Commodity Squeeze May Spur Vertical Integration
Record high commodity prices could encourage firms to integrate with their suppliers, Oxford Analytica says in a new report.
High input prices represent a risk to the security of every firm’s supply chain. In the context of volatile markets, credit shortages and recession risk, firms are considering how best to secure the necessary supplies at commercially viable prices, OxAn says.
Short of upstream integration, firms can employ various strategies under conditions of market volatility:
- Outsourcing allows firms to squeeze costs out of the supply chain by producing goods where production costs are lowest and by creating competition between would-be suppliers who act to lower their costs to win the business. These rationales potentially apply more now than in the last few years as the major industrialised countries face the risk of recession.
- Hedging. If the risk is supply price volatility, rather than availability, then some firms have found hedging to be the answer. For example, in the United States, Southwest Airlines has put in place a highly respected hedging strategy, resulting in it paying 30% less per gallon of jet fuel than some of its rivals.
- Supply chain financing. The double-blow of high commodity prices and the credit crunch has impaired the ability of suppliers to invest and innovate. One solution being offered is supply-chain financing. Here a bank agrees to pay a supplier promptly in return for collateral provided by accounts receivable offered by the downstream purchaser. The downstream firm then reimburses the bank once the accounts are settled.
In some cases however, there are strong rationales for upstream integration. For example, where an input is so essential that its loss would create long-lasting damage, a firm may have no alternative but to ‘backward integrate’ with its supplier.
Moreover, the effects of the credit crunch and soaring commodities on borrowing for investment may not be so easy to fix as the supply chain financing protagonists would argue.
Downstream firms may find it easier to bring the supplier back in-house rather than offering arm’s-length guarantees. Owning the leading part of the supply chain can increase market capitalisation by over 25%, according to Accenture. This creates a strong incentive to own the upstream assets when commodity inputs are scarce, OxAn concludes.
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