"Your focus has been on processors. What about resins suppliers? Can we use hedging tools to offer pricing choices to our customers [processors]?" Anonymous Supplier
Response: Yes, the tools are the same. In fact, if you offer pricing choices, it will be easier for your customers to offer pricing choices to their customers -- a potential win-win-win.
Essentially there are two types of pricing formulas, a standard one and what we'll call "fair and transparent" ones. Here they are in brief.
Standard: The standard, or de facto, resin pricing formula is
Index + delta
where delta is a price-adder or subtracter depending on quality, location, and negotiating skills. The index reflects market transactions between suppliers and processors, but also sets the resin price paid by some processors after delivery. Such a standard has several potential problems for supplier and processor alike, not least being the price disparities between the indexes - a reflection of the lack of transparency and liquidity in the resins market, not flaws in market information gathering. More problematic from a resins' cost control standpoint, the indexes are look-backs or current-day prices, not forward-looking. They don't provide a means to gauge or manage forward prices and risks for either the supplier or processor. They simply measure where the market has been and currently is. Price uncertainty and the inability to control it makes securing and improving profit margins difficult for both buyers and sellers. That need not be the case.
Fair and Transparent: From the standpoints of price fairness and transparency alone, the following pricing formulas are superior to the standard. They also parallel formulas used to establish physical (cash) prices of commodities in other markets, particularly energy.
Futures + basis
WTI or Brent crude oil + differential
The basis reflects location and quality differences. The differential reflects the cost of production for the particular resin plus a profit margin for the producer (oil or chemical company) plus a margin for the supplier.
In the energy markets, Formula 1 establishes the price of crude oil, gasoline, diesel fuel, natural gas, etc. in cash markets across the U.S. It provides complete price transparency and a means (futures transactions) to control prices - and, therefore, profits - for buyers and sellers alike. The basis is established at the front-end in supply contracts. There's no haggling over the absolute price, or unnecessary angst over the accuracy or fairness of price indexes.
With regard to resins, the challenges with Formula 1 are the illiquidity in resins futures and the fact that resins futures contracts only exist for polypropylene and polyethylene. (See this list of resins futures contracts.)
Formula 2 meets all the requirements for price transparency, fairness, and profit management. The oil market is as transparent, liquid, and forward-looking as any. WTI and Brent futures contracts provide multiple means to control prices (futures, ETFs, and, most helpful of all, options and options combinations), and they make sense as price markers for all resins. Resins are petrochemicals - derived from oil refining and processing. The exceptions are ethylene and ethylene derivatives that are also derived from natural gas. (See, for example, Dow Chemical.)
Suppliers and Processors Benefit
In my opinion, resins suppliers who offer fair and transparent pricing formulas like 1 and 2 will leap ahead of their competitors, and should be rewarded by processors for their innovation and flexibility. Resins suppliers will profit, increase sales, and have happy customers. As for processors, with Formula 1 and particularly Formula 2 pricing, they may easily control their resins costs with a wide range of hedging strategies, and, in turn, offer pricing choices to their customers (as discussed in 'Price Wise' over the last few weeks) and increase sales and margins.
If you're a processor, don't wait for your resins supplier(s) to offer you pricing choices. Ask for them. Suppliers who don't know how, may contact me at [email protected] for guidance. If you're a supplier, leap ahead of your competitors while securing profits, increasing sales, and helping your customers.
Much more to follow on this topic in 'Price Wise'...
About the author: Tom Langan is a risk management consultant who operates WTL Trading. He specializes in commodity cost control, margin improvement, and revenue expansion for manufacturers and their customers.