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How to hedge your bets on resin pricing.

Resin prices may go up and down, but plastics processors can now buy a form of insurance to protect themselves. Within the last two years, the same financial tools long used to manage risk in other commodity markets have been applied to plastics.

The goal of these price-risk-management tools, also known as derivatives, is to stabilize cash flow and costs. The advantages they offer include the ability to better manage inventories, price products more competitively, pass along stable pricing to customers, and enter markets that were previously unattractive because of price fluctuations.

There are currently four players, known as "market makers," in plastics risk management:

* Louis Dreyfus Plastics, a subsidiary of the Louis Dreyfus commodity-trading group in Wilton, Conn.

* Koch Chemicals International, sub. of Koch Industries, a Houston petrochemical producer and trader.

* Enron Capital & Trader Resources, sub. of energy company Enron Corp. in Houston.

* Shell Chemical Risk Management (SCRiM), a brand-new affiliate of Shell Chemical Co., Houston.

Market makers provide "insurance" against unfavorable pricing moves in the commodities you want to buy - or sell, in the case of compounders. Strategic price-risk management works by establishing price levels at which both buyers and sellers are willing to transact today for business in the future. Says Gene Kenyon, president and CEO of SCRiM, "Our job is not to take away a company's risk but to help them manage it."

Louis Dreyfus Plastics' focus is on long-term hedging of prices for polyolefins, polystyrene, PVC, and PET. Its average contracts are three to five years, although it will do quarterly or yearly contracts. Koch Chemical is a market maker for polyolefins, PVC, and PET. While it offers transactions for one or two quarters, marketing manager Ed Moody says they aim for longer-term transactions - typically one to three years.

SCRiM and Enron are currently focusing on polyolefins and polystyrene, although both say they may handle PET and PVC in the future. They offer short-term contracts, from three months to a year, and also offer longer-term hedging.

Tools and how they work

Financial contracts are settled against a "basket" of published prices. While market makers may differ in their approach, the tools they use are basically the same. They include fixed- or flat-price swaps, caps, floors, and collars. These tools are purely financial contracts and have no direct effect on your buyer-supplier relationships. Explains Adam Gross, risk-management associate at Enron, "Resin buyers have their contracts with resin suppliers and those prices are based on what is happening in the market at one given time. The contract between us and the resin buyer overlays that contract - we are saying we can protect your resin purchases by guaranteeing a price."

The hedging tool that has gained the most popularity with resin buyers is the fixed-price swap. It involves swapping the floating resin price for a fixed price. To settle the contract, the fixed price is compared with a mutually agreed-upon market index or group of indexes. If the indexed market price rises above the fixed price, the market maker reimburses you for the difference. If the market index price falls below the fixed price, you pay the market maker the difference. Each month during the life of the contract, the difference between the prices is calculated and payment is made to the appropriate party.

Caps and floors, like swaps, provide price protection, but they help you benefit from favorable price movements. They are commonly thought of as price "insurance" - i.e., for a premium, you are entitled to full price protection when prices move past a specified level.

With a price cap or floor, the full cost of the protection is predefined - it is equal to the premium paid by the buyer of the contract. There is no risk of potential future costs related to price movements.

A price cap protects against rising prices without sacrificing the advantage of falling prices. So if the price goes above the cap, the market maker pays you. If it goes below, you enjoy the lower price.

Floors are the opposite of caps: They guard against falling prices while preserving your opportunity to benefit from rising prices. They are of interest to resin producers and compounders. Premiums are based on the volatility of the commodity and how close the cap is to the market price at the outset of the contract. For example, if the going price is 20[cents]/lb, a cap of 25[cents]/lb costs much more than a cap of 30[cents]/lb.

Collars are a combination of a cap and a floor, whereby one party pays the other ira certain price moves above the cap price in exchange for possible payments when prices fall below the floor price. Essentially, the market maker is selling you a cap and you are selling him a floor. (This works the opposite way for a compounder.) On a zero-cost collar, the cap and floor prices are set so that neither party pays a premium up front. During the life of the transaction, no money is exchanged unless the price goes above or below the band agreed upon. (In a way, a collar is a swap in which the fixed price has been spread into a certain range.)

Who benefits from hedging

Market makers say you should consider hedging if you are buying resin and cannot pass on the cost, or are buying a fabricated product (e.g., film, sheet, or parts) from a processor who is passing on the cost to you. However, hedging is not available to the small fry. Market makers will typically write contracts covering purchases of a minimum of 200,000 lb/month up to 10 million lb/month.

Bill Rippe, managing director and executive v.p at Louis Dreyfus Plastics, says you should consider hedging if your gross margin is significantly affected by resin prices. "Most companies have a target gross margin. If by hedging you can hit your target or exceed it, then its worth it. By not hedging, you are speculating," he says. The next step is to decide what percentage of your risk you should hedge.

Kenyon from SCRIM says that when prices are going down, the swap tool may be a good choice because it allows you to lock in a low price, limiting your exposure to unknown factors (such as capacity disruptions). When prices are going up, you may want to consider a cap or a collar.

Greta Jacobs, risk manager at Enron, takes a slightly different view. She says that in a falling market, you can consider two options. The first is opting for a swap, which gives you price stability at the current low level. The second is to buy a cap in case prices turn around and go up.

Market makers stress they design financing tools according to customer needs. Says SCRiM's Kenyon, "You may want to hedge only a portion of the resin you're buying with a swap. Or some pieces of your business that cannot tolerate price spikes may require a cap."

Good candidates for these tools range from injection molders to compounders, say these market makers. Molders and manufacturers of branded products are the biggest users since they have more exposure to price volatility and generally have a harder time passing on changing resin costs. By contrast, commodity film producers who operate on a "cost-plus" basis at floating prices are generally able to pass costs through to the market without the need for hedging.

Compounders generally can pass on most of their resin price increases. However, Louis Dreyfus president Tim Stuart says compounders of specialized products (such as for automotive) are interested in hedging a portion of their business so they can pass on price stability to customers.

Koch's Moody says PVC and HDPE pipe producers are good candidates for risk-management tools. "They can no longer pass down increased resin costs because very aggressive companies, like Home Depot and Wal-Mart, are forcing their suppliers into long-term fixed-price contracts." He says this is also true of many food processors and producers of consumer goods and beverages.
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Author:Sherman, Lilli Manolis
Publication:Plastics Technology
Date:May 1, 1998
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