Plastics hedging rising amid US chemical industry boom

Several obstacles limiting potential growth, say plastics market participants

blue-plastic-bottles

  • A plastics derivatives market has been in existence for more than eight years but liquidity is still fairly thin.
  • Massive changes in the market dynamics of the energy and chemical industries in recent years are leading to an increased demand for plastics hedging, say banks and commodity houses. Additionally, historical correlations between energy and plastic resins have broken down, rendering traditional proxy hedges ineffective, say market participants.
  • Volumes in plastics derivatives contracts are growing steadily and there is now more market transparency due to the CME’s suite of resins contracts launched in 2008.
  • However, while there is a strong business case for manufacturers and consumers of plastics to hedge their exposure, there are also a number of things holding the market back. Having a variety of underlying indexes limits the usefulness of the CME contract to some firms. Resins producers, who hold the pricing power, tend not to want market transparency. There is not a hedging culture in many of the firms involved in the market, and plastics production can be bespoke and not easily hedged by standardised derivatives contracts. However, many market participants believe the market is gradually evolving and that it has the potential for significant growth.

A market in plastics derivatives has been around for the best part of a decade, but many corporations, even those with significant exposure to plastic resins, remain unaware of its existence, say banks and commodity houses.

Despite almost 10 years of trading, demand for these hedging instruments is still relatively low and liquidity, although growing in some contracts, remains thin overall, say market participants. However, changing market dynamics in both the energy and petrochemicals industries over the past five years are stirring up new demand for resins hedging and this could give the slowly developing plastics derivatives market its next shot in the arm, some market participants believe.

"There's been a marked increase recently in companies wanting to hedge their exposure to plastics," says Houston-based Will Shappley, managing director of structured products at oil and gas major BP. "We see more and more of a need for this from our clients, given the volatility in the oil and natural gas liquids (NGLs) space."

Much of this volatility has its roots in the US shale gas boom, a phenomenon that has reversed the fortunes of the US chemical industry, turning it into one of the most buoyant industries in the North American manufacturing sector from one that was trailing five years ago, according to analysts. Not only does the flood of new US shale gas mean cheaper fuel for the energy-intensive plastics industry, but it also provides it with cheap feedstocks in the form of NGLs.

The US is now one of the lowest-cost plastics producers in the world after being one of the highest-cost ones a decade ago, according to the American Chemistry Council (ACC), a Washington, DC-based industry trade association for US chemical companies. As a result there has been a surge of investment in new chemical plants, with more than $158 billion being committed to 261 chemical production projects between 2010 and the end of 2015, the ACC reports.

This major shake-up in market dynamics has led many corporations that are exposed to the price of plastics – particularly firms in the retailing, manufacturing, electronics and automotive sectors – to revisit their purchasing and risk management strategies, say banks and commodity trading houses. Up to now, producers and consumers of plastics have tended to manage resins price risk through supply-contract negotiations and careful inventory management, say consultants. Even the minority of firms that do hedge using financial instruments – typically big purchasers of finished plastics goods, such as food retailers – have tended to use the energy markets as a proxy hedge. However, several banks and commodity traders believe this is set to change.

Changing price correlations between energy and petrochemicals (see chart) mean traditional proxy hedges using oil or natural gas are no longer effective, say hedge providers. "It's important to have good correlation between the financial instrument and what you are trying to hedge," says Brian Jenisch, Houston-based head of sales and origination for North American energy at Cargill Risk Management (CRM), the financial trading unit of Minnesota-based commodity giant Cargill. "Crude as a proxy hedge is certainly not working any more."

As a result, firms that have been proxy hedging have become more interested in financial instruments that more specifically address the resins price risk, say banks. "We are certainly coming across more clients who want to use price risk management tools that are specific to resin," says a New York-based trader with a bank that is active in resins hedging.

brian-jenisch

Of all the energy and commodity markets we serve, we probably have the highest aspirations for plastics right now
Brian Jenisch, Cargill Risk Management

 

 

This is leading to increased interest in derivatives contracts that reference specific plastic resins, such as ethylene and polyethylene, propylene and polypropylene, say banks and commodity traders. Bilateral trade in these contracts began to take off around eight years ago and liquidity has grown every year, according to market participants. Volumes in spot and paper ethylene, for example, grew by 25% between 2013 and 2015, from 7,047 million pounds to 8,843 million pounds, with paper volumes rising from 8% of the total market in 2013 to 15% in 2015, according to data from specialist price and data provider PetroChem Wire (PCW).

While volumes are still very small relative to mature markets such as crude oil, there are high hopes for the market's outlook. "Of all the energy and commodity markets we serve, we probably have the highest aspirations for plastics right now," says CRM's Jenisch. "It is one of the fastest growing segments of our derivatives business."

Cargill and BP are two of the most active market-makers in OTC plastics derivatives, with Koch Supply & Trading, the trading arm of Kansas-based conglomerate Koch Industries, being another. Banks in the market include Bank of America Merrill Lynch, JP Morgan and Morgan Stanley, say market participants. Noble Group, the Hong Kong-based commodity trading house, is also a fairly active player, participants say.

Cargill and Koch Supply & Trading both came to the market initially to manage their parent companies' exposure to resins prices and moved on to offering that service to clients, they say. Cargill's first trades involved hedges for food retailers who were buying end-products from manufacturers. BP, on the other hand, entered the market at the other end of the supply chain through its NGLs business.

"Our resins book is founded on our recent progress in NGL trading," says Shappley at BP. "Our NGLs presence is the backbone that helps us create our market-making capabilities in the chemical and resins space."

Most of the bilaterally traded contracts settle against indexes provided by either Houston-based Chemical Data, known in the industry as CDI, or London-based IHS Markit. These indexes are published monthly and used widely to price physical supply contracts. Some buyers of hedges, however, complain that monthly indexes expose them to an unacceptable degree of uncertainty.

The Chicago Mercantile Exchange (CME) hoped to redress this when it listed a suite of plastics futures contracts in 2008 that settled against daily PCW indexes. While only three of these trade with any regularity – the Mont Belvieu ethylene spot and futures contracts and the polymer grade propylene future – the contracts have brought some much-needed transparency to the market, say participants.

"Since the CME launched these contracts, people have had a bit more trust that there's some transparency in the plastics market," says Patrick Melia, a derivatives trader at Koch Supply & Trading. "The daily settlement against PCW numbers means people can mark-to-market their positions every night against a forward curve," he adds.

While the CME continues to increase its market share in certain contracts, particularly ethylene, the bulk of the market – estimates range from 70–90% – remains over-the-counter, say market participants.

1-plastics-crude-correlation

Why hedge?

It's easy to see why hedging the price of resins could appeal. Firstly, resin prices tend to be volatile. According to data from IHS Markit, spot ethylene prices rose 48% between October 2013 and September 2014, from 48.39 cents a pound (c/lb) to 71.51c/lb, before plunging 73% to 19.32c/lb by December 2015 and then rising 42% to 27.38c/lb by April 2016. The September 2016 price was reported at 39c/lb.

Secondly, the cost of resins is a huge outlay for many firms. For manufacturers that buy resin pellets in order to produce finished goods, the cost is often between 45% and 85% of operating costs, consultants estimate. Even for companies further along the supply chain, such as retailers or restaurants that buy the finished plastic containers or wrappers, plastics can be one of their biggest outlays.

 will-shappley

There’s been a marked increase recently in companies wanting to hedge their exposure to plastics. We see more and more of a need for this from our clients, given the volatility in the oil and natural gas liquids space
Will Shappley, BP

 

Greg Ogborn, director of North American purchasing at Cincinnati, Ohio-based Sunny Delight Beverages, says high-density polyethylene (HDPE) is one of his "largest spends" racked up primarily through buying plastic bottles. "We use millions of pounds of resin a year, so if the price goes up even a small amount it can have a huge impact," he says. "I don't have a lot of elasticity to increase my prices with end-consumers, so I need to be able to lock in margins for an extended period, and that's what hedging allows me to do."

Ogborn says he uses the CME's HDPE contract to hedge purchases forward to around 18 months, scaling position as contracts roll off. In the front six months of the market he might have up to 75% of his physical supply hedged, dropping that to 50% in the following three months and 25% beyond that, adding on months or quarters as they roll off, depending on the price level of the forward curve at that time, he says.

Being able to hedge has enabled him to have much tighter control on margins, he says. "Before we were hedging I could show you the shortfall in our annual profits by how much I missed the resins market. Now that I can control where we own our resin, I deliver our plan every year."

The business case for hedging is less clear for manufacturers that can simply pass the cost of resin through to their customers. However, consultants believe hedging could provide manufacturers with a distinct business advantage. "To me, the opportunities for a manufacturer who can hedge – ie control their forward resins costs – are immense," says Tom Langan, owner of WTL Consulting, an advisory firm specialising in commodities margin management.

"If you lock in your forward resins prices you can offer your customers a fixed forward price on products that enables the manufacturer, and the customer, to meet or exceed budget or other profit expectations. This provides a great service to customers while securing profits," he says.

He argues that since very few customers currently get this sort of price certainty, a manufacturer that was able to offer it would have a definite sales advantage. This is in addition to the usual margin management benefits that the hedge would bring to the manufacturer, says Langan.

Holding back hedging

While most market participants say they feel transparency is growing slowly, they also report widespread reluctance from physical players to use the CME futures contracts because their supply contracts are priced against CDI or IHS indexes and they don't want to deal with basis risk, say market participants.

Sunny Delight's Ogborn was able to persuade his suppliers during contract negotiations to switch to using the PCW index for pricing, he says, but generally it tends to be producers, rather than consumers, that dictate which index is used, say market participants and consultants. This usually means steering away from the use of a transparent exchange-traded number, say consultants.

"Resin producers don't want transparency," says Dallas-based Andy VanPutte, senior vice-president at Resin Technology, a niche consultancy advising plastics manufacturers on purchasing and hedging strategies. "It's to their advantage that no one really knows what the price is. It's not uncommon for a producer to sell the same resin into two different industries at very different prices – they will sell at the price that each industry segment can bear."

Another obstacle stymieing growth could be that although resins prices are volatile, the pattern is often a large move followed by the market staying at the new level for some time. "This doesn't lend itself well to hedging," says a trader at a commodity trading shop.

"If it goes up and stays there, consumers won't want to hedge at high prices when the next move is likely lower, and when it goes low consumers would love to lock in prices, but there are no sellers."

andrew-vanputte

It’s not uncommon for a producer to sell the same resin
into two different industries at very different prices – they will sell at the price that each industry segment can bear
Andy VanPutte, Resin Technology

 

 

Additionally, some plastics production is fairly bespoke, with the end product being a unique composition of different resins. Not only does the end product not lend itself to a standardised derivatives contract, but derivatives on the component resins themselves may be infrequently, or never, traded. In such cases, firms wishing to hedge would need to go further back along the supply stream to one of the original components such as ethylene or propylene, or even one of the original NGLs such as ethane or propane, say consultants.

Another obstacle to market growth

is simply the culture and set-up of many firms involved in the industry, say consultants. Purchasing managers are usually not authorised to trade futures contracts and treasury departments often lack incentives to do so, they say.

"The plastics business today is what the oil business was in the 1970s and 1980s in terms of financial sophistication," says WTL Consulting's Langan. "In the oil business the move didn't happen overnight, it was a question of the old guard leaving and new people coming in. The entry of trading companies also helped."

This view of a slow evolution is shared by others in the market. "I think it will develop over time," says the trader at the bank. "Each year there are more people interested, and more are still working out what they want to do. I don't think it's going to explode, but I think it will continue to grow. There is real demand for these products from end-users; it's not an investor space," he adds.

Cargill's Jenisch believes demand will grow as more firms learn about the market: "There's still a whole host of people out there that don't know it's possible to hedge these commodities. A very small percentage of the entire North American plastics industry hedge." This means the potential for growth is huge, he believes.
"In a perfect world, the market has the potential to grow in the same way the
energy markets have."

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