Rollercoaster ride

What a difference a year makes. The baking industry was almost pushed to breaking-point in 2008 due to record ingredient costs. The American Bakers Association descended on Washington in protest at critically low wheat reserves, food inflation in China leapt up 18%, deadly food riots broke out in the Caribbean and the UK saw the price of the humble loaf edge over the £1 mark. But since the hair-tearing peaks of 2008, input prices have started to settle back down. Bread making wheat, for example, is now around £150-£160/t down from last year's peak of over £200/t.

So having fought tooth and nail to pass on some of the record commodity costs and implement price increases, many manufacturers and bakers are now seeing their retail customers ask for reductions, according to Lawrence Hutter, global head of food and beverage at consultancy firm Deloitte. "Intense competition between UK grocers will ensure that commodity price falls are passed through to consumers," he says.

But despite the recent drops, bread-making wheat, for example, is still historically expensive, says Alex Waugh, director general at the National Association of British and Irish Millers. Two years ago bread making wheat was £110-120/t, which seems like a bargain by today's standards, says Waugh. "One reason why prices have gone down more recently is because the UK's 2008 harvest produced a good yield. But the quality, due to prolonged rain during the harvest season, affected the protein levels in the wheat reducing the quality of bread-making flour."

To counter this, millers have needed to import extra quantities of wheat to blend with UK varieties, adding extra costs to a bag of flour. Millers have also added extra gluten to bump up the quality of bread-making flour, and this costs around £12,000/t. "So while the cost of bread making wheat has gone down, flour is still relatively expensive," Waugh says.

On the horizon, another factor which will have an impact on the price of UK wheat is the opening of biofuel plants. One biofuel plant is due to open in Humberside in September 2009 and will use around 1Mt of wheat a year. A second will open in the North East in 2010.

"But it is become very hard to predict the future cost of wheat," Waugh continues. "The futures market for wheat, looking at October and November, suggests that prices are going up rather than down."

And it's not just the volatility of the wheat market that bakers have had to contend with, it's also milk powder and butter, as well as oil and fat prices - including palm, soyabean, sunflower and rapeseed. The prices of these commodities also reached record levels in 2008. AAK, which supplies palm oil to the UK bakery market, says that the prices of oils and fats are directly linked to crude oil prices.

Palm oil, for example, cost between £200/t and 300/t between 2005 and 2007. It peaked at around £700/t in the first quarter of 2008. Prices are now around £470/t.

So in 2008 manufacturers were not only dealing with high energy and distribution costs, but also high fat and oil costs, says Judith Murdoch, marketing controller at AAK. "In most cases bakers and manufacturers pushed hard to get price increases. Now it's not as easy as saying commodity costs have come down, therefore, manufacturers should reduce prices, as everyone is having to contend with unfavourable exchange rates, as palm oil and other fats are bought in dollars."

Nick Peksa, business development manager, at commodities data provider Mintec, adds: "I don't think that the price of foods will start to come down just because commodity and energy costs have come down. I think that it is more the case that food inflation will start to stabilise. Most bakers and manufacturers need to make up their margins which were eroded when commodity prices spiked in 2008."

Peksa continues: "I'm sure that there will be an element of pressure on bakers to reduce their prices. For this reason I recommend strongly that they understand exactly how much they pay for commodities, how much they have paid and how much they expect to pay. If they do, then bakers are much more likely to have successful arguments to put across to retailers and supermarkets when asked to bring down prices."

One commodity price that is causing great concern is cocoa. Cocoa bean prices were between £800/t and £1,000/t throughout 2005 to 2007, according to data provided by Mintec. In 2008 prices shot up to just under £1,700/t and soared to a record £2,000/t at the beginning of 2009. Since then cocoa bean prices price have come down slightly to around £1,800/t. "So as you can see, although they have come down slightly, cocoa bean prices are still almost double what they were two years ago," says Peksa. "Supply just cannot keep up with demand. Unlike wheat, which is planted each year, it takes years for cocoa trees to mature so it's not a simple case of growers reacting to demand."

To cope with escalating cocoa prices US chocolate manufacturer Hershey launched a $10-12M commodity hedging strategy to firm up its costs throughout 2009. It estimated that it took a $100M raw material hit in 2008 as cocoa, corn sweeteners, sugar and peanuts were up between 20-45%.

But buying forward, or hedging, can be a risky business, warns Alex Hindson, head of global enterprise management at Aon. Last year, for example, Robert Wiseman Dairies bought 60% of its diesel in advance. So when prices dropped the company was locked into paying the higher prices over a six-month period. Firms also have a tendency to hedge against one risk and not another, so they might hedge against a certain commodity and not against currency rates, for example, adds Hindson. He says that manufacturers can also mitigate commodity price increases by entering contracts with suppliers.

Hutter says that businesses should give careful thought to their sourcing strategies and relationships with key suppliers because in the future raw material availability will become tighter, as the world population grows.

"The price spike of 2008 is widely seen as a taste of what's to come," Hutter adds. "Businesses must prepare themselves for ongoing volatility in the markets. Food and oil prices will almost certainly rise as the global economy recovers and the population continues to grow."