Home: November 2006 Lead Story › Taking the positives

Taking the positives

Taking the positives

30/11/2006 | Channel: Business


When the plastics contracts were launched on the LME in May 2005, there were several global factors critically influencing plastics prices. Oil and feedstock prices were soaring, inventories were weak and fluctuating demand in China, and, later on, the hurricanes in the US were causing havoc with supply. Yet price volatility may be here to stay, as monomer and polymer price movements remain exposed to these factors, and due to the recent tendency of production companies to set up facilities in politically sensitive areas, such as the Middle East. This means that the ability for the plastics industry supply chain to lock in forward prices now, to protect their margins and cash flow, seems even more valid than it did 12 months ago. Indeed, this type of protection, or 'insurance', is exactly the capability that the plastics futures contracts can provide all the industry, from producers to manufacturers.

Through the offering of two new contracts - Linear Low Density Polyethylene (LLDPE) butene copolymer and Polypropylene (PP) homopolymer - the LME is offering the plastics industry a single global benchmark reference price for both these plastics that is transparently ‘discovered’ by the market itself and subsequently utilised for all pricing negotiations. Yet for the new LME plastics futures contracts to function effectively liquidity must build - meaning that industry needs to look towards participating in the contracts more actively than it has over the first year.

Industry caution
The new contracts are designed specifically for LLDPE and PP grades, and they are based on models that have a proven track record of being applied successfully to other commodities. However, some members of the plastics industry have taken a cautious approach with respect to trading the contracts. Critics argued before the launch that it would not be possible to trade polyolefins as a commodity and that the success of previous LME commodities contracts provided no precedent. It was argued that the technical support and other value-added services required by producers of plastics at the higher end of the value chain - for example with metallocenes and the bi-modal grades - prevented them from effectively trading base grade PP and LLDPE.

Yet, the surge in feedstock costs from rising oil prices, and some stock-piling in anticipation of another potentially damaging hurricane season in the US will affect the pricing of the higher -value added grades of plastic in exactly the same way as the LME base grades. Fundamental factors can easily combine to raise prices across all grades. And other macro-economic events, such as producer price hikes, crackers going off-line, and stocking and de-stocking in the supply chain have all been pressurising the futures market in much the same way as the physical markets.

Despite some unavoidable set backs to the contracts, however - hurricane Katrina set them back several weeks - and although some members of industry have been
reticent to participate, the contracts' first year has shown some very encouraging signs. Firstly, LLDPE open interest (a measure of market liquidity) currently trades out for January 2007 delivery and PP to December 2006 - meaning that prices for the plastics are being discovered further out from the spot month. This suggests that hedging practises are being tried out further into the future by members of the plastics industry that are learning to adopt the contracts as a price-management tool.

Equally encouragingly, the total volume of trade of both grades has risen from under 10,000 Metric Tons (MT) during the opening month last May, to an average of 85,000 MT/month over the following nine months. And, the total production volume of both the LLDPE and PP grades listed by the LME suppliers has risen to about 25 per cent and 30 per cent of total global output respectively, which is already a very healthy amount.

The liquidity of the exchange is also increasing every day as new producers in Asia, Europe and North America list their brands on the LME. Additionally, an increasing number of LME-approved warehouse facilities are attracting further involvement from industry by providing global delivery options that can minimise potential shipping and transportation costs.

Price risk management
That said, the new contracts are not designed for participants to take delivery of ‘physical’ material. Rather, the LME is a ‘terminal’ market, or market of last resort, where the option of physical delivery is necessary on each transaction in order to counteract any price divergence between the physical market and the futures market. In fact, similar to all exchange-traded futures contracts, the primary purpose of the LME plastics contracts is to provide industry participants with a financial tool that allows them to manage their price margins.

In the past, price volatility was typically absorbed by the weakest member of the supply chain, but the contracts can actually benefit all participants. They will allow
producers to hedge against any predicted production shortfalls and any unsold and un-priced capacity. They also allow producers to offer long-term fixed price sales contracts. Converters are enabled to lock-in forward-purchase prices and offer long-term fixed-price sales contracts themselves. And consumers can hedge against price increases and lock-in forward purchase prices if their suppliers are unable to offer them fixed price contracts.Meanwhile, distributors and traders, who are exposed to prices on both purchases, stocks and sales,may hedge against time differences between purchases and sales and any perceived price volatility all the way along the supply chain.

Yet, the whole of the plastics industry must adopt LME pricing as the benchmark for its physical, underlying market negotiations before the contracts can provide these kinds of pricing management techniques effectively. In the meantime, the LME price must converge with the underlying physical market price to be credible as the basis for using the LME for hedging activity. For example, if distributors are buying positions in the LME futures market to lock-in attractive forward purchase prices, it is crucial that their own physical purchase pricing is well correlated with the LME contract price. Otherwise their hedge will bear no relation to their physical business.

At the moment, most physical pricing is indexed through one of the four other
principal global benchmark prices, provided by ICIS Pricing, CMAI index, CDI and Platts. It is worth noting here that these organisations calculate their pricing with
retrospective telephone polling - where it is not impossible for the parties being surveyed to hope for price movements in a particular direction. In contrast, the daily LME prices are discovered in real-time, via a wholly transparent and market driven process.

Yet during several weeks over the past year the price of LME traded plastic has differed from these other global reference prices, creating ‘basis risk’ - which is the difference between the price in the futures market and the price in the physical market. Indeed, following the two US hurricanes last autumn there was a drastic price increase in the physical market that forced the US's previously high correlation with the LME of 92 per cent for LLDPE and 96 per cent for PP to fall to below 90 per cent. Then, at the beginning of this year, the LME price for PP fell some $200/tonne lower than the physical market price in Europe.

On this second occasion, opportunistic investors took delivery of LME physical stock at the lower LME price and sold it for profit at the higher European ICIS price level. In a more mature market, bidding on the lower price and using the delivery option in such a way will work to reduce the basis risk by closing these ‘arbitrage’ windows (meaning there will be enough players for such windows to quickly be exploited and closed). However, whilst demonstrating that the delivery mechanism of the exchange is working well, this arbitrage activity only succeeded in pushing the LME price back up part of the way towards the physical ICIS price - as the LME ran out of warehoused stock.

But the contracts have been designed for industry to manage price risk, not for opportunists to speculate and take advantage of arbitrage opportunities. The key question that Natexis Commodity Markets and others are trying to find a solution for remains, therefore, what will it take to get more of the plastics industry on board?

Shifts in the petrochemicals industry
There have been some fundamental changes in the dynamics of the global plastics and petrochemicals industries which emphasise the need for the industry to adopt the use of a hedging tool. Stimulating the changes, oil companies have been diverging away from plastics production to focus on upstream businesses. Additionally, end consumers are increasingly fixing their prices as far into the future as possible, and in the case of the automotive industry, this is up to five years forward.

Additionally, a new class of financially driven companies are acquiring a larger stake of the downstream businesses that are newly divested from the oil companies. This is
heralding the introduction of a new culture of cash sensitivity that puts more emphasis on margin management. One can expect to see such firms participating in the plastics futures market over the coming months. And now that the first year of LME data is available to analyse, we can also expect signed-up but non-participating companies, and in particular the large globals that have
remained cautious about entering the contracts, to begin hedging on the LME more actively.

But despite the fact that the new contracts are generating huge interest and gaining
exposure around the globe, LME brokerages and financial institutions still need to lobby industry to take part more actively in the exchange. And the fact the LME is making continued improvements to the contracts will help this marketing effort. So far, the LME has recently extended the shelf-life to 36 months for the two contract specs to help increase liquidity, and it has also committed to the launch of shorter-dated ‘cash’ contracts (whose exact timing is to be announced).

It is up to industry, however, to start benchmarking the LME for its price negotiations and begin opening forward positions on the LME. Obviously, producers will be central to this, but customers can also request LME pricing when they enter into the price negotiations. Ultimately, increasing the liquidity will give the exchange every chance of success, enabling all players in the plastics industry to hedge their price risk and control their margins.