As noted in the BCG Perspectives article, "The Art of Embracing Commoditisation", there are several ways to survive liquidity and commoditisation.
Examples include gaining a cost-based advantage and re-differentiating product offerings by modifying their characteristics and value proposition (see figure below). These are perfectly acceptable approaches, but they come with challenges. For instance, the potential for cost-based advantage is limited if the process for making the product is itself commoditising. And product re-differentiation can be tricky to execute.
A third way
A third way to survive increased liquidity and commoditisation is to exploit market imperfections and price volatility. These conditions make it hard for companies to understand where demand will meet supply and, therefore, to predict prices. Players that know how to detect and respond to market imperfections can seize advantage of arbitrage, or trading, opportunities. In doing so, they can reap windfall profits that offset the impacts of turmoil in other parts of their business, such as production losses or eroded margins. Result: Much-needed operating stabilisation in the face of volatility.
Only a few mining companies are doing this today. Most have shied away from it. Some are nervous about the effort involved in making this approach work, which entails rethinking their strategy, repositioning themselves in their industry's value chain, and overhauling their operating model. Others view trading as an unnecessary source of risk and volatility—akin to gambling.
These concerns are understandable. But trading, when handled deftly, provides precisely the diversification and stability miners need. That's because its returns aren't linked to returns in a company's operations. And they aren't directly affected by price levels or direction. Instead, trading returns are correlated with market imperfections and price volatility. In fact, BCG analysis suggests that trading could help companies improve their EBITDA margins by as much as 5%, with minimum capital investment and limited risk.
Take oil, a commodity that has been liquid since the mid-seventies. Forward-thinking industry players have successfully exploited market imperfections by adapting an asset-backed trading approach. Returns they've gleaned from trading have helped them survive downturns in oil prices by contributing billions to their P&Ls just when they needed it the most. Miners could do the same.
How to make trading work
Exploiting market imperfections through trading requires operating models, organisational cultures, and skill sets that many mining companies will find foreign. Indeed, the toughest part about adopting this approach is the major change required. The following guidelines can help miners take the first steps.
Understand types of arbitrage opportunities
The arbitrage opportunities that market imperfections create can fall into several categories. Miners that understand these categories can further sharpen their trading strategies:
• Timing. Situations where prices for future delivery are higher than those for immediate delivery offer lucrative trading opportunities for companies that have significant marginal storage capacity.
• Location: Price differentials between locations can create opportunities for companies that have ready access to relevant logistics and can therefore easily reroute products physically.
• Quality: When supply-and-demand balances for different levels of product quality (such as coal calorific values) change import and export flows, prices start differing across the grades. This, in turn, influences producers' netback margins. Companies that adapt their product supplies in response to price optimisation opportunities can achieve superior returns.
Adapt your business model
To successfully exploit market imperfections through trading, miners must augment their traditional producer model (which extracts so-called intrinsic value from the difference between the market price of their products and their cost of production) with the arbitrageur model (which extracts so-called extrinsic value from price signal discrepancies in the market). The arbitrageur model has several important defining characteristics:
• Agility in exploiting short-lived market imperfections
• Freedom for commercial operators to make arbitrage decisions without approval from upper management
• Tight control over commercial operations and strong risk management capabilities to ensure that decision makers don't misuse their freedom, and that they stay within assigned parameters
• A superior understanding of the market, including the ability to detect genuine market imperfections and anticipate how they might evolve
• A large, diverse market footprint comprising mining assets but also third-party contractual commitments that allow easy access to the commodity beyond the company's asset footprint
How might miners blend their producer model with the arbitrageur model? We recommend a handful of best practices. Start by physically separating the entities responsible for production and for arbitrage trading. They'll each have different cultures and need different incentive systems to excel in their respective areas. But, be sure to establish a clear interface between the two entities, to foster responsiveness to market opportunities while also clarifying who has the lead when different types of arbitrage opportunities arise.
In addition, put responsibility for steering production firmly in the hands of your commercial function. That way, your company can easily manage its assets optimally against a volatile market. In addition, foster value-creation transparency along your value chain. To exploit market imperfections, decision makers along the chain must be able to quickly evaluate trade-offs between performance criteria like production efficiency versus profit margin. To weigh the trade-offs and make decisions, everyone must understand how performance at different ‘links' in the value chain (such as commercial and production) is being evaluated.
Finally, measure the performance of teams and individuals against real-time market potential. The types and levels of value that can be extracted from your company's assets and its market positions will likely vary considerably, depending on how the market changes. Sometimes, it'll be easy to meet budget targets; at other times, it won't.
No company wants to see its industry commoditised. But progressive mining companies can extract valuable benefits from the situation, if they think more broadly about the survival mechanisms they're willing to try. Exploiting market imperfections through arbitrage is worth consideration. Yes, adopting this approach requires significant change.
But miners that embrace the effort will stand the best chance of achieving stability in the face of volatility, building important new capabilities, and safeguarding their bottom line.
*Eric Boudier (E: boudier.eric@bcg.com) is a senior partner and managing director in the Oslo office of The Boston Consulting Group, the leader of the firm's commodity trading and risk management sector, and a BCG fellow. Dr Sönke Lorenz (E: Lorenz.soenke@bcg.com) is a principal from the firm's Berlin office working exclusively on commodity trading and risk management topics - covering key commodities such as power, gas, oil, oil products, coal, metals and agricultural commodities. He has worked in all key geographies.
