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Increasing profit margins & sales through controlling forward resin prices

Since resins comprise roughly 45% of processors' operating costs, resin prices determine to a large extent how profitable and competitive processors are. It follows that the more control processors have over future resin costs, the more profitable and competitive they will be. Controlling future resin costs means utilizing forward (future month) resin markets and capitalizing on the opportunities they provide.

Since resins comprise roughly 45% of processors' operating costs, resin prices determine to a large extent how profitable and competitive processors are. It follows that the more control processors have over future resin costs, the more profitable and competitive they will be. Controlling future resin costs means utilizing forward (future month) resin markets and capitalizing on the opportunities they provide.

This article identifies ways to manage forward resin prices and gives recommendations based on cost effectiveness and the ability to execute forward resin transactions at fair prices.

What margin?

In terms of managing the risk of resin costs relative to product prices, margin may be measured in one of three ways:

Nominal Gross Margin ($/lb) = Product Sales Price - Resin Price

Gross Margin ($/lb) = Product Sales Price - % Resin x Resin Price

Net Margin ($/lb) = Product Sales Price - % Resin x Resin Price - Fixed Costs

Where % Resin is typically 45%.

Regardless of how margin is measured, however, the actions required to manage and increase margins are the same.

Managing margins

I. Hope for the best

Most processors have floating resin costs against fixed price products. So profit margins depend on what resin prices do. This is a speculative, hope-for-the-best approach to profit margins.

Resin prices

Resin purchase prices are spot or index-related (IHS/CMAI, CDI, or PCW). So resin costs float with the market and are often volatile.

Product prices

Product prices are fixed; however -- if customers agree -- some processors attach resin-price escalators to product prices. Price escalators protect the processor from higher resin costs, but leave customers at risk. In a competitive environment and for large customers (e.g. big box retailers, automobile manufacturers) resin price escalators are a thing of the past.

Even for processors with resin price escalators attached to product prices, however, profit margins are volatile and unreliable. For example, a polypropylene processor with product prices that contain annual resin price escalators, the product vs. resin price chart looks like this:

Resulting in a volatile profit margin:

For processors without resin price escalators attached to product prices, profit margins are even more volatile and at-risk.

For all processors, competitive pressure and customer push-back make resin price escalators less and less feasible, particularly for large, credit-worthy customers. To defend against volatile resin costs, processors may change operations, product composition, and even cut back on personnel, but there's a practical limit to cost-cutting and it doesn't solve the problem. The solution is to go on offense against volatile resin prices, controlling forward resin costs in order to secure and, as will be shown, increase profit margins and sales.

II. Control forward resin prices

There are two preliminary steps to controlling forward resin prices.

A)    Specify objectives

Establish target profit margins for existing and new business. Understand customer needs for product prices.

B)    Put it in writing

Identify, prioritize, and approve the means and strategies to achieve the objectives. Assign responsibilities to execute forward transactions and track results. Ensure understanding and buy-in of owners and key decision-makers through signature approvals of a written, straightforward policy.

Means

1.     Physical forward transactions with resin suppliers (e.g. Exxon-Mobil, Chevron-Philips, Total, Formosa, Equistar, Nova Chemical, Dow, and others):

a.    Fixed price resin purchases

b.    Purchases of price spreads to more liquid market alternatives (ethylene, propylene, natural gas liquids, crude oil)

c.     Convert existing supply contracts to less volatile PCW calendar-average price

2.     Financial transactions:

a.    Resin futures

b.    Same as b above,  converting resin price risk to a more liquid market alternative (olefins, NGLs, and crude oil futures)

c.     Swaps (index-settled direct transactions with counter-parties)

Note: Financial transactions substitute for physical transactions if fair, fixed-forward resin prices or spreads cannot be obtained from physical resin suppliers.

Futures

PCW prices are used by the Chicago Mercantile Exchange to settle resin and olefin futures.  Analyses show historical PCW prices are highly correlated with spot prices and other resin price indexes (IHS/CMAI and CDI). So resin futures are an effective forward-pricing tool for processors.

Resin and olefin futures contracts are:

C)    Execute

Negotiate above Means 1-a, 1-b, and 1-c with physical resin suppliers.  Open and fund a futures account -- and possibly swap accounts for resins not available in the futures market - to execute Means 2-a, 2-b, and 2-c. Purchase fair, forward resins or alternatives from physical or financial supplier to offset fixed price forward products and achieve targeted profit margins.

A futures account enables execution of forward resin purchases -- anonymously or directly, without credit risk -- with a financial counter-party.  Futures transactions are CME-cleared. This avoids the cumbersome and intrusive process of establishing swap agreements with financial suppliers.

What customers? 

High volume, reliable, and credit-worthy customers (e.g. retail product producers, big-box retailers, auto manufacturers, medical device manufacturers, et al) interested in fixed price products three or more months ahead at or below their budget levels and without price escalators. These are existing or new customers.

Forward curves 

As is usually the case for energy and other commodities, the forward curves (future monthly prices) for resin and olefin futures are declining. The most dramatic decline is in ethylene, the building block for high and low density polyethylene. Declining resin prices mean, if processors purchase forward resins against current product prices, their profit margins will automatically increase.  If processors purchase price spreads to propylene and ethylene at current market, shifting their price risk to olefins -- and then purchase forward olefins -- their profit margins will increase even more.

Purchasing resins at declining forward prices creates opportunities to increase margins, but also to increase sales.  Processors need not attach price escalators to sales contracts with existing or new customers since processors may lock in forward resin prices against forward sales. Thus, processors provide forward price certainty to existing and new customers at current product prices or lower -- giving those processors a competitive advantage while capturing higher margins.

Takeaway

Control forward resin prices and go on offense for profit margins and sales. This proactive approach is new for many processors, but it is standard in other commodity based businesses (e.g. oil refining). It's also smart business, and processors who adopt the approach will secure and increase their margins and sales, while competitors still react to volatile resin prices.

Specify objectives, establish a Policy for a proactive program to achieve those objectives, and then implement the program. You and your customers will benefit, and you'll be ahead of the curve.

About the author 

Tom Langan is a margin risk management consultant dba WTL Trading. He helps commodity based businesses control costs, increase revenues, and secure profit margins. Tom is the author of many risk management articles in chemical and plastics industry publications. You may contact him at [email protected]

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