By S Venkataraghavan
The recent global economic crisis has defined a new paradigm for the chemicals industry in general and the plastics industry in particular. The need of the hour now is for a global Chemicals Derivatives Exchange (CHEMEX).

The thermoplastics market as of 2007 was worth upwards of approximately $200 billion, a comparable size to that of nonferrous metals. PP global capacity is about 46 million tons, compared to an output of 23 million tons for aluminium. Similarly, the production capacity of LL is analogous with copper, their figures being 15 million tons and 16 million tons respectively.

Price volatility has been a significant issue for the plastics industry for several decades and it exposes both buyers and sellers of polymers to a high level of price risk. With volatility rising to over 50% in recent years, many in the plastics industry supply chain are finding this difficult to manage. Futures contracts provide industry with the ability to manage this volatility.

Futures markets neither increase or decrease volatility, they merely reflect the volatility in the underlying physical market and provide industry with greater price transparency. The Global Chemex plastics contracts will provide a tool for managing exposure to that price volatility through hedging on Chemex’.

Plastics futures contracts will enable the plastics industry to hedge against volatility in plastics prices: Hedging is the process of managing the risk of a price change by offsetting it in the futures market.

The ability to hedge gives producers, converters and consumers in the industry the choice of how much price risk they are prepared to accept.

Why suppliers owned plastics futures markets?

The lesson post global economic crisis, new paradigm!

Suppliers will no more compete in the market place, supply chains will have to compete. Hence the need for transparent efficient futures plastics markets.

The futures and options markets in metals, as well as in agricultural and energy commodities, are widely used with prices fully accepted and embedded in standard industry practice. For the plastics industry, however, the process of managing price risk through hedging has yet to become well established.

Hedging is a risk management tool that offers a similar level of certainty; enabling organizations to lock-in future prices and therefore more confidently focus investment on research, development and other capital expenditure.

The acceptance of these plastics contracts will be important if the plastics industry is to make use of a tool that these Chemex facilitate – hedging.

Hedging

This is the most common term used for a company’s activities on a futures exchange intended to limit the impact of adverse price movements. Hedging is a common practice in the foreign exchange markets for multi-nationals, as well as medium-sized companies with exposure to the fluctuations in currencies that their business requires them to deal in.

Plastics producers and converters,along with the end customer,protect their businesses from price movements in currencies on a daily basis. The hope held out by the such plastics futures market is that they can also protect themselves against movements in plastic (like PP or LL) prices, which have been highly volatile in the past few years.

Another phrase for hedging,“price risk management”, indicates the active nature of a company’s involvement in the strategy, planning and monitoring of a hedging programme and not just the act of trading on a futures exchange.

Price Risk management - the principles of hedging

Through its trading members, the Chemx will serve those at all stages of the plastics supply chain, including both buyers and sellers, the opportunity to hedge their material price risk, and therefore gain protection from future adverse price movements.

Hedging is the process of offsetting the risk of price movements in the physical market by locking-in a price for the same commodity in the futures market. The reasons for doing this are clear: for a converter, for example, it allows for better control of their raw material costs and for a producer, better management of product pricing.

There are predominantly two motivations for a company to hedge:

1. To lock-in a future price which is attractive, relative to an organization’s costs
2. To secure a commodity price fixed against an external contract

When hedging, an organization starts with price risk exposure from its physical operations, and will buy or sell a futures contract to offset that price exposure in the futures market. The ability to hedge means that an organization can decide on the amount of risk it is prepared to accept. It may wish to eliminate price risk entirely and it can generally do so quickly and easily on such Global Chemex’.

Hedging by trade and industry is the opposite of speculation as its primary purpose is to offset risk. Speculators, however, come to the futures market with no initial risk; they assume risk by taking futures positions. Hedgers reduce or eliminate the chance of future losses or profits, while speculators risk losses in order to make profits.

To be successful, a hedging programme must be devised in conjunction with a sale or purchase plan, and all pricing must be basis the Chemex settlement price in order to achieve the most effective hedge and to meet the requirements for international accounting standards.

The programme can be as simple or as complex as a company wants to make it, but it will be unique depending on that company’s appetite for risk, internal practices, pricing policies and hedging motives. Not only must a hedging programme be well devised, but it must also be managed continuously in line with the changing circumstances of a company’s physical operations.

It has been observed that companies that use futures contracts to manage price exposure enjoy advantages over those that do not, or that rely on suppliers alone for price protection.

These advantages include :using a transparent and globally recognised 'chemicals' exchange price as the reference for settling supply contracts; flexibility in modifying the level of price protection depending on changes in the market or the company’s strategy; the ability to offer firm prices to a customer while offsetting this commitment in the futures market.

A company needs to decide what its aims are in its hedging programme. There are two main strategies: hedging to fix a price and hedging to offset a price.

Price-fixing hedge

The price-fixing hedge, referred to as a “fair value hedge” by accountants,seeks to eliminate the impact of future price changes in plastics on a business. An example is a film converter wanting to lock in a price for LLDPE which it will need to buy in six months time (December) to fill incoming orders.

A price-fixing buy hedge is put in place through buying LLDPE December futures now, and then selling out the futures contract in December, at the moment the supplier gives the converter a firm price for its LLDPE delivery.

A price-fixing sell hedge may be undertaken, for example, by an integrated petrochemical company concerned that the price of PP may have declined in three months time after its production has been ramped up. The company would sell futures now and then buy back the futures when the PP is priced out to customers.  Continued...