January 28, 2010
Has plastics pricing started the shift from an at-times opaque index system to a forward-looking transparent mechanism, with futures at its core?
Among the hallmarks of a successful futures contract—a high level of liquidity, the ability to hedge against volatility, and a well-regulated exchange that instills confidence—one particularly vital aspect is that its prices track physical prices in the actual marketplace. In this last instance, the London Metal Exchange’s (LME) plastics futures contract, which launched in May 2005, may now have truly arrived. Correspondence between LME prices and physical prices is quite high at this time, reaching 95%-98% in some cases, according to Robert Sheldon, LME’s plastics business manager.
In addition to higher correlation, particularly with its North American prices, another significant impetus has pushed greater adoption of futures. “Volatility is really the reason why people would want to hedge,” Sheldon says, “and the high levels of volatility that we’ve seen since the middle of last year have really highlighted the need for companies to try to manage what is, effectively, an unknown future (excuse the pun). I think it’s really made clear the fact that there is a new phase of price movement and price volatility that the industry hasn’t had to deal with before.”
Sebastian Castelli, director commodity derivatives at LME ring-trading member Société Générale, has seen a similar spike in interest in futures from his customers. “The decision [by Société Générale] to support these markets was made based on real demand coming from the industry itself,” Castelli says. “After a bumpy start, where some radical changes were made to the contracts, demand for risk-management solutions based on the LME sharply increased during the last 12 months.”
Sheldon verifies that heightened activity, which rose relative to the incredible volatility seen in resin prices, became very evident in 2008 when key commodities tested record highs and lows in the same calendar year. “We were already seeing greater interest from the first quarter onwards of ,” Sheldon says, “but since August/September of 2008, we’ve been seeing greater interest in trying to manage risk, and people seeing the LME as one of the avenues to do that.” Sheldon also says that in a time when money is tight, the ability for a processor to hedge a cost as large as materials greatly promotes cash-flow management.
OEMs and brand owners â€¨want a hedge
Sheldon says that at this point, the entire plastics value chain—from producers to distributors to processors to end users—is involved in the market, if at varying levels of participation. “We’re probably a little lighter on the supply side,” Sheldon says, “but there are certainly producers actively promoting these tools to their customers.”
Where the LME is seeing greater interest, which could ultimately push broader adoption of the contracts and their pricing, is at the opposite end of the chain, from participants like retailers, OEMs, and brand owners—so-called consumers or end users. “The consumers are pushing back down the chain through their suppliers to the producers,” Sheldon says, “saying they want LME-based pricing to bring about stability.”
Société Générale’s Castelli says that progression is typical for a futures contract, with end users showing the most interest because they have the biggest exposure. Often buying raw materials at floating prices, they then sell finished goods at fixed prices over a long period of time.
“In the bullish and volatile environment we have lived in over the last two years, [end users] suffered the most as their margins were squeezed,” Castelli explains. “Producers and converters who are buying and selling at floating prices suffer relatively less, but the rise in price volatility levels over the last few years has made most participants in the plastics value chain start seriously considering risk-management tools.”
Ultimately the mark of a successful futures contract is widespread adoption within the industry it serves. The LME has observed appreciable, if incremental, steps in this direction, but roadblocks, some of which have been thrown up by industry, remain.
“The fact is, the price is credible,” Sheldon says, “and people are starting to use that price in their commercial contracts to allow them to hedge. Admittedly, it’s in a small way, if you look at the industry as a whole, but there are certain key companies and individuals who are committed to trying to develop this concept and use it to add value to the services they offer to their customers.”
But just as there are plastics futures champions, there are also opponents, satisfied with the status quo of price discovery as it exists today. “There are some players that profit from the lack of visibility,” Castelli says, “and they will obstruct any new development. Transparency is not good for everyone.”
Castelli notes, however, that a move to a futures-based pricing system, instead of one using various indexes, can take time. “The pricing systems used in the plastics markets are the typical result of the evolution of any industry,” Castelli explains. “The problem is that with the current massive industry size and increased price volatility levels, they seem primitive.”
Time for a change?
The LME deals in a huge volume of aluminum contracts, but that wasn’t always the case. When that market launched in 1978, it experienced many of the same challenges plastics futures are working to overcome. “It took about eight to 10 years for aluminum to really get to a level of notable liquidity,” Sheldon says. Celebrating their fifth anniversary in the LME this May, and in a market with sustained volatility, perhaps plastics are tracking a trajectory once traveled by aluminum, with greater adoption to come, thanks to the efforts of end users. “The final users, who pay the price of increased volatility, are pushing for a change in a more transparent direction,” Castelli says.
Neil Banks, former director of exchange development at the LME and since retired, back in a 2006 appreciated the direction the industry would likely head, stating his view then as the contracts marked their one-year anniversary. “What really differentiates LME pricing from prices provided by polls, surveys, or index providers is the very immediacy and transparency of the process,” Banks wrote. “LME prices are the result of real buying and selling of physical material. It is this that led the metals industry to use LME pricing, and I believe it will ultimately lead the plastics industry to follow suit and, therefore, reap the benefits.” —Tony Deligio
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