By: Catherine Kavanaugh
April 17, 2014
CHICAGO — Back in 2002, the price of polyethylene and polypropylene began a turbulent climb.
Monthly fluctuations of 5 percent to 10 percent turned into annual swings around 30 percent. By 2004, prices doubled.
A period of crisis followed: hurricanes Katrina and Wilma, plummeting real estate values, bankrupt automakers and partisan politics heightened uncertainty.
Things haven’t changed that much in the last five years, according to Andy VanPutte, a senior vice president at Resin Technology Inc., who points to wild weather, feedstock spikes and the aftermath of the financial crisis all keeping resin prices vulnerable to sudden increases.
“We now feel like we’re in an event-driven industry,” VanPutte told business representatives at the inaugural Plastics News Financial Summit on April 2 in Chicago.
The good old days — if they even ever existed — are gone, and it’s time to take action, he added. VanPutte said he thinks volatility in the resin market is here to stay and needs to be managed with a strategy just like sales, purchasing and manufacturing activities.
“By not managing that volatility, by just riding the rollercoaster and buying as you need at the price at the time, you’ve already decided unconsciously to accept price risk,” VanPutte said.
“You’re speculating that your business can cope with whatever the rollercoaster hands you. It presents challenges. If you have difficulty with managing your sales price, if you’re trying to meet budget on costs, you need a new tool. You need something else.”
As RTi’s hedging practice leader, VanPutte, a chemical engineer, sees three primary ways to protect against adverse price changes for PE and PP. They are physical hedging, which entails buying ahead of needs; supplier hedging, which is negotiating for fixed pricing; and financial hedging, which uses futures, swaps and options.
Hedging — a form of price-risk management — consists of taking a position in one market to offset exposure to price changes in another market. Getting started often requires a change in mindset. Instead of looking at price-risk management as a profit-and-loss measurement, think of it as a stability measurement, VanPutte advises.
“You have to understand that stability in cost is the goal and not profit or loss,” he said.
Buy low, by chance
Physical hedging is almost a speculative move but it is commonly practiced when prices seem low, at least comparing the moment to what it could be in a few months. VanPutte said that could be a good reason to purchase extra material.
“Fill up the silo. Fill up the warehouse, or even line up extra cars on the track out back. This is your classic cash-and-carry hedge,” he said. “Buy the material and store it until you need it.”
However, the supplier could have trouble meeting the terms of the deal because of a power outage or some other problem.
“What if you can’t get that material you contracted for? You have to take all of this into account if you’re going to try to deliver stability to your business through negotiating with your supplier,” VanPutte said.
Another strategy uses financial instruments, such as a futures contract, a swap or an option to offset changes in raw material prices. A futures contract facilitates the exchange of an asset for an agreed-to price with delivery set at a specified future date.
Swaps are agreements to exchange a floating market price for a pre-determined fixed price for a specified period.
And, options give the purchaser the right to buy or sell at a pre-determined strike price.
If market prices go up, futures and swaps provide a positive offset to the cost increase. If market prices go down, a negative offset nets against the cost decrease.
With options, if the market price goes up beyond the strike price and the premium, a positive offset nets against the cost increase. But if the market declines, the option isn’t exercised and the premium is lost; the business simply benefits from the cost decrease of the raw materials.
Financial hedging offers several advantages: It’s private, in your control, capital efficient and there are no storage or spoilage concerns.
The financial instruments can be obtained through the over-the-counter market or an exchange, such as the NYMEX Exchange, which settles on the PetroChem Wire (PCW) price index for linear low and high density polyethylene swaps, polypropylene and PCG swaps.
Shale gas factor
While the shale gas boon is making natural gas more of a North American commodity, that doesn’t mean price advantages are trickling down to plastics processors. The extra margin is being retained by the resin producer.
“Dow Chemical Co. doesn’t owe you a profit,” Tom Langan, a risk management consultant with WTL Trading Inc., told attendees. “They may benefit more from shale gas more than you but you can use the futures market to your advantage. How cheap does natural gas have to be before you buy some or you buy a call option against it years ahead?”
Another bright spot is that the raw material will continue to be produced in the United States, which bodes well for film and sheet makers, according to Peter Schmitt, managing director of Montesino Associates LLC.
Dealing with cost volatility is a critical part of managing a plastics business. Variations in resin pricing affect costs and earnings and make hedging a tempting new tool.
“We don’t want to look at everything like a nail and hammer,” VanPutte said. “We want to have a screwdriver for when we need it.”
However, using hedging to stabilize prices brings another risk. If you hedge and the market drops, you could be vulnerable to an unhedged competitor.
“They rode the rollercoaster down and now they’re nipping at your heels,” VanPutte said. “You could look back in hindsight and say man if I hadn’t hedged, my average costs would be lower. I would have been better off if I didn’t hedge.”
To be successful, he recommends creating a methodical program with specific guidelines, strategy and scope that gives authority to accomplish the intended goals.
VanPutte also urges use of caution and common sense to determine the best time to use the hedging tool.
“It’s not a panacea,” he said. “We should be using it in concert with our sales strategy, with our purchasing strategy, with our manufacturing strategy. Put all four together for the best case for your business.”