Column: Supply chain management
Commodity risk management in transformer industry
Transformer manufacturing includes a number of raw materials, which show significant price fluctuation and therefore represent a major risk for transformer producers. During 2004-2008, when commodity prices exploded globally, many producers have had huge losses due to lack of understanding of the risk management methodology and wishful thinking. Some of the raw materials used for transformers are market-traded commodities and specific commodity exchanges exist (copper, aluminum, crude oil). But there are other raw materials such as structural steel and grain-oriented electrical steel where no specific commodity exchange exists. It is a complicated process to understand the risks involved in managing these raw materials and finding proper methodologies to mitigate these risks. This requires combined efforts of sales, procurement and treasury/finance functions, and well-established company policies and procedures.
Copper is the most important commodity among these raw materials and it accounts for roughly 10% of the cost of a transformer. Considering that power transformers have a cycle time of more than a year, handling the copper price fluctuation is a major challenge when prices change by hour. The London Metal Exchange (LME) is the global center for copper trading and even when the copper sale does not take place on the LME, the prices of LME are taken as a reference. Hedging is the most common risk management tool for copper and it is possible make forward contracts for copper price on the LME for long periods (2, 3, 4 or more years, up to 123 months). Once hedging is done, the cost of copper is frozen and the customer is not affected by the market fluctuations of copper price. It is important to understand that hedging is a risk mitigation tool and it protects your calculated margins in a project. It is not a lever for cost savings. The market price of copper can drop below the hedged price and that can be a lost opportunity. However, nobody can guarantee that the market prices will not go up. Taking the risk and exposing yourself to the market fluctuations is gambling and it can end with huge losses. It is a tempting behavior to read analyst’s reports and try to estimate the copper price trend and decide whether to hedge copper or not. This is a desperate attempt. There is a popular joke which say that if one is able to estimate the future copper prices accurately, he does not need to work for a company and he could make more money on his own, which is correct. In the past decades, analysts used to estimate future copper prices based on very sophisticated mathematical models forecasting the copper demand and supply and the gap between these two was the main driver of copper prices.