Second-round effects of high energy prices are largest in the food and beverage industry | ING Economics

Second-round effects of high energy prices are largest in the food and beverage industry

Procurement from very energy-intensive sectors (see graph above) as a share of total production, 2018*

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Four different ways in which sectors are impacted by high energy prices

Sectors that use a lot of energy are not by definition hit hard by rising energy prices. The impact depends on their profit margins and the ability to pass on price increases to clients. A previous article by us provides more detail on our methodology.

Sectors vary in the degree to which volatile input prices impact profit margins

Sector development in The Netherlands, 1997-2020*

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Wholesale and healthcare sectors are the least impacted

In the left corner (Quadrant III) we find sectors that aren’t that exposed to procurement price shocks. Consequently, their profit margins are quite stable as they aren’t regularly faced with price increases. In this quadrant, we find the retail, healthcare, wholesale and construction sectors. We have seen that the latter two sectors are vulnerable to second-round effects but historic data reveals the impact is marginal.

The aviation and metals industries are most impacted

In Quadrant I, we find aviation and the basic metals industry. These sectors face high, volatile input prices and profit margins. The extreme energy intensity (see first graph) and the homogeneous product that is delivered in these sectors make it very hard to react to energy price fluctuations.

Profit margins in automotive, the cement industry and travel sector come under pressure due to slow pass-through

High profit margins are a cushion for higher procurement prices. It is often thought that market power gives companies the opportunity to pass through higher input prices. However, this is not generally the case. Often, these firms have already increased their sales prices to an optimum level for themselves that clients are able (or willing) to pay and maximise their margins. As a result, they can’t increase prices further without losing too many sales. Consequently, higher energy prices will harm the high profit margins of these companies with market power.

This is the case for many firms in the sectors in Quadrant II of the graph. For instance, building material companies of concrete, cement and bricks operate in a small local market. This is due to the characteristics of their products and materials. They are large and heavy and therefore difficult and costly to transport. This makes these local markets less competitive. The pass-through of energy price fluctuations is, therefore, slower as these companies already have relatively high output prices. Appreciating energy prices will therefore be mainly absorbed by a drop in their profit margin.

Profit margins in food, shipping, road transport and agriculture are less impacted due to price negotiations

In general, sectors with high competition will have firms with lower profit margins due to price battles in these markets. What will happen in these markets when companies are confronted with higher costs from soaring energy prices?

Due to the low profit margins, firms in these markets aren’t able to swallow the higher procurement prices, otherwise they will be loss-making and in a worst-case scenario could potentially go bankrupt. There will be severe price negotiations, and in some cases suppliers might stop or threaten to stop delivering for a while, but eventually the price will go up. So, these companies don’t have a huge profit cushion but they can and have to pass through higher procurement prices. The market output price will go up because all competitors are facing the same problem. These sectors are found in Quadrant IV, for example the food industry and road transport.

How companies can cope with energy price risks

As profit margins are often thin and many sectors are energy-intensive, firms have to closely follow oil and gas prices. There are several strategies that companies can follow to mitigate price fluctuations. All of them have their pros and cons and most companies make use of a combination of these strategies. Therefore, we should point out that the exposure, risk appetite and market situation for every single company is different:

Minimise energy use: By using energy-efficient production processes, the amount of energy will be diminished and the vulnerability to energy price hikes will diminish. Air carriers can, for instance, invest in more energy-efficient aeroplanes. This strategy however takes time and is less suitable to accommodate the immediate impact of high energy prices.

Use a price escalation clause: This makes it possible for firms to pass on energy price increases to the customer. This is mainly done in B2B markets. Price clauses with private consumers (B2C) are more difficult to achieve and therefore not common.

Directly procure inputs: Firms can directly procure oil, gas or power at the moment a sales deal is closed. This secures the calculated energy price at the moment of closing the deal. They can do this in two ways. First, they can agree on the price with a supplier and ensure delivery of the fuel at the moment needed in the production process. However, it must be said that suppliers are sometimes reluctant to lock in such long-term contracts as the price risk is handed over to them. Second, firms can buy the needed energy directly and have it delivered directly and stored until needed. Yet, this results in (high) storage costs and a decrease in working capital.

Commodity futures: If the above strategies are not possible, a hedge with a commodity future is an option. However, futures are complicated financial products which have to be fully understood and constantly monitored.

Corporate decision-makers face a new normal. Energy prices are likely to stay high for much longer. Both gas and oil markets are extremely tight and future prices indicate no return to the low energy prices of recent years any time soon. Our analysis shows that the impact of high energy prices differs per sector. Irrespective of a company’s sector, corporate decision-makers have some tools at their disposal to mitigate the impact of high energy prices.