Evaluating risk in resin pricing is important

One of the biggest non-stories of the past few quarters has been the price of plastic resins, and by extension, the price of crude oil. Don't get me wrong, resin pricing is of the utmost importance to people who make their livings in plastics (i.e. the readers of this newspaper). And the price of crude oil is a huge factor in the overall performance of the global economy.

But a really interesting story, even for an economist, has an element of drama. And for one of the few times in my memory, there has been a dearth of drama in materials pricing. For the past year and a half, the prices of both resins and oil have stayed within a relatively tight range (which means low volatility) at a moderate level by historical standards.

These conditions are good for managers and owners of companies who buy resin because they lower the risk of running a business. So I will concede that maybe you could use a boring story once in a while. I will even bet that many processors would like to lock in these low-drama conditions forever.

But we all know this situation will not last forever, and when it changes, it can change quickly. So the question is, as always, "What happens next?"

About 20 years ago, I was asking myself this same question. At that time, I was interested in comparing the trend in resin prices to the trends in other materials such as aluminum, glass, paper, copper and lumber. To facilitate this analysis, I created my resins prices index. This index is based on a weighted average of the published price of the top six thermoplastic resins by volume. It is expressed in cents per pound, and it is derived from the data that is published in the back of every issue of Plastics News.

This index is not the actual price you may pay for any particular resin, but rather it is intended to capture the underlying trend in the price of all resins. And as you can see, the index correlates closely with the monthly average price for crude oil expressed in dollars per barrel.

This chart clearly shows the extreme volatility that is possible in the markets for these commodities, and it also shows that there is a lag of only two or three months at the major turning points of the two lines.

It should come as no surprise that the price of crude oil is a leading indicator for resin prices, but the problem is that there is not much of a lead. This problem is compounded by the fact that it is impossible to predict the future price of crude oil. It may happen someday, but for now it remains a mystery.

So even though the internet allows us to get real-time updates on the spot price of crude oil, it still takes a few months to determine whether a change in the direction of the price of oil represents the start of a major trend or just noise. During that time, you could easily commit to a decision in your own businesses that will ultimately turn out unprofitable because of an unanticipated and rapid change in the price of materials that goes way against you.

One of the best strategies for mitigating this risk is called hedging. Because of the strong correlation between the price of oil and resins, you could purchase one or more futures contracts for crude oil as a hedge against future, unknowable changes in the price you will be forced to pay for your materials. This is analogous to purchasing insurance; therefore, it is not a decision you should enter into without careful consideration because all good insurance plans have a cost. But over time, the cost can be well worth it if it is done prudently.

In this simple example, if the price of resin goes up due to a rise in the price of crude oil, the increased value of your futures contracts would offset your increased materials cost. If the price of crude oil goes down, the value you would lose on the oil contract will be offset by the lower materials costs you have to pay. Hedging strategies, such as the type and number of contracts you may need at any given time, can vary widely in their complexity. So it is crucial for business owners and managers to evaluate constantly their unique levels of exposure and their particular risk profiles.

At the present time, the need for insurance does not appear to be as great because resin prices are relatively low and the volatility in the market is also low. You should also know that these low-drama conditions probably mean that your cost of insuring against future risk is also going to be relatively low at the present time. But appearances can be deceptive, so this is no time to become complacent.

Just because the trends in my chart over the past 18 months indicate we have had low volatility in oil and resin prices, it does not mean that the actual probability of future risk is low. It's just that the perceived odds of future risk are relatively low, and the market for insurance against future risk is relatively subdued.

Oil prices are extremely sensitive to changes in geopolitical conditions, and I am growing increasingly receptive to arguments that geopolitical instability is rising. At the present time, you may not feel the need to insure your future profits against risk. But this is a good time to evaluate your risk strategy and prepare for future, adverse changes in the marketplace.