LME to launch plastics futures

John Pizzey, chairman of the London Metal Exchange (LME), first mentioned the possibility of trading derivatives contracts for plastics at the annual LME dinner in October last year. “At first sight this might seem odd,” he said at the time, but “there is a significant volatility, and a growing desire for risk management tools from both producers and consumers. It seems to fit a deliverable contract.” In the past there has been no obvious forum for conducting such trades.

The LME plans to introduce plastic futures and options contracts gradually, starting at an as yet unspecified time in 2004. It will be cashing into an industry almost as large as metals – both are valued by the LME at approximately $120 billion. The industry is substantial in every continent, and consumption in 2002 of the five major thermoplastics reached 150 million tonnes.

Two classes, polypropylene and linear low-density polyethylene, will be the only plastics tradable to begin with. Trading will be conducted alongside metals, and in the same way, with five-minute rings providing maximum liquidity. Pending the success of this trial, numerous other categories of plastic could be introduced.

The idea was the brainchild of Edward Wilson, principal at UK-based Chemair Technologies. In the late 1990s, working at Koch Industries, he became familiar with the LME’s work. Later, he worked with Dow Chemicals, where he was exposed to the perils of price risk in the plastics industry. He saw the significant similarities between plastics and metals as tradable asset classes, and took the idea to the LME, where enthusiasm has grown steadily ever since.

Wilson says it had previously been assumed that plastic trading would be best conducted as if it were an energy product, on the International Petroleum Exchange. “There was a huge misconception, because plastics are essentially a type of industrial raw material like metals,” he says. “Transactional practices ought to dictate the model that you use to trade a product, not its raw material heritage.”

Francois Combes, head of metals at Société Générale in London, agreed that there are striking similarities between metals and plastics in terms of storage, delivery and consumers, but there would be challenges to overcome. “Maybe one problem for the LME will be that the energy world is not familiar with the way the LME works – it is quite different from most energy exchanges. That being said, plastic is not energy. It’s somewhere between metal and energy,” Combes says.

Neil Banks, director of operations at the LME, sees a clear correlation between the two assets: “Once we looked at how the contract market works, how the process of production works, and that many of the potential consumers were already consumers of our other products, we realised what a tight fit it is,” he says.

“Producers thought their product was special, and couldn’t be commoditised. I think increasingly they’ve come to realise that this is not the case, and also that consumers can more easily substitute one product for another,” says Banks. This in turn led to a growing appreciation that they needed tools for price risk management.

According to Banks, the price volatility of polypropylene is greater than aluminium, but lower than oil. Certainly, the data collected was deemed to substantiate Wilson’s claim that there was a demand for plastic hedging products waiting to be met. The next phase was consultation with the LME’s major clients. Banks mentions the packaging and car industries as two important areas where the idea has been received with enthusiasm.

Consultation with all LME members is now helping to decide the remaining details of how the contracts will be traded. A number of round-table discussions have been held, in centres such as Houston and Geneva, with another for Asian clients scheduled for January in Hong Kong. Predictably, consumers are showing the greatest enthusiasm at this stage, according to Banks: they are the most exposed to price risk on the supply side, with fixed prices for their manufactured articles on the other causing profit volatility.

Good response

Banks says he has been very satisfied with the response of plastic producers, who are traditionally less enthusiastic about such ventures in their embryonic stages. These are also the companies with least experience of the LME. “They’re intelligent enough to know what we do and how we will bring benefits to their business,” says Banks.

The structures of the contracts to be traded have been discussed with all relevant parties at length, says Banks, and the LME is close to a decision on how the derivatives will be structured.

The popularity of plastics continues to grow as manufacturers find more uses for the product, and it provides a potential growth area for the LME. As Pizzey says, it is a question of “what we can do to extend the range of LME-tradable contracts. Sitting back on the current portfolio is not acceptable”.

The LME does have a number of initiatives to improve the service. Another is the overhaul of LME select, its electronic trading platform. The original system had been in place since February 2001. In December 2003, the system was upgraded, with an improved platform designed by Cinnober Financial Technologies built to the specifications of the exchange, designed to improve functionality for the user. The LME says it will also bring significant cost savings and improve security.

Banks expects trading in plastics to be thin early on, but stresses that many small trades are better than a few large ones. He predicts there will be ample liquidity for spot and forward trades.