Last time, we discussed using the difference between a daily resin price (reported by PCW or TPE) and crude oil futures as a trigger for hedging forward resins purchases. The resin/oil difference (or spread) mimic the profit in producing the resin and, where commodities are concerned, profits typically normalize in a few weeks; so, spreads that mimic profits are good indicators of future price movements.
Time-to-wait saves 5 ¢/lb
A hedge is either a fixed-price financial or physical purchase or a protective purchase. (Doing nothing isn't a hedge, but it is a valid decision based on the resin/oil spread.) What is a protective purchase? For processors, it's insurance against resin prices moving higher than expectations or an acceptable level (e.g. the price required for a minimum profit margin). In crude oil and other commodities futures, insurance against higher prices are call options. For a premium (hence, insurance) related to the term and strike price of the option, a call option gives the buyer the right (not obligation) to buy a commodity at the strike price on or before the expiration of the option. Call options are preferred hedging tools of most risk managers because they limit (or cap) upside price risk for much less capital and risk than outright purchases. More important, price caps give a buyer time to wait coolly for a lower price since a price cap protects against the market moving higher while the buyer waits. In the volatile resins markets, I estimate such time-to-wait for a lower price could save processors 5 ¢/lb or more in resins costs.
Oil is good, resins are best
Resins call options are not available in the OTC or futures markets. So, processors who want to cap their resin price risk must buy the next best thing: crude oil call options. The good news is call options in crude oil futures and ETF's are readily available and liquid, and they offer plenty of choices for the most capital-constrained and risk-averse processors. The not-so-good news is that, even though resins and crude oil prices are highly correlated (80-85%) over the medium to long term, they don't necessarily correlate well in the short term (next week to next month). Resins price caps are best to manage short-term risk, but where can you get them? Call a friendly, service-oriented, and sales-driven supplier. He may provide them, to your and his benefit.
What might resins price caps look like?
Resins price caps would be similar to price caps in other commodities. I recommend a contract volume of 10,000 pounds and strike prices that settle against an average of daily prices over a calendar month. PCW provides daily prices that the CME uses to settle its calendar swap futures in polypropylene and polyethylene. If PCW prices are good enough for the CME, they should be good enough for OTC resin price caps. For the more adventurous and those with purchase contracts that settle against the more widely subscribed CDI monthly index, resins price caps could also settle against that index. However, being a one-time price and, therefore, more volatile than a monthly average, price cap premiums for a CDI-settled price cap would be higher.
It's clear processors will benefit strategically and economically from resins price caps, but what about suppliers? Here's a list of benefits:
- Additional revenue
- Selling covered calls and decaying assets
- Easy to manage
- Customer satisfaction
- Competitive advantage, new customers
- No credit risk (price cap premiums must be paid up-front)
- Leading edge reputation
Understand how price caps work and how they will help you control resins price risk and reduce costs. Then, contact your suppliers and determine their willingness to design and offer them at fair market prices that you can calculate or estimate. If your suppliers are not willing to work with you, contact other suppliers. You process resins to make a profit, and resins price caps will help ensure and insure that you do just that.
At-the-money and near-the-money price caps for PE and PP in 1Q2013
About the author: Tom Langan dba WTL Trading is a risk management consultant. He helps manufacturers control resins and other commodities costs, increase revenues, and secure profit margins. Email Tom at [email protected].