Successful commodity risk management at consumer-packaged goods companies (CPG) tends to focus primarily on protecting margin while removing volatility, providing margin recovery, and providing predictability to the business.
The way that this is traditionally accomplished is to align the companies hedging strategies and tools with brand elasticities and market conditions. This allows organizations to repeatably choose the right tool for the right coverage for any given brand.
Sounds easy, right? It’s actually a very difficult process to put in place and one that, if not done correctly, can send companies astray or worse – it can add risk instead of removing risk from a business.
To provide a little bit more context, let’s unpack this.
Aligning Hedging Strategies with Brand Elasticities
The CPG space is dominated by competition. For each category, be it frozen pizza, or cereal, or anything in between there are multiple brands to choose from at multiple price points and a seemingly endless supply of new market entrants. You would think that this solely creates a unique challenge for the sales and marketing teams to overcome, but it also bleeds over into the commodity risk management space as well.
Having so much competition creates a situation where brands need to be able to remain as nimble in their pricing as other competitors or they introduce margin risk to their business.
Said differently, the intense competition in the food space creates a pricing situation where the opportunity cost of not pricing down, or being forced to price up, when your competitors have/have not is immensely large.
Let’s take a quick look at two examples:
- If you are a milk or an egg producer selling gallons of milk or dozen boxes of eggs on grocery store shelves – you should generally have very little hedge coverage on. Customers expect the prices of these goods to change regularly. If you have hedge coverage on that is significantly longer than your ability to price those products, or competition, you are adding margin risk to your business.
- On the opposite side of the spectrum, consider frozen entrees. They generally contain 10+ ingredients and there is not a single major ingredient that accounts for the majority of the spend (excluding packaging). Customers expect the prices of frozen entrees to be relatively stable on the shelf – lending itself to longer hedge coverage for the hedgable ingredients.
Determining the hedge duration of your brands can be accomplished a few different ways. You can pull various pricing data sets and compare against significant commodity price changes to determine pricing windows. If you are food service oriented, you can simply look at the length of your customer contracts. There are also general guidelines used by some.
The most important take away here is that once you have determined your “pricing window,” that should be a guide to the length of your coverage. If your pricing window is 6 months and you have 4 months of coverage on, you are effectively short the market. Likewise, if your pricing window is 6 months and you have a years’ worth of coverage on, you are long.
Choosing the Right Tool for the Right Market Conditions
Once you have a good idea of what your pricing window is, you can then weave market conditions into the equation. The most effective and consistent way of achieving this is to let pricing percentiles guide whether you are using futures, options, OTC products, or any combination of the like.
Let’s look at an example:
Above is a chart of nearby corn futures from January 2014 to January 2023 with the 10th, 50th, and 90th percentiles all plotted on the chart.
Looking at things from this perspective, it is easy to see that when prices are in the 10th percentile over a given time period, you probably need firm upside protection, but not much downside opportunity. What’s an effective way to execute that? Futures.
Likewise, when markets are in their 90th percentile over a given time period, you probably need a bit of downside recovery if prices collapse. How do you achieve this? Options.
Letting your pricing window guide your duration and market conditions guide your tools allows for effective risk management.
Repeatable Coverage Decisions
Once you’ve determined your pricing window (i.e. duration) and the market conditions (i.e. tools), the final step you need to take is to develop and implement a process for repeatable coverage decisions.
Far too often, risk management employees try to pick market tops or bottoms and “nail the market.” The problem with this is that it’s impossible. There are simply too many variables to consider to make it repeatable. If anyone could get it right, even 50% of the time, they would be sitting on a beach drinking Corona and not working.
So, how do you get around this?
Some companies realize this issue and take the exact opposite approach of trying to time the market. These companies simply direct employees to buy along the forward curve at predetermined intervals, creating weighted average coverage. The problem with this? You become a complete price taker. If you are simply buying one week at month, using one tool type, and not considering market inputs you have given away all of your control.
Someone, or something, has to make a decision to buy, so what do you do?
The ideal scenario is to build out a complete process and implement a policy that the company can and will abide by. You should start with learning your brand elasticities, choosing the right tool, and using some sort of systematic market indicator to produce buy and sell signals.