The Two Faces of Price VolatilityMay 21st, 2009
Price volatility in agricultural commodity-based industries wears two faces. Media headlines often portray the ugly visage: market shocks such as the H1N1 outbreak and the spike in demand for ethanol disrupt industries that already face razor-thin margins. On the other hand, it’s often said that swings in market prices provide opportunities to make money, particularly if you’re better prepared to handle price shifts than your competitors. Which face is the true one? Should you try to eliminate price volatility, or actively manage around it?
One answer lies with understanding which factors cause prices to move up and down, whether those factors are at all predictable, and whether the resulting price changes represent dangers or opportunities. Agricultural markets generally exhibit strong seasonality – regular cycles of weather, biological processes, and consumer demand result in a certain amount of predictability in price swings. Such patterns are particularly apparent in the protein industry, which will be a focus of this blog entry. This kind of price volatility can be managed; a good forecast model can allow you to appropriately adjust your forward sales profile to up- and down-markets. The ability to spot market turns earlier and more accurately than your rivals is a competitive advantage. It allows you to adjust your prices sooner, so you avoid taking too long a position in an upswing or facing a fire sale in a downswing.
Seasonality is not the only source of market price changes. Other factors including market supply, access to export markets, changes in retail demand (think consumer downgrading from tenderloins to cheaper end meats in the face of the current recession, or the significant shifts brought about by the Atkins diet), and exchange rates also play significant roles. The predictability of these factors varies, and recent structural changes in agricultural markets have made spotting price shifts even more difficult. Feed prices, which are a driving factor in the price of beef, pork, and poultry, are now tied to the prices of oil through the increasing demand for ethanol. Energy commodities have historically exhibited greater volatility than corn, and some of this additional uncertainty has been translated to the protein and to other agricultural industries.
A common approach to managing unpredictable market price volatility is hedging. Unfortunately the salvage nature of the protein industry makes hedging difficult because orders are taken for products, but futures markets operate on the animal. There can be significant variation of the product price relative to the animal. The correlation coefficient between product prices and animal prices can range from 0.9 on the high side all the way into negative territory. Hedging of long term contracts against futures may actually add to the contract risk rather than negate it. In general, it is very difficult to find the right hedge position to offset risk for specific transactions.
So market price volatility, while not exactly a benign face, at least provides you with opportunities to out-maneuver your competitors. Other sources of price volatility can be even more troublesome. The figure below shows sales data from a large U.S. meatpacker, altered to protect the source’s identity. We examined every transaction over the course of a year, and computed the percent deviation between the transaction price and the USDA market price. The graph’s horizontal axis shows the deviation from the market prices (0 means the transaction price equaled the market price), and the vertical axis shows the fraction of annual revenue generated by transactions at each deviation.
Impact of Volatility on Revenue
While the actual data has been modified, the shape of the graph is correct. Most transactions took place near the market price, but notice that the curve is lopsided. More revenue (meaning a lot more volume) was generated at below-market prices than above the market. Customers recognize a good deal when they seen one, and they pick you off when quoted prices are too low. The result is that mistakes on the low side are a lot more significant than wins on the high side, so focusing on tools and processes that allow you to reduce this form of price volatility will lead to higher overall revenues.
The graph shows variability in the company’s product prices above and beyond any volatility in the USDA market prices. What causes this volatility? A variety of factors, most of which have to do with either the company’s supply position at the time of the transaction, or with the company’s pricing processes. Above-market prices may have been the result of a strong forward sold positions, while price below market may have resulted from a fire sale caused by too low a sold position. Alternatively a low price may reflect an inability to call the market, or a poor negotiation on the part of an individual salesperson.
So what is the true face of volatility: opportunity or risk? Both. Pricers should try to build a two part strategy. First, incorporate better forecasting technology to separate out random volatility from predictable market movements, thereby generating competitive opportunity. Second, stabilize pricing patterns that give customers the opportunity to exploit randomness and pick off low price events.