Author: Dr. Stephan Hofstetter, partner at Kloepfel Consulting.
The lower market price level and purchasing prices
In recent months, prices for gas, electricity, and key raw materials have experienced significant declines. However, overall, prices have not yet returned to pre-pandemic levels. Nevertheless, compared to the enormous spikes seen last year, they are considerably more moderate.
As a result, there is currently a high expectation for the short-term development of purchasing prices. At first glance, it may seem like an advantageous situation. However, upon closer inspection, a certain degree of disillusionment may set in. The actual leeway heavily depends on the contract and purchasing strategies of suppliers and customers, as well as the relative bargaining power of supply and demand.
Contract strategies of suppliers
The question arises as to how suppliers procure their inputs, which heavily rely on raw material prices such as aluminum, steel, or copper, traded on exchanges like the LME.
Manufacturers typically have several contract strategies to choose from. The selection of a strategy depends on various factors, including the industry in which the company operates, the volume of demand, the type of product they are purchasing, and the specific risks associated with procurement.
One of the typical contract strategies for commodities such as aluminum, steel, or copper is entering into futures contracts on an exchange like the LME. These contracts allow suppliers to secure the price of their commodities in advance and protect themselves from price volatility. If commodity prices rise in the market, suppliers are protected as they can pay the agreed-upon price instead of the higher current price.
Manufacturers can also purchase options on an exchange like the LME to hedge their position. An option grants the buyer the right to buy or sell a specific quantity of a commodity at a predetermined price. This strategy is more flexible than futures contracts because the buyer has the right but not the obligation to buy or sell the raw material.
Finally, suppliers can also utilize the spot market to purchase commodities. In the spot market, commodities are bought and sold without a prior price agreement. This strategy can be useful for short-term needs but carries a higher price risk.
It is important to note that each contract strategy has its advantages and disadvantages, and the selection of the strategy depends on various factors, including market conditions, industry, and specific requirements of the company.
A fundamentally different contract strategy is entering into supply agreements, for example, directly with a partner who owns their own power plants, rather than through an exchange as in the previous contracts. These contracts can be long-term supply and purchase agreements, where the quantity, capacity, and price of the energy are determined for a specific period. Such contracts provide planning security and allow for better calculation of energy costs.
Contracting strategies of buyers
The buyers and their suppliers can ultimately use a stock market price or an index of a commodity or energy as a reference point for their contracts in relation to the cost structure. The product price is synchronized with the market price level through the “index price,” which adjusts dynamically.
An index price can, for example, be calculated based on the average price on the exchange or based on a specific contract on the exchange. The supplier and the buyer can additionally agree on a fixed surcharge or discount on the index price to adjust the price to the specific product and delivery conditions. During volatile periods, significant fluctuations, such as energy or freight price surcharges, may be passed on to customers.
There are also specialized providers that offer index prices for various commodities. These can serve as a reference point for contracts between suppliers and buyers. The providers often use a methodology that reflects the current price on the exchange and regularly updates the price.
It is important to note that the use of an index price for contracts between suppliers and buyers has advantages and disadvantages. One of the advantages is that it allows for transparent pricing and reflects fluctuations in the market price. However, there can also be problems if the index price does not precisely match the specific requirements of the buyer or if there is high market price volatility. Depending on the buyer’s market assessment, fixed contract prices on an annual basis are often preferred.
Procurement prices
Currently, market prices for energy (electricity, gas) and raw materials are weakening significantly, yet these benefits are not always passed on to the buyers.
There are several reasons why suppliers may not be able or willing to pass on the advantages of lower market prices for energy and raw materials to their buyers. Some possible reasons include:
- Current contracts: Contracts were renewed at an inopportune time last year at prices significantly above current price levels. In such cases, suppliers may be forced to continue charging higher prices even if market prices have fallen.
- Long-term supply contracts: Suppliers may have long-term supply contracts with fixed prices that are still at a lower price level than the current one. In this case, prices were not increased in 2022 and, of course, cannot be reduced further at present.
- Inventories: If suppliers have already stockpiled a large quantity of raw materials at a higher price, they may be forced to continue charging higher prices to cover the original cost prices.
- Lack of transparency: If cost structures are not sufficiently transparent, changes in raw material and energy prices remain purely a matter of negotiation. In the absence of a recognised reference price index,, a sliding adjustment is also difficult. If suppliers are not willing to discuss their own contracting strategies, it is difficult to assess whether an adjustment would be justified.
- Supply and demand: Even if market prices for raw materials or energy fall, demand can remain high. If suppliers are unable to meet demand due to tight capacity, for example as a result of the war in Ukraine, or other factors, they may continue to charge higher prices.
- Market power: Suppliers may in some cases have a strong bargaining position that allows them to charge higher prices. For example, if there are few suppliers in the market or if the supplier has a strong brand or reputation, they may be able to impose higher prices.
It is important to note that these reasons vary by supplier and that there may be other factors that influence supplier behavior.
Recommendation
Various scenarios can be developed for the respective purchasing and contracting strategies of the suppliers and the customers. This includes a precise analysis, which the consultants of the Kloepfel Group can carry out. This shows whether a reduction in purchasing prices would be justified in the specific market situation and negotiable with good arguments.
In case of a tight margin, buyers should still become active now. Then they may be able to proactively use the currently weakened price level for negotiations for 2024. For the coming winter, there is still a high degree of uncertainty as to how availability and prices for energy, for example, will develop. Of course, the specific circumstances have to be assessed.
In general, all protagonists within the value chains are currently acting cautiously. At the same time, the partners in the supply chain have learned their lesson at the latest during the Corona crisis. As a result, they are now trying to hedge or avoid risks as far as possible in the current market situation.
The consultants of the Kloepfel Group can offer support with great expertise and skill. After analyzing the purchasing and contracting strategy, the further course of action is determined. In this way, hidden opportunities, if any, can be quickly identified and seized in order to profit from the falling prices on the energy and raw material markets.
Do you suspect that the current turnaround in raw material and energy prices will also make favorable purchasing prices possible for you? Then get in touch with us!
Contact:
Kloepfel Group
Christopher Willson
Pempelforter Str. 50 | 40211 Duesseldorf
Tel.: 0211 941 984 33 | Mail: rendite@kloepfel-consulting.com