Degrees of Risk
I had a meeting recently with a company who told me they don’t trade futures markets for a commodity of which they are a major consumer. The reason? They don’t want to take on “too much risk” and be caught in a “volatile” market.
Rather than trade this commodity on an exchange, they prefer to continue to pay for their product while locked into a supply contract that often has 1 price per quarter. And their contracts don’t always guarantee timely or on-spec delivery.
Now that’s what I call high-risk and volatile!
Traditional supply contracts have been the ruination of many a company’s bottom line, for both sellers and buyers. A story was recently related to me from a man who worked in a company that no longer exists. He said one of the most frustrating parts of his job as a sales manager was dealing with his contract customers. If they didn’t like their price, they refused to pay and turned away the product.
That is a position that’s hard to get out of!
When people in those positions are offered risk management tools, there is often some fear of the unknown. But it is the fear of the known — the fear of history repeating itself — that can be the true devil in the markets. Getting out of a position on a calendar strip on a futures exchange is fairly easy and routine. Getting out of a 2-year supply contract at a price you have grown to distrust and/or hate is not easy and is messy, if it’s even possible. Few companies sue their own customers.
There is a way to lessen the degree of risk traditionally worn by these buyers and sellers. That way is to trade the market.
Fear of price volatility is another reason I hear cited as keeping some companies away from trading futures or cleared OTC contracts. Again, the most volatile pricing mechanism I can think of is a quarterly contract, with a price that can easily double from one delivery date to the next. Trading in a market every day enables one to buy according to the price trend. Volatility smoothes with liquidity - and a monthly or quarterly contract is the opposite of liquid.
The cultural mindset of those who consider themselves risk-averse often baffles me. Buying or selling a commodity on a limited time basis with infrequent pricing and often no insurance on counterparty performance is extremely risky. The purchasing managers and sales managers at major manufacturers take on risk that would make a Wall Street veteran sweat, for it is the culture of price-taking that is the riskiest of all.
But this culture is changing, and it’s changing from the bottom up. Retailers are often blamed with “ruining” the trickle-down theory of the pricing chain. A large retailer will often name its price to its supplier, because of their enormous pricing power. Lately, these same retailers are questioning their suppliers’ risk management practices. An example in recent years was seen in fuel markets. Rising fuel costs were passed along to retailers in the form of surcharges. Realizing that the surcharges were the result of certain fuel suppliers making the choice not to hedge or manage their fuel price risk, some retailers forced them to do so, and in effect forced an efficiency in the fuel supply chain.
These same consumers and retailers are now asking the same questions of many of their vendors: do you hedge your resin price risk? Is there a tool to do so? Yes? Why aren’t you doing that? It is a refusal to be a price taker that is leading this bottoms-up charge, and those at the top of the upstream supply chain are, of course, already using such risk management tools.
It will be interesting to see the middle of the chain adapt to these new efficiencies - and begin to understand the degree of risk they currently take on.
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