India Inc faces commodity rally challenge to manage costs

The rally in commodity prices is about to complete two years and there are indications that prices will either consolidate or reach higher levels. However, the rising commodity prices have posed a challenge for companies, especially consumer firms, which have to manage raw material costs.

In the past two years, prices of most commodities are up between 30 and 100 per cent, and many companies are now working on active price management and hedging raw materials to protect both costs and margins. Companies are trying to pass on the price increase in raw materials to customers and/or hedging commodity prices, either directly or indirectly.

While some companies like Larsen & Toubro (L&T) already have a strategy in place and will be in a position to deal with the rise, it will not be the case for most others, especially the small and mid-sized ones, which are evaluating solutions.

L&T Chief Financial Officer (CFO) R Shankar Raman said, “As an EPC (engineering, procurement and construction) company executing several large projects, we have always been dealing with the challenges of forecasting input costs over extended time periods/price cycles.”

He said there were several solutions for managing costs. “L&T usually has an exposure to price movements of its various inputs. In many instances, L&T has contractual clauses, which provide protection against inflationary price movements.” 

Further, he added, suitable negotiation with supply chain partners and contracting for hedges against commodity price movement also provided the requisite insulation from unfavourable price movements.

Raman also gave credit for the consistent margins in its various businesses to its effective input price management strategies and processes. However, for many small and mid-sized companies, it is easier said than done.

Both large and mid-sized companies are working to mitigate commodity price risks. T Gnanasekar, director, Commtrendz Research, a risk advisory firm, said, “Companies that are actively hedging their raw material costs are finding it beneficial because passing on rising costs to consumers may not be possible and hence the trend to hedge price risk or manage price risk is catching up.”

Perhaps, this cost management, along with some pricing power with producers, is helping India Inc to keep its raw material cost to sales ratio under check, though consumers of commodities have not been able to digest cost hikes completely.

Commodity brokers and industry experts said consumer firms of crude oil, metals, petrochemicals, and agricultural products are active in hedging their cost of raw materials. After linking petrol and diesel prices to market, oil marketing companies have also become active hedgers in the domestic and international markets. Fast-moving consumer goods (FMCG) companies, synthetic textile and plastic goods makers hedge their raw material risk on petrochemicals and polymers through crude oil, which is a mirror contract for their raw materials.

While metal companies, especially those with conservative management, are less active in price hedging, those active in trading are opting for various risk management strategies, according to sources. FMCG companies, too, seldom kept price or currency risk open, they said.

Experts expect the rally in metals to continue. Andrew Cole, principal analyst, Metal Bulletin Research, said, “The strong global economy has lifted demand and sentiment, which in turn has driven up prices across the board.” In zinc, major mine closures and suspensions led to the rally but as new mines open, suspended mines restart and expansion projects are completed, zinc may be in surplus by 2019. “Zinc may be getting close to the top of its cycle,” he said.

But other metals like copper and, to some extent, lead are going the other way – they will rise over 2018 and 2019, with copper in particular set to get very tight again due to lack of new mine projects in the pipeline. “We could be looking at $8,000/tonne copper again in 2019-20. Aluminium is harder to call,” Cole added.

Strong global growth and developments in China, especially the enforcement of environmental rules, will leave their mark on the commodity rally. 

Ricard Torné, head of economic research at FocusEconomics, a research house, said, “Commodity prices are nowhere close to previous highs.” He expects the ongoing rally to continue next year, though at a more moderate pace. He is bullish about energy prices, but the Organization of the Petroleum Exporting Countries cut and the resultant sharp oil price rise will be partially offset by increased production in the US, limiting the upswing in prices.

According to Torné, “Base metals will be heavily dependent on developments in China. Capacity cuts and stricter environmental regulation in the world’s second-largest economy will continue to exert upward pressure on prices. However, concerns that demand from China could moderate next year and still low utilisation rates in the country pose uncertainty about the evolution of base metal prices.” He expects precious metal prices to rise slightly next year on the back of mounting geopolitical risks.

There are a few caveats, though. Gnanasekar alerts that China’s growth is still subdued, even as its environmental norms enforcement and past capacity cuts are keeping prices rising. The positive, though, is that global growth is improving demand for them. “China’s economic growth and how fast or moderate is the pace of interest rate hike in the US will be determining the continuation of the commodity rally,” he said.