How low can prices go? It's the question that has fuelled the latest stand-off between Tesco and its suppliers.
Tesco's demands for discounts and changes in payment terms have left suppliers aggrieved and fearing for their livelihoods. But as ever, the story has two sides.
Tesco claims its revised terms are merely a reflection of falling world commodity prices. It argues that as it helped absorb suppliers' cost increases when commodity prices rose, it's only fair they repay the favour now the trend is reversed.
Suppliers protest that lower input costs have yet to filter through and Tesco is asking too much, too soon. So where does the truth lie?
There's certainly evidence of a sharp drop in some commodity prices in the past month. The biggest relief for many in the industry comes in the shape of falling oil prices, which are now down more than 25% year-on-year. Oil peaked at about $120 a barrel in July, but in recent weeks prices have almost halved. As this filters through to petrol, energy and packaging costs, the downward effect on prices should be significant.
Other food commodities have also fallen sharply. Mintec reports wheat prices down almost a third year-on-year. Milk powder has fallen over 40% and other soft commodities have fallen a long way from their peak, even if they remain pricier year on year (see table, p21).
This does not, however, mean the costs paid by suppliers have fallen, Mintec warns. "The time it takes for falling commodity prices to affect suppliers varies a lot," says commodity analyst James Hutchings. " The variance depends on the amount of processing involved, the supply chain and the lengths of contracts. Of course, if animal feeds and grains fall, the price of meat should eventually come down, but it will take a while. How long is anyone's guess."
"It's our job as retailers to make sure no-one in the system is introducing extra costs," says Tesco corporate affairs manager Katherine Edwards. "It's not about Tesco losing out on money, it's about our customers losing out. We understand it's a tough time for suppliers. It's a tough time for everyone."
Suppliers remain unconvinced by Tesco's defence of its tactics. "Prices may have fallen, but they're still much higher than two years ago," says one supplier. "And Tesco didn't go anywhere near matching the price increases in the first place. It beggars belief that it's trying to do this so quickly. It isn't just asking for lower prices, but new trading terms and one-off charges as well. It's a recipe for more and more companies to go out of business."
Retail pricing cuts in the current climate could drive some manufacturers to the brink, a stock analyst warns. "Suppliers aren't seeing costs fall as yet," says Martin Deboo of Investec. "There's no question commodity prices are falling sharply, but suppliers' Q3 results show they haven't benefited. We don't expect them to start seeing the results of lower commodity prices until the middle of 2009.
"There's a delicate picture emerging and whether suppliers will cope is the $64,000 question. It's clearly going to be a difficult period."
Who is in the best position?
One reason suppliers have yet to feel the benefits of lower commodity prices is because they hedged against expected high prices by using financial derivatives - the financial instruments blamed for causing the credit crunch - to insure against future price rises in their input costs. This, says Deboo, was a sensible precaution given the uncertainty of commodities markets, but had the downside of locking suppliers into high price levels for several months to come.
Other suppliers managed their risk by building up stock. "Not long ago people were talking about $200 a barrel of oil and there was no wheat to be had," says Alastair Dickie, director of crop marketing for the Home Grown Cereals Authority. "Now some people are saying oil could fall as low as $40 a barrel. It's been a rollercoaster and no-one knows where prices are going to go next.
"Companies that made efforts to be responsible by bringing forward supplies of raw materials to make sure they had stock have ended up paying high prices, and it's now bought and paid for. "
Dickie says almost all companies would have either built up stockpiles of inputs or taken out hedging contracts, meaning very few would be in a position to absorb price cuts in the short term. He questions the tactics that Tesco has adopted with its stringent new terms.
"It's unreasonable to backtrade," he says. "It's not unreasonable to expect some pressure as prices begin to fall, but people made efforts in a tough environment to secure supply and now they're being punished for that. The falling commodity prices will eventually feed through, but not straight away, no matter who's asking."
Retailers should also be aware that not all commodities are falling in price, Dickie adds. Though wheat prices have dropped significantly, the price of high-quality wheat for breadmaking remains high and has decreased only slightly year-on-year. Other grain crops had similar problems with quality, meaning that the spot market prices were often a misleading guide to real costs.
The pound flounders
Currency is an even bigger issue for suppliers dealing with commodity prices on the world markets. As commodities are often priced in dollars, currency fluctuations affect the UK price. The pound has fallen almost 25% against the dollar in recent months, to offset many falling prices.
"The pound's weakness against the dollar means many dollar commodities are pricier," says Dickie. "Protein for animal feeds, for example, is falling in dollar terms but rising in pounds. This is definitely working against falling commodity prices on the world markets."
Dickie concludes that although Tesco is justified in trying to reduce prices for customers, it should be wary of putting excessive pressure on suppliers. "There's real commercial tension," he says. "Supermarkets feel responsibility to keep prices low for consumers, so are almost obliged to put pressure on prices. But they are assuming commodity prices stay down. There are no guarantees of this. Volatility is here to stay and we need to adapt. The commercial sector as it stands can't cope with it."
Commodity prices are also predicted to be volatile for the next decade due to a huge growth in food demand from developing economies such as India and China. This means adverse weather and other shocks to the system will have a greater effect than in previous years, as demonstrated this week when the price of oil and other commodities rose sharply due to the weakening dollar and fears of an OPEC production cut.
Analysts generally conclude that Tesco is right to ask for discounts as commodity prices fall, but is expecting them too soon.
Suppliers, meanwhile, are anxious for some respite after a difficult two years.
"A lot of companies in this industry were in a poor position two years ago, and then we've taken a battering over costs for two years," says one. "Now we're facing a recession and already getting asked for cuts. It'd be nice, just for once, to have a bit of a break."
Tesco's demands for discounts and changes in payment terms have left suppliers aggrieved and fearing for their livelihoods. But as ever, the story has two sides.
Tesco claims its revised terms are merely a reflection of falling world commodity prices. It argues that as it helped absorb suppliers' cost increases when commodity prices rose, it's only fair they repay the favour now the trend is reversed.
Suppliers protest that lower input costs have yet to filter through and Tesco is asking too much, too soon. So where does the truth lie?
There's certainly evidence of a sharp drop in some commodity prices in the past month. The biggest relief for many in the industry comes in the shape of falling oil prices, which are now down more than 25% year-on-year. Oil peaked at about $120 a barrel in July, but in recent weeks prices have almost halved. As this filters through to petrol, energy and packaging costs, the downward effect on prices should be significant.
Other food commodities have also fallen sharply. Mintec reports wheat prices down almost a third year-on-year. Milk powder has fallen over 40% and other soft commodities have fallen a long way from their peak, even if they remain pricier year on year (see table, p21).
This does not, however, mean the costs paid by suppliers have fallen, Mintec warns. "The time it takes for falling commodity prices to affect suppliers varies a lot," says commodity analyst James Hutchings. " The variance depends on the amount of processing involved, the supply chain and the lengths of contracts. Of course, if animal feeds and grains fall, the price of meat should eventually come down, but it will take a while. How long is anyone's guess."
"It's our job as retailers to make sure no-one in the system is introducing extra costs," says Tesco corporate affairs manager Katherine Edwards. "It's not about Tesco losing out on money, it's about our customers losing out. We understand it's a tough time for suppliers. It's a tough time for everyone."
Suppliers remain unconvinced by Tesco's defence of its tactics. "Prices may have fallen, but they're still much higher than two years ago," says one supplier. "And Tesco didn't go anywhere near matching the price increases in the first place. It beggars belief that it's trying to do this so quickly. It isn't just asking for lower prices, but new trading terms and one-off charges as well. It's a recipe for more and more companies to go out of business."
Retail pricing cuts in the current climate could drive some manufacturers to the brink, a stock analyst warns. "Suppliers aren't seeing costs fall as yet," says Martin Deboo of Investec. "There's no question commodity prices are falling sharply, but suppliers' Q3 results show they haven't benefited. We don't expect them to start seeing the results of lower commodity prices until the middle of 2009.
"There's a delicate picture emerging and whether suppliers will cope is the $64,000 question. It's clearly going to be a difficult period."
Who is in the best position?
One reason suppliers have yet to feel the benefits of lower commodity prices is because they hedged against expected high prices by using financial derivatives - the financial instruments blamed for causing the credit crunch - to insure against future price rises in their input costs. This, says Deboo, was a sensible precaution given the uncertainty of commodities markets, but had the downside of locking suppliers into high price levels for several months to come.
Other suppliers managed their risk by building up stock. "Not long ago people were talking about $200 a barrel of oil and there was no wheat to be had," says Alastair Dickie, director of crop marketing for the Home Grown Cereals Authority. "Now some people are saying oil could fall as low as $40 a barrel. It's been a rollercoaster and no-one knows where prices are going to go next.
"Companies that made efforts to be responsible by bringing forward supplies of raw materials to make sure they had stock have ended up paying high prices, and it's now bought and paid for. "
Dickie says almost all companies would have either built up stockpiles of inputs or taken out hedging contracts, meaning very few would be in a position to absorb price cuts in the short term. He questions the tactics that Tesco has adopted with its stringent new terms.
"It's unreasonable to backtrade," he says. "It's not unreasonable to expect some pressure as prices begin to fall, but people made efforts in a tough environment to secure supply and now they're being punished for that. The falling commodity prices will eventually feed through, but not straight away, no matter who's asking."
Retailers should also be aware that not all commodities are falling in price, Dickie adds. Though wheat prices have dropped significantly, the price of high-quality wheat for breadmaking remains high and has decreased only slightly year-on-year. Other grain crops had similar problems with quality, meaning that the spot market prices were often a misleading guide to real costs.
The pound flounders
Currency is an even bigger issue for suppliers dealing with commodity prices on the world markets. As commodities are often priced in dollars, currency fluctuations affect the UK price. The pound has fallen almost 25% against the dollar in recent months, to offset many falling prices.
"The pound's weakness against the dollar means many dollar commodities are pricier," says Dickie. "Protein for animal feeds, for example, is falling in dollar terms but rising in pounds. This is definitely working against falling commodity prices on the world markets."
Dickie concludes that although Tesco is justified in trying to reduce prices for customers, it should be wary of putting excessive pressure on suppliers. "There's real commercial tension," he says. "Supermarkets feel responsibility to keep prices low for consumers, so are almost obliged to put pressure on prices. But they are assuming commodity prices stay down. There are no guarantees of this. Volatility is here to stay and we need to adapt. The commercial sector as it stands can't cope with it."
Commodity prices are also predicted to be volatile for the next decade due to a huge growth in food demand from developing economies such as India and China. This means adverse weather and other shocks to the system will have a greater effect than in previous years, as demonstrated this week when the price of oil and other commodities rose sharply due to the weakening dollar and fears of an OPEC production cut.
Analysts generally conclude that Tesco is right to ask for discounts as commodity prices fall, but is expecting them too soon.
Suppliers, meanwhile, are anxious for some respite after a difficult two years.
"A lot of companies in this industry were in a poor position two years ago, and then we've taken a battering over costs for two years," says one. "Now we're facing a recession and already getting asked for cuts. It'd be nice, just for once, to have a bit of a break."
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