Global Risk & Trading Practice HOT COMMODITIES VOLATILE COMMODITY PRICES SHOULD BE ON THE CEO S RADAR SCREEN. John Drzik

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1 Global Risk & Trading Practice HOT COMMODITIES VOLATILE COMMODITY PRICES SHOULD BE ON THE CEO S RADAR SCREEN John Drzik

2 VOLATILE COMMODITY PRICES Japan s nuclear crisis and political unrest in the Middle East have triggered price spikes and supply disruptions in everything from oil to wheat to gold. It might be tempting to view these recent price swings as a temporary phenomenon. They re not. They are the new normal. Changes in both supply and demand dynamics are likely to create a long period of sustained commodity price volatility, with significant downstream implications for many businesses. The recent Global Risks 2011 report published by the World Economic Forum with partners including Oliver Wyman revealed that 580 experts, business leaders and policy makers believe it is likely the world will experience extremely volatile energy prices, commodity prices and consumer prices in the next ten years. There are a number of structural reasons for the sustained increase in commodity price volatility. Global demand for commodities such as food and energy will grow at a double-digit rate over the next decade due to population growth and increases in per capita usage driven by economic development. This rising demand will likely fuel investment in commodity extraction, encouraging players in these businesses to consider increasingly risky projects that will be more prone to disruption. Supply disruptions will also be more frequent due to changing climate patterns and the increasing number and magnitude of extreme weather events that they will cause. Floods, droughts, hurricanes and many other types of extreme weather events are all projected to increase in the next decade. Shortages in some regions will likely be further exacerbated by a rising number of governments taking unilateral actions to cope with their scarcity of resources. In the last twelve months alone, Russia, Pakistan, India and Vietnam have all restricted exports of agricultural commodities ranging from grain to cotton to rice. Further price swings might also be created by political choices related to the trade-offs inherent in addressing interconnected resource shortages. For example, the International Energy Agency predicts the globe will need $1 trillion How much more companies and consumers will need to pay for oil in 2011 if US oil contracts remain at $110 per barrel 3.2 million barrels per day of biofuels to meet policy incentives related to reducing vehicle emissions. However, producing those fuels could amplify food shortages and put further pressure on water shortages as well. The range of geopolitical and environmental uncertainties surrounding commodity supply will also likely fuel financial speculation in commodities amplifying price volatilities even further. RISK JOURNAL 3

3 GLOBAL RISKS LANDSCAPE 2011 Source: Global Risks 2011: Sixth Edition, World Economic Forum and partners including Oliver Wyman ECONOMIC RISKS Asset price collapse Extreme commodity price volatility Extreme consumer price volatility Extreme energy price volatility Fiscal crisis Global imbalances and currency volatility Infrastructure fragility Liquidity/credit crunch Regulatory failures Retrenchment from globalization Slowing Chinese economy (<6%) GEOPOLITICAL RISKS Corruption Fragile states Geopolitical conflict Global governance failures Illicit trade Organized crime Space security Terrorism Weapons of mass destruction ENVIRONMENTAL RISKS Air pollution Biodiversity loss Climate change Earthquakes and volcanic eruptions Flooding Ocean governance Storms and cyclones SOCIETAL RISKS Chronic disease Demographic challenges Economic disparity Food security Infectious diseases Migration Water security TECHNOLOGICAL RISKS Critical information infrastructure breakdown Online data and information security Threats from new technologies PERCEIVED IMPACT IN BILLION US $ Slowing Chinese economy 50 Space security Weapons of mass destruction Retrenchment from globalization Asset price collapse Infrastructure fragility Threats from new technologies Extreme consumer price volatility Global imbalances and currency volatility Regulatory failures Critical information infrastructure breakdown Extreme commodity price volatility Food security Air pollution Online data and information security Ocean governance unlikely likely very likely PERCEIVED LIKELIHOOD TO OCCUR IN THE NEXT TEN YEARS Commodity price volatility, and its management, have always been critical issues in some businesses. For example, they have been on the agenda of airline CEOs since jet fuel prices (and their hedging) have been a strategic issue for some time. Similarly, CEOs of energy, chemical, pharmaceutical and food companies have had to grapple with commodity price volatility over the past several years. Now, however, no matter whether a company competes in the technology sector, and therefore depends on rare earth minerals, or automotive and Liquidity/ credit crunch Geopolitical conflict Chronic diseases Infectious diseases Earthquakes and volcanic eruptions Higher perceived likelihood Fiscal crises Climate change Extreme energy price volatility Economic disparity Global governance failures Demographic challenges Corruption Fragile states Flooding Organized crime Water security Illicit trade Terrorism Migration Storms and cyclones Biodiversity loss Higher perceived impact cell phone sectors, and relies on semiconductors, commodity price volatility impacts the profitability of firms across the board. Nevertheless, many businesses treat commodity price volatility as a tactical management issue to work through periodically. Going forward, this issue should move up the agenda of many companies since the degree of impact of commodity price swings on the volatility of overall earnings will rise and be more than a temporal effect. 4 RISK JOURNAL

4 VOLATILE COMMODITY PRICES The stakes are rising. Consider: On April 7, US oil contracts exceeded $110 per barrel for the first time in two and a half years. If oil prices remain at that level, we estimate that companies and consumers will need to figure out a way to pay $1 trillion more for oil this year than they did in But that estimate just scratches the surface of the costs that companies and consumers will need to bear since there have been recent increases in the prices of many other commodities as well. As a result, businesses ranging from manufacturers to retailers to bakers are all struggling to manage the volatility that raw material prices are introducing into their earnings. Some are discovering that the cost of their electricity supply, for example, is becoming a core driver of their earnings. Others are being forced to renegotiate contracts with their suppliers if they don t accept higher prices, their suppliers are at risk of going bankrupt as they are paying much higher prices for raw materials. CEOs need to determine the degree to which taking commodity price risk fits with their risk appetite and shareholder expectations. It might be that their investors expect the company to have this risk, and fully expect to see the resulting increase in earnings volatility that stems from increasing commodity price swings. However, it might also be that the bet investors are making on the company lies in other factors, such as superior operational management or customer distribution. In these businesses, CEOs will likely want to mitigate the effect of commodity price swings on earnings. These companies need either to invest in the risk management capabilities necessary to manage through a long-term pattern of heightened commodity price volatility or to redefine their business models (for example, through supplier contract structures) so they are not directly exposed to the risk. Separately, all companies should consider investing in methods and technologies that ensure more effective and efficient usage of resources and commodities to reduce their overall exposure to volatile prices. It is likely the world will experience extremely volatile energy prices, commodity prices and consumer prices in the next ten years Global Risks 2011: Sixth Edition We are entering a new age of commodity price volatility, likely to extend for ten years or more. The impact on the earnings volatility of many companies is likely to be substantial and sustained resulting in a meaningful effect on shareholder returns. These companies need to consider whether they change their business model or management approach or both to align their commodity risk exposure to their risk appetite. CEOs should have this issue on their radar screen and take the lead in arriving at an answer. John Drzik is the CEO of Oliver Wyman Group RISK JOURNAL 5

5 ABOUT OLIVER WYMAN Oliver Wyman s Global Risk & Trading Practice enables the world s top industrial corporations and commodity trading organizations to gain competitive advantages by assisting them with managing risk across their businesses more effectively. By working with global leaders in a broad range of industries, our practice has developed unique capabilities that help industrial corporations and commodity trading organizations create value and maximize their performance by making risk-adjusted strategy, investment and capital allocation decisions. With offices in 50+ cities across 25 countries, Oliver Wyman is a leading global management consulting firm that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation, and leadership development. The firm s 3,000 professionals help clients optimize their businesses, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is part of Marsh & McLennan Companies [NYSE: MMC]. For more information, visit For more information, please contact: John Drzik, CEO, Oliver Wyman Group John Drzik is the Chief Executive Officer of Oliver Wyman. He joined the former Oliver, Wyman & Company in 1984 and was appointed its Chairman in Drzik played a key role in establishing the firm s leadership position in financial services strategy and risk management consulting, advising financial institutions across the capital markets, wholesale banking, retail banking and insurance sectors. Copyright 2011 Oliver Wyman. All rights reserved This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman. Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of thepossibility of such damages. This report may not be sold without the written consent of Oliver Wyman.

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