Quantifying Risk. A Look At Commodity Risk and Country Risk Interaction

Quantifying Risk A Look At Commodity Risk and Country Risk Interaction Paul Robinson Senior Economist, IHS Pricing and Purchasing Service 17 April 2013

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Agenda Volatility explained: What is it and why does it matter? Where have we been: A recent history of volatility Building commodity risk ratings: A way to quantify the interaction of country risk and commodity risk Commodity Market Overview Automotive Materials Update 3

Volatility Explained What is it? Variation in price over time How is it measured? Standard deviation CBOE s VIX (equities) Implied volatility in S&P 500 index options risk compensation Why does volatility matter to you? Timing buys Coping with changing inventory values Makes planning more difficult 5

Recent History of Volatility Standard Deviation of MPI (52-Week Moving Average) 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 1998 2000 2002 2004 2006 2008 2010 2012 Chicago Board of Options Exchange VIX Index 80 70 60 50 40 30 20 10 0 1998 2000 2002 2004 2006 2008 2010 2012 7

Volatility Drivers Micro Just in time inventory (JIT) Inventory/Shipments Ratio 1.7 1.6 Lengthening supply chains Example: Japan earthquake 1.5 1.4 1.3 1.2 Supply boom/bust cycles Example: Shipping 1.1 1.0 1992 1995 1998 2001 2004 2007 2010 2013 8

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Volatility Drivers Macro Monetary policy liquidity Exchange rates - dollarization Exchanges (ETFs)/High frequency traders Country risk 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 70 75 80 85 90 95 100 105 110 115 120 MPI (2002 = 1.0) - Left Trade-Weighted Dollar Exchange Rate (1973=100) - Right 9

Premise A key part of the risks associated with buying a given commodity is the risk of the country you are sourcing from Items such as Conflict Minerals have gotten a lot of attention, but the truth is that the operating environment in many countries is subject to high levels of risk We can develop a quantitative method for capturing country risk as a way of better understanding commodity price volatility 11

Selected Commodities Energy Oil Coal Natural Gas Ferrous Metals Iron Ore Non-Ferrous Metals Aluminum Chromium Copper Lead Manganese Molybdenum Nickel Tin Zinc 12

1. Gather the (Production) Data Energy Oil (IEA) Coal (World Coal Association) Natural Gas (IEA) Ferrous Metals Iron Ore (USGS) Non-Ferrous Metals Aluminum (WBMS) Chromium (WBMS) Copper (WBMS) Lead (WBMS) Manganese (WBMS) Molybdenum (WBMS) Nickel (WBMS) Tin (WBMS) Zinc (WBMS) 13

2. Ranking the Largest Producers 14

3. Calculating the Concentration Ratios Highly concentrated production is risky in any country Capture difficult risks like weather (Australian floods) and geography (Straits of Hormuz) Calculate share of top 4 producers Iron Ore Millions of Metric Tonnes China 1300 Australia 525 Brazil 375 India 245 Top 4 Total 2445 Global Production 3000 Top 4 Concentration Ratio 0.82 15

4. Developing Country Risk Scores Calculate scores for additional country specific risks IHS Country Risk services Mining sub-category 16

5. Weight Country Risk Ratings by Production Simple weighted average of the individual country risk ratings to create a commodity risk rating Multiply by the concentration ratio from step 3 to take into account additional risks Commodity Top 4 Producing Countries Production IHS Country Risk Rating Top 4 Weighted Average Risk Rating Iron Ore Total 3000 China 1300 14.35 7.63 Australia 525 3.19 0.68 Brazil 375 6.68 1.02 India 245 6.77 0.68 10.02 17

6. Gather the (Price) Data Energy Oil (IMF) Coal (IMF) Natural Gas (IMF) Ferrous Metals Iron Ore (IMF) Non-Ferrous Metals Aluminum (LME) Chromium (AMM) Copper (LME) Lead (LME) Manganese (AMM) Molybdenum (AMM) Nickel (LME) Tin (LME) Zinc (LME) 18

7. Calculate Standard Deviations...Or just let a computer do it for you 3 Year standard deviation of the monthly percent changes of each variable 19

8. Interpreting the Results 20

Assessing the Outliers Natural Gas Why is natural gas more volatile than its scores show? Seasonality Difficult to store/move Artificially low score (United States) 21

Assessing the Outliers Tin Why is tin less volatile than its scores show? Hedging (LME) Long history operating in elevated risk countries Mines close to ports or even offshore 22

SURPRISE! Oil and Copper Low Risk/Low Volatility? Still volatile, just not as volatile as some Growing production in United States; Growing stability in Chile 23

Conclusion This is just the beginning Improvements: Build commodity risk scores based on exports, not production Group oil producers locked within the Straits of Hormuz with Iran s score Go build commodity risk scores! 24

Crises Averted, Worries Remain Good news: global growth has stabilized. Monetary stimulus and deleveraging are setting the stage for a modest acceleration Bad news: risks abound the never ending Eurozone crisis, the US sequester and frothy Chinese property markets are all headwinds to better growth For Supply Chains: Growth is not fast enough to tighten markets and trigger general price increases But not slow enough that prices slump Commodity prices look to move sideways (like 2012), though with an upward drift as we move into 2014 (unlike last year) 26

Backlogs and Delivery Times Still Show Buyer s at a Slight Advantage 60 Global Purchasing Managers Indexes 40 55 50 45 40 44 48 52 56 Buyers Advantage 35 60 30 2008 2009 2010 2011 2012 2013 Backlogs (LHS) Delivery Times (RHS) 64 Higher delivery time numbers correspond to faster deliveries (scale inverted) Source: Markit 27

Automotive Material Costs Chart (2000 = 1.000) 3.0 A Range-Bound Outlook 2.5 2.0 1.5 1.0 0.5 2000 2002 2004 2006 2008 2010 2012 2014 *Weighted average of key material costs such as steel, plastics, aluminum, rubber, and glass Excludes Fuel, Processing and Transportation costs

Oil Energy Chemicals Steel Nonferrous The buying environment for oil will be more favorable in the near term Sourcing Guidance: Oil prices will fall, beginning in the second quarter of 2013 2013Q2 One Year Ahead (2014Q1) Prices Lower Lower Demand Neutral Stronger Supply Ample Ample Demand - Global oil demand growth will be positive in 2013 but not as strong as 2012 - A second straight year of Eurozone recession will dampen global demand in the near term + The geopolitical risk premium will persist through 2013 Supply - Inventories are building and production expansions will keep the market well supplied in 2013 - Unconventional plays will continue to gain popularity in 2013, increasing global supply - Saudi Arabian interest in shale drilling bodes well for OPEC supply growth Prices Prices remain elevated in the near term but will move lower though 2013 Brent prices should fall below $100/barrel by the second half of the year

Petrochemicals 120 110 100 90 80 70 60 Energy Chemicals Steel Nonferrous The buying environment for petrochemicals remains mixed. Sourcing Guidance: Chemical prices will correctly modestly in the second quarter as oil prices fall 2013Q2 Plastic Resins Price Outlook 2010 2011 2012 2013 One Year Ahead (2014Q1) Ethylene Flat Lower Propylene Lower Lower Polyethylene Flat Lower Polypropylene Lower Lower PVC Higher Higher 1600 1500 1400 1300 1200 1100 HDPE, USA (Cents/Pound; Left Scale) Polypropylene, USA (Cents/Pound; Left Scale) HDPE, EU (Euro/Metric Ton; Right Scale) Polypropylene, EU (Euro/Metric Ton; Right Scale) Demand + Modest improvement in downstream demand and production issues tighten the spot ethylene market. In the US, polyethylene demand is quite strong, especially for exports. - Improvement in ethylene demand has not been fully matched by increased demand for propylene derivatives. Supply + Production issues in the US and flat-to-falling inventories push sellers into a better negotiating position. + In Europe, with relatively stable costs, cracker margins remain at reasonable levels Prices Price gains in the first quarter will not last throughout the year Expect softer prices in the second quarter

Steel sheet Energy Chemicals Steel Nonferrous The buying environment for hot-rolled sheet will be slightly more favorable in the second quarter Sourcing Guidance: Waiting to buy until late spring will yield positive results 2013Q2 Prices Lower Flat Demand Weaker Neutral Supply Neutral Tight One Year Ahead (2014Q1) Demand Improving fundamentals in North America will lift prices in the third quarter Chinese and European demand are looking worse over the immediate near term Supply Iron ore shortages will create a seasonal bump to prices General restocking led prices higher in the first quarter Prices Steel sheet prices should peak sometime near March and decline soon after Delay buying if possible to take advantage of lower prices

Copper Energy Chemicals Steel Nonferrous The buying environment for copper will remain neutral in the second quarter Sourcing Guidance: Prices will be tightly range bound in the near term, before moving lower in 2014 2013Q2 One Year Ahead (2014Q1) Prices Flat Flat Demand Neutral Weaker Supply Ample Ample Demand The new copper ETFs being introduced by JP Morgan and Blackrock Investment Management will be non-factors in the market Supply Large exchange stock increases and weak prices over the past month have reaffirmed our view that copper is transitioning to a surplus market condition A large deposit in the LME Singapore warehouse creates anxiety about the strength of East Asian demand and about the size of "hidden" inventories in China Prices The bottom line for copper is that a surplus market condition undercuts support for prices at current levels Prices are headed lower with a correction on the order of $1,500/metric ton a real possibility over the next six quarters

Aluminum Energy Chemicals Steel Nonferrous The buying environment for aluminum will be less favorable during the second quarter of 2013 Sourcing Guidance: It is hard to be anything but pessimistic about aluminum over the near term 2013Q2 One Year Ahead (2014Q1) Prices Slightly Higher Slightly Higher Demand Slightly Stronger Weaker Supply Ample Neutral Demand Consumption appears to be slowing A contango in the forward curve makes financing deals less attractive Supply Production cuts are beginning to move the market back toward balance The decision by China's State Reserves Bureau to purchase 300,000 metric tons of metal is symptomatic of aluminum's chronic oversupply condition Prices Prices have dropped under $1,950 per metric ton on the London Metal Exchange (LME), well into the cost curve, limiting the downside But the upside is equally limited by projected surpluses in both 2013 and 2014 and the huge existing inventory overhang

The bottom line A flare of up political risks have undermined momentum in markets European and North American concerns have moved back to the forefront of pricing The prospect of a lengthy sequester has downgraded US GDP Growth rates are now forecast at 1.8% for 2013 Commodity markets will be only tangentially affected European markets have again been besieged by political risks A slew of elections in the Eurozone will challenge the resolve of current policy makers Problems in Cyrpus underscore the risk that still remain Long term debt problems and chronic unemployment threaten the medium term recovery Chinese indicators will be very important in coming months The growth profile of China will be the driver of myriad commodity prices Overall, we assume a modest acceleration in growth with top-line GDP advancing 8.2% this year Energy prices are diverging Oil prices are going to fall based on fundamental supply expansion, but the political risk premium persists Conversely, natural gas prices will move higher throughout most of 2013

Thank you for your time Questions? Paul Robinson Senior Economist IHS Pricing and Purchasing Service paul.robinson@ihs.com 36