Complexity intensifies in ingredient purchasing

by Morton Sosland
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If most people engaged in food manufacturing were asked whether the process by which ingredients are purchased is more or less important than the price at which the transaction is made, agreement probably would be widespread that the price is what counts, not the process. After all, it was the skyrocketing of ingredient prices in 2008 that impacted the earnings of most food manufacturers, prompted worrisome uprisings in a few nations around the world, and captured the attention of political leaders. A close watch on what was written about this period of soaring food prices saw little attention being given to methods or processes involved in purchasing food ingredients. No one questioned whether the timing, the length of contracts, contents or terms had anything to do with the concerns ruling a few years ago.

Thus, it was with those attitudes in mind that a recent brouhaha about iron ore pricing — a commodity whose basic role in producing steel is similar to the significance of wheat, corn and soybeans to food — drew more than casual interest. What is unusual is that the change in iron ore seems such a simple modification. Instead of ore quotations applying to a full year’s supply, they now stand for only a quarter at a time. Much of the upset about this change stemmed from modifying a pricing system that had been in place on a formal basis for 40 years and which some say actually had lasted for nearly a century. The clamor over the change, which was initiated by the three leading iron ore mining companies in response to a bullish environment for spot supplies, was exacerbated by sharp market advances as three-month pricing went into effect. Spot iron ore soared to 18-month peaks, and prices generally were at least double the levels ruling during 2009.

Iron ore contracts between mining companies and steel mills are more involved than such a change in method indicates. Like what food manufacturers face in purchasing an array of ingredients as well as in buying a few major ingredients using increasingly complex methods, metals producers consider quality variations in iron ore that mainly reflect their actual ore content. China says it is unwilling to buy ore with less than 60% iron content, causing further upset for a market dealing with exceptional turbulence.

Considering how long iron ore has traded on annual fixed-price contracts, the situation in food ingredients seems almost bizarre. One major food ingredient, high-fructose corn syrup, is also sold by annual contracts not unlike those formerly used in iron ore. At the other extreme is wheat flour where complexity has been built on top of complexity as wholesale bakeries have broken down flour into components like wheat futures, cash wheat premiums and millfeed. Many bakers, in an effort to apply their own knowledge to these fast-moving, volatile markets, take positions in these

components rather than by outright purchases for a given contract period. This same method of purchasing also rules generally in soybean oil. At the other extreme is refined sugar, where forward purchasing has resulted in coverage of as much as two years ahead.

Whether it is food ingredients or iron ore, these new methods, as well as the possibilities of sudden shifts from one system to another are often driven by fluctuations in futures contracts as well as in options on contracts. Beyond these markets are derivatives created to represent new methods of capturing an advantage in booking ingredients. It is apparent that as markets have swung in recent years efforts to respond by new trading methods have come front and center. It may be premature to declare one method as having been proved superior. Yet, food manufacturing obviously is well ahead of many other industries, including steel-making, in how it has chosen to cope with a global marketplace fraught with so many dangers, including many that are new.

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