On May 27, the London Metal Exchange will launch two plastics contracts for polypropylene and linear low density polyethylene. The move into the plastics market is a new venture for LME, marking a historic departure from 128 years trading solely in metals.
Drawing on its experience with metals, however, the Exchange is confident that the plastics contracts will deliver real benefits for industry. The plastics industry - largely new to the benefits of hedging - has been engaged in debate over the potential impact of the launch.
But what are the key issues under discussion, and what is the rationale for launching futures contracts for plastics?
Members of the plastics supply chain have faced, and been damaged by, the effects of price volatility for several decades. Indeed, price volatility has become an industry characteristic, with a two-in-three chance that PP prices will fluctuate by 22 percent in any given year.
Many organizations resort to stockpiling - or just plain hope - in an attempt to manage price risk. Neither method has helped manage balance sheets.
Consequently, there is now a real desire for a reliable mechanism with which to manage price risk. Futures contracts, for the first time, will provide the plastics industry with an insurance policy that will enable organizations to forecast accurately income and expenditure, lock in profit margins and draw up reliable budgets for business growth.
However, it is worth pointing out that LME does not expect futures contracts to have a significant impact on price volatility, but simply to provide a tool for managing it.
Metals vs. plastics
The plastics and metals industries have marked similarities, which - coupled with the absence of a tool to manage price risk - make LME's transition into plastics a natural step. Both are primary industrial raw materials, with $120 billion markets, and share similar supply-chain processes. In addition, many companies that buy plastics also buy metals - for example, packaging and automotive - and so already have established relationships with LME. As with all its contracts, LME has undertaken extensive study and detailed consultation with industry in developing the contracts, and a committee was established to ensure that they meet industry requirements. The committee includes representation from all aspects of industry: producers, converters, end-users and those who will trade the contracts.
Speculation vs. risk
For many, the word ``exchange'' resonates with images of Michael Douglas in the movie Wall Street, amongst suited men indulging in risky speculation. The reality is that exchanges like LME are used primarily by industrial organizations that hedge via the exchange to manage the amount of price risk they are prepared to accept.
A futures contract is a standardized agreement to buy or sell a set amount of a product at a pre-agreed price on a pre-agreed date. By financially settling the contract on the due date, the user can offset the adverse effects of a future rise or fall in prices, even during the most extreme periods of price volatility.
Hedging is about achieving certainty; speculation is about risking losses in an attempt to make profit. Those who use the market to speculate in effect take the price risk from the hedger and provide liquidity to the market.
At what cost futures?
Inevitably, there will be costs for those who choose to participate in the market. Costs will be incurred when appointing a broker, who will also charge a commission for the ongoing services they provide.
Different LME brokers offer different services and the choice of broker will ultimately depend on an organization's objectives, business model and the services they require.
The plastics industry is already accustomed to paying for services that add value; brokers fees will be no different and can be equated to insurance premiums - small in comparison with the risks associated with price volatility.
Fears have also been raised that the use of benchmark grades will ultimately result in product commoditization. In truth, commoditization is a prerequisite, not a result, of a futures market. LME's benchmark grades are designed to provide a baseline price to which premiums are negotiated for higher grades, etc. As such, the plastics contracts will not cause standardization in the plastics industry, beyond levels already in existence.
Business as usual
Finally, if a company chooses to hedge via LME, its existing relationships within the supply chain will not change. It will still continue to buy or sell its raw material via its usual channels.
A futures contract is simply a financial tool that operates alongside the existing physical purchase or sale arrangements, to offset adverse price movements in the future.
The delivery element of any LME contract plays a crucial role in creating convergence between the future and the physical price. In fact, in the case of metals, less than 1 percent of all contracts actually result in delivery, with the majority being financially settled. The vast majority of deliveries are undertaken by merchants and traders that are able to source or place the benchmark grades used on LME.
>From May 27, members of the plastics supply chain will have an effective mechanism with which to manage raw material price risk, and will therefore be able to forecast their budgets more reliably.
LME will publish daily reference and closing prices and official monthly settlement prices that are discovered in a highly transparent and well-regulated environment, providing industry with a credible global price for the very first time.
LME looks forward to a new era trading in plastics, built on the foundations of 128 years providing risk-management tools to the nonferrous metals industry.
For more information, visit www.lme.com.
Neil Banks is strategy director for the London Metal Exchange.