physical foreign exchange hedging by building plants on different continents and matching production with sales takes years. Similarly, substitutions of basic commodities, such as switching from steel to aluminum or from diesel engines to electric drivetrains, take time because of the nontrivial changes in product design and manufacturing.

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