Demand in the great modern consumer economy still exists, believe it or not, despite the impression left by the never-ceasing deluge of bad news. But how businesses manage in this new economic order – one that could last for as long as six years – requires very different approaches from those that served companies so well during the economic mega-boom of 2002-07.

Who would want to be a financial controller working for a big company or the jack-of-all-trades managing director of a small or medium-sized enterprise? Every purchase order and every invoice, literally every single transaction, needs to be reviewed by whoever understands overall credit availability. One small step out of line, one tiny error by an over-enthusiastic purchasing manager or sales executive and bang, you’ve exceeded your credit limit. Even if you have a sound business model, your bank might have no option but to say “sorry, but that’s it - we are withdrawing all your credit”.

However, companies, like those in manufacturing, can explore other financing options other than those offered by banks. “The immediate source of capital would be the upstream (suppliers), and downstream (retailers, wholesalers) parties in the supply chain,” said SMU operations management professor Onur Boyabatli. “These parties are the ones that would be immediately affected by the financial difficulty of the manufacturing firms. Hence, they would be more than eager to share some of the underlying credit risk.” This can be in the form of trade-credit or vendor financing, which is already common in major industry groups like automotive, semiconductors, and retail.

Also, despite the general reluctance of banks to lend, all is not lost, for they can still try to raise capital from financial institutions, but in a more effective way. For instance, with lots of assets sitting on their balance sheets, companies can use tangible assets such as inventory, manufacturing capacity, or even technology as collaterals for so-called asset-based financing, noted Boyabatli.

Tighter credit sometimes begins from within. For example, purchase orders require a higher level of approving authority. Furthermore, companies need to very carefully monitor the credit situation of both their suppliers and their customers. Companies should also try to win over enough customers and sign up enough suppliers from each major market, in case any of them go under.

Raw deal, raw materials

This new economic order could have major implications on how the pricing of raw materials behave. Old understandings on how to read the direction of markets might need to be revised, according to participants of a recent ICIS World Polymers conference.

Let’s use the confectionary industry as an example: all along, there are two main kinds of demand in this industry – long term and short term, both dealing with very different dynamics. For example, nothing has changed when it comes to those big one pound-bar of chocolates. A plastics wrapping supplier, in this instance, can still ship large volumes of the packaging material from say, China, to America, as slow-moving items like such one-pound chocolate bars will sit on the shelf for months. But for the so-called “fast-moving” confectionery, for example, discounted bags of miniature chocolate bars placed on toddler-reach shelves near supermarket checkouts, shipping wrapping material from China no longer makes sense.

“A big percentage of a confectionery manufacturers’ revenue comes from fast-moving and short-term promotional offers. The trouble is that these promotional offers are no longer as fast-moving because consumers are cutting back on spending,” pointed out a plastic wrapping manufacturer at the conference. Much smaller quantities of wrapping material are needed and so for logistic-cost savings reasons, buying locally adds up.

If you make chocolate in a developed market, buying from local manufacturers might have previously been ruled out because of their high labour costs and weaker economics of scale, compared to China and other emerging-market giants. These giants were created in order to tap into booming global growth which justified big-volume long-distance shipments of everything from plastic-wrapping material to shoes, children’s toys and increasingly higher value-added machinery and electronics.

Supply chains have become increasingly complex, yet, markets, even if they are across the world, are increasingly inter-linked. For a supplier who wants a piece of the “fast-moving” market, it is no longer economical to half-fill a container and ship it all the way from China. In cases like these, proximity holds the upper hand as local suppliers can much more quickly respond to small day-by-day changes in demand.

Volatility, uncertainty

There are other reasons to buy in small quantities, and therefore locally. Oil prices move in an almost perfect relationship with equity markets these days. Stock markets rebound as investors clutch on to some fleeting good news and crude rallies by a few dollars a barrel, only for the reverse to occur the following day. So nobody, at any point, in any product chain, wants to sell or buy big, in case they end up on the wrong side of a shift in highly erratic energy prices. For example, why buy a big quantity of polypropylene (one of the plastics or polymers used to make wrapping material for confectionary) today only to see the oil price fall the next?

Oil is the basic raw material for polymers and therefore polymer pricing responds very quickly to changes in the cost of crude. Wrapping material made from polypropylene will also change in price very quickly in response to shifts in crude. Your equally hard-pressed customers, even the ones you have worked with for years, will not be able to do you any favours if you plead that you made a mistake on the direction of oil prices or overstocked your inventory.

So what can companies do to manage the volatility in raw material prices? In this climate, this is a question that surely interests more than just plastic-wrapping material buyers and sellers.

Companies should draw up better-designed procurement contracts, for instance, physical options contracts. “Rather than directly buying the raw material, companies can actually buy an option on the delivery of the physical input, and later, after they have a better understanding on their actual needs, they can decide whether or not to exercise these options,” said Boyabatli.

Another option is for companies to use financial instruments to hedge the commodity prices, like trading commodity futures on the markets to lock-in prices of the inputs. However, in doing so, companies should manage these financial instruments “holistically with the physical procurement, as the positions taken in financial and physical contracts are intertwined,” he added.

Pool the risks

A further reason to keep inventories low is the huge economic uncertainty out there. Nobody knows how deep this recession will be and how long-lasting. “We keep looking further and further back into history for parallels,” said Matthew Sullivan, director of energy structuring and origination for Standard Chartered Bank, in a speech at the same ICIS conference.

First the comparison was with the dotcom bubble crash of 2001, then the Asian financial crisis and next, the global economic downturn of 1980-82. Now all the talk is of the Great Depression. “Vehicle sales in the US, on a population-adjusted basis, have fallen to their lowest level since World War II,” added Sullivan. “I hate to give you the bad news, but I think it could take five-to-six years to get through this. Most of the iceberg is still beneath the water.”

In the midst of economic calamity and the resulting shift in buying patterns, how might raw material prices behave? Chinese buyers used to periodically withdraw from raw-material markets en masse. This would lead to major price declines due to the large volume of lost trade. The guessing game would then begin over inventory levels and demand – meaning, when they would need to re-stock imports of the raw materials needed to manufacture finished goods for re-export. When they did return, of course, volumes on the positive side were equally big, resulting in big price rallies.

However, increments are, these days, as low as US$20-30/tonne a time. To again use the plastic polypropylene as an example, because of small-volume sales, prices quickly retreat again. Just a few months ago, polypropylene prices would surge by several hundred dollars a tonne at a time, resulting in big gains for those who read the market the right way. The problem is that when prices retreat, even more ground can be lost than had been gained, due to a general air of pessimism towards the economy.

In the meantime, there are some strategies, involving operations, as well as hedging, credit management, which companies can adopt, in cohesion, to ensure that they stay viable. Everyone in the supply chain is in this together, and they should also share the risk, recommended Boyabatli. Companies that are more financially stable should help to raise cheaper capital. For those down the line, in closer contact with the end consumers, they should help to provide accurate forecasts of demand. “Allocating risks to the right party, in a right manner, is essential for profitability, or even the survival of the supply chain,” he said.

In the end, despite the prevailing gloom, chins should be held high, for nobody is in this alone. “This economic downturn is the perfect timing for manufacturing firms to apply these strategies, as there is a mutual understanding of the financial crisis by supply chain partners as well as the financial institutions.