Hedging to deal with rising food prices

Posted by Daniel Palmer on 24th June 2008


Hedging has long been a tool used by companies to counter the impact of potential changes in market conditions, but rarely have restaurants engaged in the practice.

With skyrocketing food costs and fears that price hikes may continue it now appears, however, that restaurants and other foodservice organisations are embracing the concept, particularly overseas.

In the past restaurateurs have discounted the thought of hedging due to the complications of the process, a lack of market size and the rationalisation that competitors are facing the same issues so there is nothing one can do about it. With food commodity markets now attracting more buyers, though, the potential for benefit from sound hedging strategies is greater than ever before.

The practice is known as hedging because the sale of a futures contract forms a hedge of protection for the owner of the contracts. Consequently, the profits reaped if prices rise lessen the impact of food price rises on the business and allows a business to lock-in margins for the coming months. Due to the nature of markets, though, it is really only useful for medium or large businesses due to brokerage and tax costs.

Essentially, it is a risk management tool but before considering entering the market with a fat wallet one needs to understand the concept completely.

A futures contract involves a deal between two parties to buy/sell a commodity at a specified price and date. If the price of a contract rises then the owner capitalises and the business recoups some of their losses from increased food costs. If the price falls then the company will, however, lose money, although the pain should be mitigated by the likelihood that their food expenses will have fallen. For example, a pizza restaurant may purchase a milk futures contract to counter the issue of rising cheese prices, as, because milk is used to make cheese, the price of cheese usually fluctuates in-line with the price of milk. If the price of milk goes up over the course of the year then they will profit from their futures contract but face higher business costs – as cheese prices should have increased. Similarly, if milk goes down then their costs should decrease but money will be lost from the sale of the futures contract.

A more conservative approach to hedging is buying call options on futures contracts. That allows the buyer to establish a ceiling price for a particular commodity and is similar to a futures contract. Like a futures contract, a specified date and price is arranged but, unlike the futures contract, the holder has the ‘right’ to sell rather than the obligation. Consequently, the holder of call options makes a profit if the market rises, but loses only the money outlaid to purchase their options if the market falls.

Confused? The complexity of the futures market is daunting and “diving in head first” is not a recommended option for those considering entering the market. If you or your consultant understand how to use the futures market to counter escalating prices, though, it can be rewarding to a foodservice business; but a lack of comprehension will inevitably lead to failure.

Some restaurants, reeling from the effect of the volatile food prices, appear ready to try something new even though they mightn’t fully grasp the concept.

Food manufacturers have cottoned onto the concept with some realising that the bottom line can be substantially improved via smart investing. Nestle, for example, profited last year from forward thinking, posting a 7% sales increase worldwide as opposed to the industry average of 1.8%. They managed to do this by forward-buying raw materials, which helped them negate the rising inflation that hurt many other food companies.

The practice of hedging is likely to become more prevalent in the food industry as commodity markets expand in size. It should, however, be done with caution as it is not a fool-proof solution to escalating food prices but merely one option which can reduce the risk of hikes in costs. Like the process of stockpiling there are inherent risks. For example, if the market crashes those who have recently entered could be in trouble – particularly if they have entered without the adequate knowledge.

Ultimately, it is not about playing the markets for profit but about using the markets to provide protection.