Commodities forecasting: It's all in your head
Prices of commodities can rise quickly when production falls and supply is tight; conversely, they cost less when output rises and supply surges. Trying to gauge which way the trend is going makes forecasting tricky.
By Tom Stundza -- Purchasing, 6/14/2007 2:00:00 AM
Strong global growth has pushed industrial commodity prices to new heights in 2006 and 2007. This has wreaked havoc with procurement budgets and created a quandary for buyers trying to forecast pricing trends in the second half of this year and into 2008. In a nutshell, forecasting has been muddled by supplier consolidations, pricing volatility, economic uncertainties, monetary unpredictability and geopolitical concerns.
But forecasts are critical in business. Estimated prices are the core of product-development budgets. Those estimates are also the basis for evaluating buying strategies, planning quarterly cash flows, making forward pricing decisions and implementing such risk-management plans as hedges.
So what's a buyer to do in the face of all the economic uncertainty? Use his or her head.
Of the three types of commodity price forecasts—those based on personal judgment, those relying exclusively on historical price data and those incorporating commodity futures prices at the time of the forecast together with historical price data—the judgmental forecasts have the best record of accuracy.
According to Aasim Husain, of the International Monetary Fund's research department in Washington, analysis indicates that "judgmental forecasts tend to outperform the model-based forecasts over short horizons of one quarter for several commodities." They're also the most popular, he says.
Purchasing surveys show that many buying groups tend to use home-grown projections or forecasts developed for them by various research organizations. Academicians explain that's because statistical models can be short-circuited by the volatility of energy, metals, chemicals, plastic resins, wood products and other production materials.
But if you're going to use personal judgment in commodities forecasting, you have to base it on the right factors. Analysts and buyers alike agree that the most critical data to review are:
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market intelligence
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global economic trends
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supplier safeguards against volatility
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your own company's selling strategies
Even in calm economic times, those tools are critical. With the current volatility in commodities, they're essential. "The commodity markets are crazy these days," says Peter Connelly, CPO at diversified manufacturer Leggett & Platt in Carthage, Mo., which buys $3.7 billion annually in production and packaging materials. "Prices are affected by local and world demand and supply trends, global currency movements, the economic policies of such developing economies as Brazil, Russia, India and China—and even today's instant communications."
The latest demand boom for base metals is in its third year and has elevated nonferrous metals pricing to record highs. Steel prices are reflecting iron ore, scrap, ferroalloy and energy costs—rather than demand trends—probably for the first time.
"Pricing cycles for commodities are shrinking," says the global procurement manager at a Detroit-area auto parts company. "The steel cycle used to be 7 to 10 years in length from peak to valley in prices. Nowadays, it's more like 18 months due to the rapid change in delivery of information."
Atop all that, says Leggett & Platt's Connelly, "supplier consolidation and pricing volatility is making forecasting difficult and, actually, past a 90-day window very inaccurate." Rather than a sign of the top for commodity prices, analysts worry that the deal-making could help put a lid on supply and put even more pressure on a host of commodity prices.
This view is supported by research director Anirvan Banerji at the Economic Cycle Research Institute in New York. Most forecasters have a dismal record of predicting the timing of cyclical turns in economic growth, jobs and inflation, he writes, "because most people and forecasting models expect recent patterns to persist in the near future." This is "a sure recipe for being surprised on prices by the next turn in the global industrial cycle."
And then, there is nature. The late-summer hurricanes of 2005 taught energy and petrochemical buyers just how fast supply can be disrupted and prices can explode.
"It's all about energy and raw materials these days," says Dan DiMicco, CEO of Nucor Corp., the Charlotte, N.C.-based steelmaker. "With the volatility in and high level of materials pricing nowadays, nobody wants to carry inventory—whether it's in the raw materials at my mills or the finished products we ship to our customers."
Intelligence is king
Stating that "in a commodity market today, intelligence is king," DiMicco tells a recent steel industry conference that "to run as efficiently as we can, mills and service centers will have to start at the customer—and talk to buyers about what they really need and what they expect they will be paying. Only then can we take some volatility out of the metals market—and come to some equitable long-term arrangements on price and supply."
So, the foundation for any successful commodity forecasting program must be based on detailed market knowledge that can smooth out current volatility and help ensure against disrupted flow of raw materials, says Mike Burns, global business director for polyethylene at supply chain consultancy Resin Technology Inc. in Fort Worth, Texas.
He insists that buyers "emerge from their comfortable silos" and get knowledgeable about global economics, supply, demand and sourcing alternatives—"whatever they need to know to become expert about their company, their industry and their regional and global supply chain." Solid market facts are needed to develop effective buying plans, and that includes accurate price forecasting, says Burns in an interview.
It's a small world
A key piece of advice from this purchasing coach and several top-level buyers interviewed: Whatever the commodity, watch the international marketplace to determine supply, demand, pricing and trading trends. That's because economic conditions that affect supply and prices are changeable—and usually global. "Buyers have got to know demand, as best as they can, but not just demand in North America—demand globally," says Burns.
Today's Lean and highly outsourced supply chains leave procurement teams with little visibility to anticipate and react to global risks, complain some analysts. That's why they suggest that buyers learn as much as possible about global supply chains and determine what safeguards their world supplier organizations are putting in place to maintain continuous supply and honor agreed-upon future pricing.
"The days of going out with an RFQ (request for quote) and a spreadsheet of needed materials are over," agrees the commodities buyer for a Chicago-based multinational corporation. "Past-paid price averages are just the start of what we'll expect to pay in the future. We have to work closely with materials engineering and quality folks on the materials specifications and then we have to find out what's available. Remember, you can't buy all over the world for the same price—ever."
Yet another essential weapon in the commodities-forecasting wars is knowledge of your own company's strategies. "The key to future pricing is to remember that the company's sourcing strategy is there to support the company's business," says Dan Ronchetto, vice president of global direct materials for Greif in Delaware, Ohio. "So, the purchasing organization has to know how the company sells into the market—what the competitive dynamics are and how competitors are competing."
In an interview, Ronchetto says the sourcing strategy has to be in line with the company's sales strategy. If a company's sales are on an annual fixed basis, then purchasing arrangements should be on an annual fixed-prices basis. "The bottom line is the key issue! Wall Street doesn't like surprises or volatility," he says. And it's not just for public companies. Sourcing strategy has to be aligned with overall business strategy and how end customers are served. "If you sell monthly, buy monthly," Ronchetto advises. Fixed 2-year or 3-year contracts are disappearing into indexing to adjust quarterly market changes, he says.
Some analysts suggest that futures prices on commodity exchanges in London and New York may be the best measure of imminent sales price trends. The various commodity futures exchange markets do provide a mechanism for price discovery on an aggregate level through arbitrage between multiple buyers and sellers.
To many buyers, though, futures trading is just one of several possible tools to guesstimate future pricing—and only for certain raw materials. While nonferrous metals are traded globally, other materials—such as resins and lumber products—have limited regional exchange liquidity, and other materials, such as steel, have yet to find a trading floor. Also, price discovery at any given location—whether that is New York, Chicago, Winnipeg, London, Tokyo or Shanghai—is not necessarily definitive because supply and demand relationships are murky.
Nevertheless, buyers are the ones expected to navigate the terrain. Says Greif's Ronchetto, "My CFO and other chief financial officers also are putting more and more pressure on manufacturing and purchasing colleagues to reduce corporate costs." And forecasts, however unscientific, are an important tool in that effort.
| 2005 | 2006 | 2007 | ||||
| forecast | actual | forecast | actual | forecast | actual * | |
| * 1st qtr 2007 Forecast: World Bank; Actual: London Metal Exchange |
||||||
| Aluminum | 80 | 85 | 104 | 116 | 91 | 127 |
| Copper | 156 | 167 | 279 | 305 | 237 | 269 |
| Nickel | 625 | 666 | 945 | 1102 | 870 | 1878 |
| Lead | 41 | 44 | 51 | 60 | 44 | 81 |
| Tin | 314 | 335 | 345 | 397 | 278 | 577 |
| Zinc | 59 | 64 | 130 | 148 | 119 | 164 |
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