Words of Wisdom: You, the plastics industry, and futures contracts

On May 27, 2005 the London Metal Exchange (LME) launched the first ever futures contracts for plastics, specifically PP and LLDPE. LME has been providing futures contracts to the nonferrous metals (e.g. copper and aluminum) industries for 128 years.

These new plastics contracts have the potential to dramatically change the way that the plastics industry manages the price volatility that has intensified in recent years. The contracts will bring many benefits to converters, end-consumers, and producers through the ability to hedge?a transparent pricing system?and providing a delivery point of last resort.

For the past 30 years the plastics industry has suffered high price volatility. In fact, such volatility has become an established market characteristic, with a 67% chance that PP prices will fluctuate by 22% in any twelve-month period.

Until now, members of the plastics supply chain have lacked any reliable methods of tackling price volatility, and have been left unprotected against damaging price hikes and falls (depending on your sector). Since methods such as stockpiling have not proved satisfactory, a real desire for a reliable mechanism to manage price risk has developed?a desire the LME is looking to fulfill.Plastics may seem an odd choice for an exchange that has only ever dealt in metals, but there are more similarities than you might imagine. Both are primary industrial raw materials with a similar market value of around $120 billion per year, and they both pass through similar supply chain processes.

Established in 1877, the LME has a long history of launching successful contracts for the metals industry, including copper and aluminum, which are traded elsewhere in the world on other exchanges, but at only a fraction of the volume that goes through the LME. It is the credibility and expertise gained through metals that led the LME to consider using its template for other industrial materials.

It is worth pointing out that the LME does not introduce contracts that are conceived in a vacuum. Its enduring success is its integration with, and continuous response to, industry needs. The contracts for plastics have been developed with the full involvement of an official Plastics Committee to ensure that the contracts meet the requirements of the industry. This committee includes representation from across the supply chain, from producers, consumers, converters, and distributors, including those who will ultimately trade the contracts.

The majority of users come to the Exchange to hedge (through their LME broker), and so reduce their exposure to price volatility. Hedging is the process by which price risk is reduced or eliminated through a futures contract. Futures contracts are simply agreements to buy or sell a set amount of a standard product at a pre-agreed price on a pre-agreed date in the future.

By financially settling the contract on the due date, the user can offset the adverse effects of a future rise or fall in prices, even during the most extreme periods of price volatility. This is very different from speculation, which is the practice of risking losses in an attempt to make profit. Hedging is designed to deliver price certainty.

Just as an insurance policy might compensate for losses from fire or theft, a futures contract is a financial tool that works alongside existing supply/sale arrangements. Futures are a dependable means of managing adverse price movements in the future. They provide a stable financial base. By locking in the materials-cost part of a job, a company can budget with confidence and plan secure strategies for business growth and investment. As more plastics users get on board with plastics futures, the industry as a whole stands to benefit with no disruption to current practice.Plastics futures are set to benefit the plastics industry as a whole by bringing absolute price transparency. The LME sets a daily reference price and a monthly settlement price, ?discovered? through open-outcry trading. Because this pricing is based on real industry supply and demand trades, the LME expects its reference prices to become established as a reliable benchmark.

How does it work?

A company?s decision to start hedging using plastics futures contracts depends on its policies on hedging and risk management. The management of hedging is typically done through a finance department, so the first requirement is that the company has sufficient resources to plan, implement, and manage a hedging program.

Following a decision to get on board with plastics futures, a company needs to make contact with an LME member firm to act as broker or intermediary to the marketplace. The level of interaction you want with the market and the services you require will affect your choice of member firm?a full list of LME members is available on www.lme.com.

All trades on the LME are transacted by a broker on your behalf via either the open-outcry trading forum, electronically through LME Select, or via the inter-office telephone market.

The costs of trading futures come in the form of compensating the broker for his services, as with any brokered financial services, but these costs are negligible in comparison to the risks associated with price volatility in the plastics industry.