Plastics futures; the long term solution to price volatility and effective cash flow management

It has been a challenging and a reflective time for the plastics industry since this time last year. Polypropylene and polyethylene prices have shown high levels of volatility. Just shy of $2000/mt in July 2008, the LME price for PP North America fell 70% to $610/mt in December, rising to $1050/mt more recently.

What does this mean for the polymer industry? How can market participants forecast costs, revenues etc? We have all seen the impact on major producer financial statements since Q4 of last year. Demand destruction has meant that crackers, plants have been shut down for extended maintenance periods and less cost-effective capacity has been permanently removed from the market.

An ExxonMobil executive was quoted earlier this year (“ExxonMobil waiting out global recession, preparing for recovery”, Plastics News,Aug. 13, 2009) “…high prices aren’t the problem. All the materials that polymers compete with are up even more. What hurts is volatility. How do you plan? You can’t lock in to six-month contracts because polymer prices and crude [oil] prices aren’t good to the end of the year.”

Yes you can. Volatility in polymer prices is leading to a re-think of current business models and strategies. For the London Metal Exchange (LME; London) this has meant increased interest in hedging using its Polypropylene (PP) and Polyethylene (LLDPE) futures contracts. Volumes have been steady and there is open interest (an indication of forward business) well into Q2 2010.

Frustration with existing price indices tied to price reporting services is also driving interest, according to LME member firms and LME executives.

LME PRICES MORE ACCURATE THAN INDUSTRY SURVEYS
An exchange-derived price is transaction-based - one of the most effective price discovery mechanisms available. It increases transparency and does not rely on phone rounds of industry participants. According to Sunoco Chemical; a North American polypropylene producer, quoted in Chemical Week, the “LME cash settlement prices are more accurate than industry surveys as an indicator of polypropylene pricing.” (Chemical Week August 3/10, 2009, page 27).

This is significant because LME prices should be referenced in sales and purchase agreements when using the futures market for hedging and they must therefore be reflective of the actual price of polymer.

Over-the-counter (OTC) business (derivative transactions that are neither standardised nor transacted on an exchange) is often a precursor to on-exchange trading. This now represents more than five times the on-exchange business and will move on exchange in due course.

These financial tools enable volatility to be managed or ‘hedged’. An equal and opposite cash flow to the normal sale or purchase is created which offsets any movement in the price of the underlying product. This provides the ‘hedger’ with a known cost in a similar way to a fixed rate loan from a bank helps when budgeting monthly expenditure.

The LME has persevered with highlighting the importance of its services and is seeing real progress. Introducing pilot hedging programmes into organisational strategy is the way forward. One step at a time has been the mantra, and steadily organisations, where resource can be allocated, are seeing the benefits. Some North American
organisations have reported taking market share from competitors during the downturn.

SUCCESS AT NPE 2009
North American industry continues to be the most responsive. This was reflected in the workshop the LME held at NPE in Chicago at the end of June. The majority of attendees were converters and large end consumers from the USA and Canada.

The interest is clearly there. The team-based workshop was run by practitioners from LME member firms; MF Global, RBS Sempra, Société Generale and Macquarie Bank. Due to the workshop’s interactive nature numbers had to be restricted to 60 places. Over-subscribed by 50%, most of those not participating were happy to watch proceedings from the remaining seats in the auditorium.

There is still conservatism towards futures contracts and many myths still abound. Some producers suggest that a futures market will commoditise their business, but how many produce commodity grades and how many had their financial statements impacted by the collapse in the price of polymer last year? In fact many producers are starting to offer LME based prices to their clients.

The prospect of allocating resource to a new product or formulation can be perceived as risky. It is true, this is not an undertaking to be entered into lightly. A pilot scheme; hedging small volume initially and gaining experience gradually is the proven
way forward. As the saying goes, seeing is believing or in this case doing is believing.

For more information on managing volatility and improving cash-flow:
email: [email protected]; web: www.lme.com/plastics