Oil equals headache for commodity management

Buyers review sourcing strategies for 2006 based on higher barrel costs

William Atkinson -- Purchasing, 11/3/2005

As if oil prices spiraling out of control for traditional reasons weren't enough, Hurricanes Katrina and Rita added another wrinkle to the situation, frustrating buyers of commodities in a variety of areas. Department of Energy forecasters have raised the average price forecast of West Texas Intermediate (WTI) crude oil for 2005 to $58.80 per barrel. Prior to Hurricane Katrina, the year-to-date 2005 average for WTI reported by Purchasingdata.com had been $51.22 per barrel. For 2006, the Energy Information Administration (EIA) outlook is $63.46 per barrel. Prior to Katrina, its 2006 forecast was $56.70. In comparison, the 2004 price was $41.44.

EIA's updated forecast noted that oil supply from the Gulf of Mexico won't recover until November or December. It also added that lower energy demands would occur, since higher oil and natural gas prices will begin to put a damper on economic growth. All of these prices and forecasts, of course, are assuming that the Gulf avoids another catastrophic hurricane, something that is not assured, given that the hurricane season is still in progress. The crisis has forced many purchasing organizations to look more closely at the downstream impact of oil prices in setting buying plans for next year and beyond.

According to Tracy Harrison, manager of corporate procurement for First Data Corp. in Omaha, Neb., many procurement professionals take oil supply for granted until problems occur, such as natural disasters or shortages caused by overseas conflicts. "By then, it's too late," he points out. "You need to plan for these situations in advance." First Data works to make sure its oil contracts are up to date and have been reviewed and renewed on a regular basis.

"We have found that as fuel shortages occur, the contracts that we have kept updated and renewed regularly are the ones with which we are the safest and present the least amount of trouble," Harrison reports.

Which contracts are important? "Oil prices affect a lot of things that you might not even think of," he replies. These include areas of spend such as the cost of fuel for corporate jets, travel expenses for employees, shipping costs, lawn service, and building maintenance. "Oil and fuel prices also affect remodeling and construction projects," he adds. "All of these are on contract, so you should take a good look at them and keep the oil market in mind as you are negotiating these in the future."

When it comes to planning for future oil price trends, Harrison admits he's "no smarter than anyone else, but I would expect fuel prices to come back down again and then stabilize. Of course, they won't come back down to where they were." Rather, he expects them to come down from current highs and stabilize at prices higher than what they were in the past.

While some companies may purchase little oil directly, they do purchase a lot of derivatives, the prices of which are closely tied to the oil market. One such company is Progressive Dynamics in Marshall, Mich. "We don't buy oil directly, but we use derivatives such as resins," says Dennis Madison, materials control director at the company. Madison believes the best oil strategy is to watch the market and try to predict where it is going, then make strategic buys when pricing seems advantageous.

"I've been watching the oil market and considering larger buys in our plastic resins," he states. "As a result, I have stocked up pretty well and thus avoided a number of price increases and shortages."

Graham Packaging in York, Pa. is another company that relies heavily on derivatives. Martin Sauer, vice president of global sourcing, has a simple solution to the oil situation. "Hedge everything!" he says jokingly. "Of course, if you do this, then everything will go down, so hedging is probably not always a good strategy," he adds on a more serious note.

The company has been wresting with shortages for the last few weeks as a result of Katrina and Rita. In one month, for example, it lost half of the supply of its major raw material. The company's plants provide updates on their inventories every day. Corporate management then identifies the highest priorities, based on which plant is running out of material first. It then ranks these each day, making sure it has its top five or 10 customers covered. Then, it keeps pushing out dates further and further until its suppliers get back in business and can supply normally again.

"We have created a large cross-company group to help with this," states Sauer. "We currently manage and release every order from suppliers to make sure they go to the right plants."

Sauer has adopted some additional strategies. One is, to the extent the company's contracts will allow it to do so, to pass cost increases along to customers. "However, we need to communicate with our customers to let them know what oil prices and supply are doing to us," he emphasizes. In the future, he expects fuel surcharges and other pricing scenarios to be incorporated into the company's contracts. "I suspect that our suppliers will be coming to us asking for this," he notes. "And, of course, on the customer side, we will also try to do this."

As noted, Graham Packaging says the current situation is particularly challenging as a result of Katrina and Rita. "I have five major resin suppliers, and three have declared force majeure," Sauer reports. "We are currently doing the best we can with what they have available." While some companies are attempting to browbeat struggling suppliers, Sauer has found more success with a collaborative approach. "The one thing I have heard from all of our suppliers is that, unlike some of their other customers, we don't yell or scream at them for not being able to supply us," he notes. In sum, it's not "the squeaky wheel that gets the grease."

Instead, Sauer talks through all of the issues, explaining to suppliers what he absolutely needs. To the extent that they have some flexibility, they will adapt to what he absolutely needs as much as possible. Sauer poses questions to suppliers, such as, "When can we get your next load? Do we have any alternatives? Can we get any other resins? Can we juggle some things around?"

In going through situations like this, he has learned which suppliers he can—and can't—count on. "Some of our suppliers have really surprised me, in that they have stepped up to the plate and done a magnificent job for us," he reports. "These are the ones we will remember and reward going forward." Conversely, he will also remember the ones who have let his company down by saying they have no alternatives and offer no flexibility.

Sauer communicates almost as often with customers as he does with suppliers. "I update them every day or two with what's going on with our supply," he explains. "Once I explain the source of the problems to the customers, they become easier to work with." For example, a lot of customers complain because the company has changed some resins and done some other things. However, when Sauer takes the time to explain to them why his company is doing this and how big of an issue this is in the whole industry, they are more likely to understand.

Sauer says his job has changed from being a buyer to being a communicator. "If any of us get at odds with each other, such as us with suppliers, or us with customers, the whole thing will fall apart," he emphasizes.

The impact of oil prices on all commodities has procurement professionals evaluating sourcing and risk management strategies in a variety of areas. "In shortage situations, we use a dual source strategy as much as possible, especially in a time of tight supply," reports Rick DeHart, chief procurement officer for Scientific Atlanta in Lawrenceville, Ga. "In fact, we try to have two to four sources for every tight commodity, if possible."

The company utilizes two strategies, one with suppliers, and the other internally. As to the former: "We rely heavily on our long-term executive relationships with suppliers," he states. The company generates a far more intensive supplier visibility program when shortages occur. "We try to always be visible to our suppliers, but we have even more visibility when suppliers are experiencing shortages," he explains. In tight supply situations, the company also typically makes longer commitments, reserving more supply for further out.

Internally, during times of commodity shortages or other instabilities, the company schedules more forecasting meetings and communicates more frequently with senior management. "We are also linked into a common SAP platform, so we can consolidate all of our demands centrally from all of our manufacturing sites worldwide and negotiate longer-term commitments for global demands," adds DeHart.

Madison of Progressive Dynamics also has some additional strategies for dealing with unstable commodity situations. "We do a lot of sourcing overseas, so in times of shortages we often have to rely on premium transportation to meet deadlines at factories," he reports. "We also encourage our suppliers and contract manufacturers to maintain raw material inventories for future production above and beyond our actual orders, so we can implement fresh orders when we need them."

Madison, like Graham Packaging's Sauer, finds that cooperative, rather than adversarial, relationships with suppliers pay off in these situations. "Even though we are not a large buyer, we have found that having good relationships with suppliers pays off. In some situations, our suppliers will go to bat for us and try to obtain material from some of their extra customers that have excess."